As investors, we take leverage for granted, but as we saw with the September 2022 gilt crisis, it can have severe consequences. While leverage is vital for an online trader/day trader, as a means of maximising their exposure and, hopefully, their profits, there are several factors to consider.
Mini-budget 2022
Whether a day trader or medium/long-term investor, you willlikely be aware of the impact the September 2022Conservative budget had on money markets. In a perfect example of how leverage can work against stock markets, this highlighted the issues associated with what are known as Liability Driven Investments (LDI). In simple terms, because pension funds need to maximise their assets in the short term to avoid accounting deficits, they were forced to leverage their short-term investments.
Akin to a day trader using a margin account, they invested in specialist LDI funds with exposure to gilts. Due to the use of financial instruments to create leverage, every 1 pound invested into these specialist funds created exposure equivalent to 3 pounds. Of course, the pension schemes needed to lodge collateral to support their leveraged position, but this seemed a viable option before the mini-budget.
Leverage working against the market
In the days after the mini-budget, we saw a sharp spike in long-term gilt rates which set in motion a self-fulfilling prophecy few had predicted. As gilt prices fell and yields increased, pension funds were forced to lodge more and more collateral. Their most liquid assets were gilts, which they were forced to sell, pushing prices lower, and yields higher which resulted in the need for more collateral. Very quickly, we had a self-fulfilling prophecy, a vicious circle emerging, which only ended when the Bank of England effectively became the buyer of last resort for long-term gilts.
While the increase in gilt yields in the aftermath of the mini-budget was unprecedented, it does show the challenges of leverage. Several unconnected issues came together, new accounting practices, greater use of gilt LDI funds, and a sharp increase in gilt yields. To say this will never happen again would be foolish, but we should probably expect both accounting and regulatory changes in the future.
Different types of leverage
Online traders and day traders will be well aware of the different types of leverage available, which include:-
• Bank borrowings
• Margin accounts
• Trade options
• Futures
• EFT options
Whether your leverage is 1:5, 1:10 or 1:30, the idea is simple;maximise your gains while limiting your losses. It is difficult enough to predict index and asset price movements in the long term, never mind on a day-to-day basis. While day traders will focus on the positives of leverage they are still acutely aware of the dangers.
Leverage, liquidity and regulations
In reality, leverage has always been a part of financial markets, business markets and personal finance. The currentlevel of liquidity would be slashed if investors had to fully fund all investments. Collateral connected to margin accounts ensures sufficient protection to maintain market integrity. This is the key to the long-term success of leverage and liquidity because, without it, there would be less confidence and less trading, which would then filter down into the economy.
When it comes to restrictions, the various regulators across the globe are only too aware of the importance of leverage. While these issues are reviewed regularly, as new instruments and trends emerge, leverage will never be outlawed. The impact on liquidity would be dramatic, drastically reducing normal dealing sizes.
Conclusion
The concept of leverage is the same for a pension fund looking to maximise short-term assets using LDIs as it is for a day trader looking to introduce a degree of "gearing". The current structure is built around trusted settlement parties, with sufficient collateral lodged, and the system has worked well for hundreds of years. While the LDI issue, in light of the UK mini-budget, may have been a “one-off”, it does show the potential dangers of leverage.