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The Margin Investor

Is Portfolio Margin Dangerous? Required reading for brokerage firm employees.

5/11/2012

15 Comments

 
I recently came across a highly insightful 2010 working paper out of the University of Sydney Business School entitled "Portfolio Margining: Strategy vs Risk" by E.G. Coffman, JR & D. Matsypura & V.G. Timkovsky.

The paper explores a number of different ideas including the riskiness of regular Reg-T margin versus Portfolio margin, the impact that the Portfolio Margin Pilot program may have had in terms of contributing to the stock market crash of October 2008, and the authors' belief that strategy-based margin has been unfairly discredited as a result of misinformation about the computational complexity of the strategy-based margining problem combined with the general bias towards heuristics by those (typically of the lawyer mindset) setting strategy-based margin rules.

Here is the abstract for the paper: 
This paper presents the results of a novel mathematical and experimental analysis of two approaches to margining customer accounts, strategy-based and risk-based. Building combinatorial models of hedging mechanisms of these approaches, we show that the strategy-based approach is, at this point, the most appropriate one for margining security portfolios in customer margin accounts, while the risk-based approach can work efficiently for margining only index portfolios in customer margin accounts and inventory portfolios of brokers. We also show that the application of the risk-based approach to security portfolios in customer margin accounts is very risky and can result in the pyramid of debt in the bullish market and the pyramid of loss in the bearish market. The results of this paper support the thesis that the use of the risk-based approach to margining customer accounts with positions in stocks and stock options since April 2007 influenced and triggered the U.S. stock market crash in October 2008. We also provide recommendations on ways to set appropriate margin requirements to help avoid such failures in the future.
The paper is quite advanced and may not be accessible to the average reader. However, for the technically inclined reader, the paper is definitely worth a read as it contains thought provoking examples of how Portfolio Margin can cause a pyramiding of debt under certain plausible market scenarios. 

So what does this all mean? Admittedly, not that much for the average investor. 
However, this paper and the concepts it contains should be read and mastered by anyone who works in margin and risk control at a brokerage firm. I applaud the authors for their work. 

For your conveniance, I've included a copy of the paper below.
15 Comments
Vadim Timkovsky link
5/14/2012 05:08:22 pm

Thank you for your interest to our paper. It is very pleasant to know that there exist people (exept the authors) who undestand what the paper says.

Reply
Jason Apolee link
5/15/2012 01:59:44 am

Hi Vadim,
I thought the paper was very good and very relevant. I sure hope the senior folks in brokerages are able to grasp the concepts described in you paper. By the way, did you submit the paper to the FAJ? It seems like an abridged version would fit really well into that journal.

-Jason

Reply
Vadim Timkovsky
5/21/2012 06:00:20 am

Jason,
Thank you for your second response. Unfortunately, the paper has been rejected by many journals (finance and operations reaserch). We received absolutely ridiculous reviews. It seems people do not understand what we are talking about. Finance people are confused by the absence of stochastic models, OR people say that this is for finance journals. So, we are somewhere in between. We already published some parts of this paper in OR journals but as a whole it remains just a working paper. It is interesting that I passed this paper to the SEC, and they put it in their website: www.sec.gov/comments/s7-08-09/s70809-3727.pdf.
But nobody cares. Thank you for your advice about FAJ. May be we should submit. I should also say that you are the first to understand the pyramids. All the reviewers of the journals that rejected the paper even did not reach this section.
Best regards,
--V

john s piscotty link
8/31/2020 11:42:29 am

Would you pls send a copy of your paper on "iis portfolio margin
dangerous".
Many thanks,
John Piscotty

Reply
Vadim George Timkovski link
9/1/2020 03:05:45 pm

Please send me email vgt777@yahoo.com

Jiju Kurian
9/6/2012 10:36:30 pm

Hi Vadim,

Missing your lectures in operations and missing interacting with you. Who is going to help me develop a mathematical culture now?

All the very best,

Jiju

Reply
Vadim Timkovsky
12/3/2012 09:47:10 am

Hi Jiju,
Have you been my student? Where did we meet and when?
Best regards,
--V

Reply
Vadim Timkovsky
12/3/2012 09:54:53 am

Now I remember: you are from Kazakhstan, and you attended my lectures at the University of Sydney. Right?

Reply
Vadim Timkovsky
2/28/2013 12:30:57 pm

I devoted 5 years of my career on studying the difference between the strategy-based (Reg T) and risk-based (which is also called portfolio margin) approaches to margin calculations. There is a big misunderstanding of portfolio margin. This is a fragment from my article:

"The risk-based approach also appears in margin regulations and business-related literature under the names ``portfolio margining approach'' and ``risk-based portfolio margining approach''. The argument standing behind the term ``portfolio'' is based on the misrepresentation of the strategy-based approach as a treatment of a margin account by considering individual positions only, while the ``portfolio approach'' treats a margin account as a whole. This is absolutely not true. The strategy-based approach also treats a margin account as a whole; although it does so in a different way, it is also a portfolio approach."

Of course, the risk-based (i.e., portfolio margining) approach is much more attractive for investors in comparison with the strategy-based (RegT) because it gives much more credit. However, it is the same trap as the excessive credit for mortgages.

My analysis shows that the "portfolio margin" approach became the main reason of the stock market crash of October 2008. The subprime mortgage crisis was NOT the main reason!

For example, buying a stock on "portfolio" margin requires only 15% down payment, while 10% down payment was required in 1929, and it was the reason of the stock market crash of 1929! Reg T requires 50% initial and 30% maintenance margin for stocks.

Just imagine the margin payment of, say 5%, for example. The stock market crash then will be within a months or two, for sure. I could place my article on this website but I do not know how to do that.

Finally, I would like to predict that a devastating market crash is coming this year or the very beginning of the next one because portfolio margin is still in effect. It is just enough to maintain $100K equity to qualify for portfolio margin, and all institutional investors qualify for this. To enter a short position under portfolio margin is so easy; you have to pay almost nothing but it is a trap.

Also please keep in mind that every individual investor entering the market now is actually entering the war between trading robots developed by institutional investors. It is a very risky and dangerous endeavor.

Reply
Usha
10/19/2014 12:57:42 pm

Vadim Timkovsky, how can I get a copy of your paper? Your thoughts on the impact of portfolio margin accounts is very interesting. Thank you

Reply
Vadim Timkovsky
5/23/2015 12:08:15 pm

Hi Ursha,
Please give me your email address, and I will send you my papers.
Best regards,
--Vadim

Reply
Usha
5/24/2015 06:56:31 am

Hi, my email address is usha.sharma626@gmail.com

usha
10/19/2014 01:01:08 pm

Reply
Nomadding Nina link
11/22/2020 07:10:53 pm

Nice bblog post

Reply
planos de saúde niterói link
1/6/2021 07:21:37 am


thank you for the blog, very good

Reply



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    Jason Apolee is a contributing editor to The Margin Investor where he focuses on news commentary and evaluating broker offerings.

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