Leverage is Good

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

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.

And customer interest in the accounts is on the rise. “In the last six months, most of our clients and many prospects have inquired about portfolio margining,” Richmond says, but there’s been less demand to make the jump. Nevertheless, Merrill has signed up three very large hedge funds and has several more in the pipeline. The current users, says Richmond, are major players in the options market, where portfolio margining provides the most significant collateral benefits.

The Chicago Board Options Exchange, which approved two broker-dealers to offer the accounts, provides some examples on its Web site of how significantly portfolio margining can reduce collateral requirements compared to traditional strategy-based margin rules.

In a short-call transaction requiring margin of $172,760 under traditional rules, the new requirement fell to $115,429; in a collar previously requiring $498,850 in margin, the new requirement plummeted to $37,538.

Options Play

That explains why broker-dealers with a forte in the options markets were quick out of the gate. Engmann formerly ran options market maker Preferred Trade, which was acquired in 2005 by Fimat, another major options player. Retail-oriented optionsXpress, based in Chicago, also received an early nod from the CBOE, its designated examination authority (DEA). And Interactive Brokers and Dallas-based Penson Worldwide, which clear for a large contingent of broker-dealers catering to day traders and smaller hedge funds, transact huge options volume, which is why they were among the 12 firms approved to offer portfolio margining.

Market makers and their clearing firms have a head start in the world of portfolio margining, as do large Wall Street firms with proprietary trading desks. They already used risk-based models to calculate their capital requirements. Risk-based capital methodologies closely resemble the Options Clearing Corp.’s Theoretical Intermarket Margin System (TIMS), the only risk-based model approved so far for portfolio margining. It requires users to stress-test portfolios’ values when the market increases or decreases by 15 percent, and at the 3 percent intervals between those points. The approach’s flexibility allows margin to be more accurately aligned with a portfolio’s risk, and represents a sea change from traditionally static and limiting margin rules.

With flexibility, however, comes more responsibility for broker-dealers, which must be self-clearing to provide the accounts. Not only must they have the systems in place to calculate portfolio margining requirements throughout the day in real time, but they must be sure their customers are fully aware of the additional risk more leverage represents and the new requirements they will face. “One of the key things for customers is, they will have less time to meet a margin call,” Morgan Stanley’s Barry says. He says the new rules require broker-dealers to take a capital charge on margin calls more than a day old, which will likely prompt them to require customer calls to be met right away, rather than two or three days later, as under the old rules.

Diversified Assets

As a result, the three DEAs that permit

portfolio margining-the CBOE, the NYSE and the NASD-have set up stringent approval processes. And there remain differences among broker-dealers about which clients are most likely to use the new accounts. At least initially, Morgan Stanley will offer portfolio margining only to its large hedge fund customers, requiring a $5 million account minimum. Steve Vermut, managing partner at New York’s Merlin Securities, says portfolio margining is most appropriate for investors with assets of at least a few hundred million dollars under management-large enough to allow for diversified assets.

“The requests we’ve received have come from the upper end of our client range,” Vermut says, adding that most of his firm’s prime brokerage clients manage between $75 million and $150 million in assets, with several approaching $1 billion.

Vermut anticipates making portfolio margining accounts available to clients by mid-May. Like other correspondent broker-dealers, Merlin is relying on its clearer-in this case, Bear Stearns-to have its systems ready. Bear plans to roll out the accounts to its correspondents shortly.

Penson has been ready since the get-go, preparing its systems in-house, according to Daniel P. Son, co-founder and president, but as of mid-April, no accounts had been launched. “We have correspondents with the paperwork in their hands to complete it, but nothing has come back yet,” Son says.

Getting Ready

One Penson correspondent, ChoiceTrade, is tweaking its own front-end trading system to introduce the accounts to its customer base. Its customers comprise active retail investors, as well as smaller registered investment advisers and hedge fund managers. Neville Golvala, chairman and CEO of the East Brunswick, N.J.-based firm, says customers have inquired about the new accounts, and while his firm hasn’t analyzed those customers’ portfolios, he believes they are relatively sophisticated investors with a range of securities in their portfolios. “The most usage will likely be by options traders or traders using options as a hedge,” Golvala says.

Other correspondent broker-dealers may have significantly longer to wait before they can offer portfolio margining to customers. Pershing, the largest clearing firm, with more than 1,000 correspondents-many of them servicing professional traders-is currently analyzing the technology and other requirements needed to offer its accounts.

Craig Gordon, president of RBC Dain Correspondent Services, in Minneapolis, says his firm has been monitoring portfolio margining developments closely. Gordon believes it will be important to offer the accounts-even necessary to remain competitive.


Given portfolio margining’s favorable collateral treatment for options and equities, the new accounts are anticipated to increase the use of those financial instruments. Merrill’s Richmond says portfolio margining will increase assets under management and trading activity. Consequently, hedge funds and broker-dealer market makers will be looking to hire additional “derivatives trading talent from the various trading floors and desks on the Street,” he says.

In terms of broker-dealers, however, the early bird may get the worm. Fimat’s efforts, for example, were driven in part by the opportunity to pull assets away from competitors-and that appears to be working. “We have a variety of smaller hedge fund clients who were not getting offshore leverage from their prime brokers, or their prime brokers were approved to offer portfolio margining, but haven’t yet,” Engmann says.