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Highwire act

Regulators look to rein in high-risk stock trading

By Paul Voosen
Staff Writer, The Prague Post
March 14th, 2007 issue

Competition isn’t always what it’s cracked up to be.

Take the Czech Republic’s brokerage firms, which jockey to invest huge amounts of their clients’ money on the bullish Prague Stock Exchange (BCPP) using high-risk trading.
“Their competition is driven not by their quality of service, quality of research or price of execution,” said Petr Koblic, director of the BCPP. “Instead, it’s a hunt to offer the riskiest leverage.”
Over the past five years, the Czech Republic has seen a huge upswing in the number of investors using loans to drastically increase their stock returns. Margin trading, as the practice is called, is more popular here than anywhere else on the Continent, Koblic said.
The competition among brokers to offer ever higher margins and returns to their clients is making the stock exchange too volatile, according to the BCPP and the Czech National Bank (ČNB). Some form of regulation is needed, whether it comes from the exchange, the government or brokers themselves.
The bank and the exchange are now in talks on how such regulation can be best achieved, whether through legislation or voluntary rules imposed by investment firms.
Brokers are skeptical.
“There’s no need for regulation of margin trading, since it doesn’t present a risk to the broker,” said Tibor Bokor, an analyst at the Wood & Company brokerage.
Herbert Krpeš, an analyst at Patria Direct, disagrees.
“Reform is needed,” he said. “Some investment companies are preying on the innocence of their clients.”
New leverage
Once the stock market stabilized and began steadily growing several years ago, it was natural that some sort of leveraged trading would become popular: Confidence in the economy and years of projected growth meant investors could cash in on a bull market.
Brokers working on the BCPP adopted margin trading because it is easy for individual investors to understand, and the BCPP was not yet outfitted to handle more complex types of leverage trading, such as futures.
“Margin trading is not about how much money you have,” said Jan Schiesser, chief economist at Atlantik, one of the country’s largest brokers. Some Atlantik clients only have 100,000 Kč ($4,660) invested in margins; others, tens of millions.
“It’s about how much experience you have investing” and how well you manage your risk, he said.
Simply put, margin trading allows investors to buy more stocks by using loans from their broker. The Czech Republic lacks regulation over what percentage of an investment can be footed by a loan, meaning that a broker could provide, say, 90 percent of a stock purchase to the investor’s 10 percent.  
This amplification of purchasing power allows huge gains when the market is booming. But, as the broker’s share increases, so does the risk of losing your shirt: If stocks bought through margins drop by the percentage of the client’s collateral, brokers have the right to immediately sell the stock so they don’t lose their loan. Meaning that, in the example above, if the stock dropped 10 percent, you’d lose all your money.
As smaller brokerages set the minimum required percentage of the client lower and lower, the stock market becomes increasingly volatile. A steep one-day drop could come faster than some brokers could handle, putting them out of business and causing clients to lose it all.
The ČNB and BCPP don’t want to see this, and want to mandate the minimum percentage of a stock purchase that must be bought with the investor’s money. They haven’t agreed on a number, but it could be anywhere from 15 percent to 30 percent, said Jiří Opletal, deputy director of the BCPP — well above the cut-rates offered by some small brokers.
Also necessary is promptly updated public information on how many of the PSE’s stocks are controlled through margins, said Pavel Zúbek, spokesman for the ČNB. The PSE does not track this. If it did, then brokers could calculate their own risks and use margin trading more responsibly.
Unfortunately for the ČNB and BCPP, they can’t simply institute new rules on the stock exchange.
“This is not only about regulating members of the stock exchange,” Opletal said. Smaller brokers trade on the BCPP without becoming members and can’t be regulated.
That’s why government involvement may become a necessity if brokers don’t step up and come to a mutual agreement on controls. And that seems a doubtful possibility.
“In principle, we’re not against regulating margins,” said Schiesser of Atlantik. “But these regulations must apply to all market participants.”
Regulating only the larger brokers, those most responsible for managing the market and maintaining its liquidity, would not make any sense, Schiesser said.
He expects that the current talks between the ČNB and BCPP will lead nowhere. The two institutions made noises over the past two years about regulation, but have not come up with anything, Schiesser said.
That’s unfortunate, because the business could use some reform, particularly in the way brokers educate their clients on the risks of margin trading, according to Atlantik and Patria Direct. Currently investors are only required to answer a questionnaire, then are free to invest their life savings.
Atlantik repeatedly warns its clients about the risks. But smaller firms may not be so frank, Schiesser said.
Futures rising
One question overshadowing margins is how much longer they’ll remain a viable investment option in the Czech Republic. Throughout most of Europe, another type of trading, in futures, has replaced the margin business, said Koblic.
The BCPP is a bit behind, having only launched a derivatives market in October. Investors have yet to take much notice, with the volume of futures traded disappointing, Schiesser said.
“It’s going to take a couple of years before futures become important,” he said. It took Poland three years for the volume of futures to surpass margins. But they did, and will likely do the same in the Czech Republic.
One certainty is that, as long as the economy is booming, leveraged trading will remain, making money for bold investors.
“With the bull market and low interest rates, demand for leveraged products will continue,” Bokor said. “And margin trading is going to be one of the most popular options.”

Paul Voosen can be reached at pvoosen@praguepost.com


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