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Message: <blockquote data-quote="sherlock" data-source="post: 10846849" data-attributes="member: 106046">Brokers Credit or Margin Credit – a necessary part of stock market tradingThe Securities Exchange Commission introduced a prohibition on Broker firms extending credit to clients. This was done to prevent overheating of the market with a possible bubble being created which when it bursts harms both the market as well as the economy.The SEC so acted because a significant segment of trading in the market was on the basis of credit extended by the broker firms. The broker firms did not have legal margin agreements but extended credit to clients informally. The clients assumed that they could buy on credit and sell whenever it is profitable for them to do so despite the settlement provision of T+3. The brokers did not force sell but allowed extended credit. Some broker firms charged interest while others even gave free credit. All this encouraged the clients to buy much more than their assets warranted. The broker firms took the risk but as the market was continuously going up they made light of the risk exposure.  This sort of situation prevailed in USA during the years before the Great Depression of 1929 and was a contributory cause to the stock market bubble of the late 1920s which led to the bursting of the bubble in 1929.The Colombo Stock Exchange had a rule that credit extended by brokers should not exceed 50% of the value of the client’s portfolio. Of course the portfolio value keeps changing with the changes in the market prices of the shares that constitute the portfolio.The Brokers were allowed to lend to a client up to 50% of the value of the portfolio. If the value of the portfolio fell the client was required to make up the value by depositing cash up to the value of the shortfall. The client was required to make good the shortfall within 24 hours. If he fails to do so the broker firm is required to sell such number of shares as necessary to bring up the 50% requirement. These rules of margin trading were not followed by the broker firms and they thereby took on the risk of the fall in market value of the portfolio. Some did not even conform to the Regulation. But the broker firms did not force sell at all. This sent the wrong message to the clients who borrowed. But this is an unstable situation and the broker firms were risking exposure to undue risks.Broker firms in other countries require an initial margin in cash of about 25% of the value of the shares they want to buy in addition to the maintenance margin of 50%.The SEC has now allowed broker firms to lend up to the value of the liquid assets they hold. These assets are defined in the annex to the circular. How many firms have already exceeded the value of their liquid assets? The extent of Debtors balances may have exceeded the liquid assets of some brokers. They would have to force sell unless they pump more cash to the company. The SEC calls it zero leverage. Will the broker firms be happy with the new rule? As I see it there are two problems. One is concerned with the financial stability of the broker firm which the SEC has addressed. The other is prudent lending to clients. The broker firms should at least enforce the 50% maintenance margin requirement and stop credit to clients whose debit balance exceeds the 50% value of the portfolio.</blockquote>

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