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May 16, 2007

Leverage is Good

Some Firms and Clients Jump Out Early; Others Play Wait-And-See

By John Hintze

Despite the leveraging power and greater returns it potentially provides, portfolio margining has exited the gate at a trot, although Wall Street pros anticipate its pace will build to a steady gallop before long. Portfolio margining represents the biggest change to margin rules since the Securities Exchange Act of 1934, many say.

But since its arrival on April 2, most brokerage firms and their customers appear intent on easing into the new product, which gives investors significantly greater leverage and their broker-dealers much more risk to manage.

Some brokers-dealers, however, have aggressively sought a head start. Fimat USA, the U.S. affiliate of French banking giant Societe Generale, opened more than 50 accounts in the two weeks after receiving approval from the New York Stock Exchange on April 2. Eleven other broker-dealers were approved to begin offering the accounts on the same date.

Douglas Engmann, managing director for North American equities at Fimat, says the new account holders range from sophisticated individual investors to small and midsize professional trading groups and hedge funds. Many were existing customers that shifted over to portfolio margining accounts. These accounts require a regulatory maximum of 15 percent collateral for equities, compared with the 50 percent initial requirement under the Federal Reserve's Regulation T and the NYSE's 25 percent maintenance requirement thereafter. "On the hedge fund side, they're mostly volatility arbitrage investors or funds that actively use options in their portfolios," Engmann says.

Many trading groups that used joint-back-office (JBO) arrangements to increase their leverage potential have given up their broker-dealer licenses-necessary to participate in JBOs-in favor of portfolio margining accounts, Engmann adds. Fimat's early entry into offering portfolio margining accounts stemmed from its desire to gain experience in this new area. It was the only firm to pilot portfolio margining accounts holding broad-based indices, starting in December 2005. Fimat was also the only firm approved last fall to offer the accounts containing options and single-stock futures.

Greenwich, Conn.-based Interactive Brokers and New York's Merrill Lynch Professional Trading, a division of Merrill Lynch, also claim early success opening portfolio margining accounts. But giants such as Bear Stearns and Morgan Stanley, among the largest prime brokerage units, are easing more gradually into the new world of higher leverage and greater risk-management responsibilities. Morgan Stanley, for example, had yet to sign up any portfolio margining accounts by mid-April. James Barry, global head of margin services at the firm, says that besides the time-consuming legal necessities to open an account for each of a fund manager's funds, "most funds out there are getting the leverage they need through other vehicles."

Other Vehicles

Of course, Morgan Stanley's prime brokerage unit deals mostly with extremely large hedge funds, which have the resources to increase their leverage by setting up offshore accounts, establishing themselves as market makers or remote market makers, or using financing vehicles such as securities lending and swaps.

"When we speak to a prospect, portfolio margining is one of the solutions we offer," says Curt Richmond, managing director of sales for professional traders and broker-dealers at Merrill.