The role of margin calls in market downturns
The macroeconomic factors driving the current market downturn are clear to all: inflation, rising interest rates and geopolitical uncertainty. But there are other forces at play that don’t receive the same attention. One of the biggest of these is margin financing.
Margin debt refers to money borrowed by investors to purchase stocks, which then act as the collateral for the loan. It’s a tactic that can multiply gains – and losses – by allowing investors to take bigger positions than they could otherwise afford. Notably, surging levels of margin debt have historically been a strong indicator of an over-exuberant market, and therefore also a leading indicator of a coming crash.
Buying on margin magnifies market fragility
For investors, the fear of missing out on further gains is particularly powerful in the late stages of a bull market, making investors willing to take on more risk in search of greater rewards. Margin-fuelled buying helps take the market to new highs. When margin debt levels become very large compared to the historical average, however, the market becomes more fragile.
When the tables turn in such a scenario, even a small decline in the value of the stocks bought on margin can lead to brokers demanding investors deposit more funds into their trading accounts to cover the shortfall. These so-called margin calls are often funded by selling holdings, which can accelerate the market’s decline when sentiment turns bearish.
In some cases, investors unable to satisfy margin calls are subject to forced liquidation – as happened in the 2021 collapse of hedge fund Archegos. Large-scale forced liquidation leads to fire sales that can have destabilizing knock-on effects for portfolios and whole markets. The collapse of Long Term Capital Management in 1998 is another classic example.
Margin debt surges ahead of market crashes
The market crashes following the dotcom bust of 2000 and the 2008 financial crisis were both preceded by surging levels of debt. This time around, margin debt for US stocks reached an all-time high of $936 billion in October 2021 – up 95% from March 2020, when the market was briefly roiled by the advent of the Covid-19 pandemic, before embarking on a heady bull run.
With interest rates rising, the cost of financing these positions is now increasing. This, along with falling prices of equities, has led to sizable margin calls: the most recent data from the Financial Industry Regulatory Authority (FINRA) showed that US margin debt had dropped 27% by June 2022 from the October peak. Though the margin debt overhang has become less severe, it has far from disappeared. Following the previous two market crashes, margin levels shrunk by at least 50% before the S&P 500 began recovering.
Though there is no guarantee that the equity markets will follow that pattern again in the second half of 2022, investors should be aware there is a good chance that margin debt levels could decline quite a bit further before the market stabilizes. The one thing that is clear is that the euphoria stage marked by surging margin debt levels is well and truly over.
Prescription for stability
During periods of market turbulence, investors generally fare better by taking the long view and holding onto positions rather than selling and returning to the market at some point in the future. Several studies show that historically, time in the market beats timing the market.
The typical margin loan, however, often makes that strategy impossible: investors who cannot top up the value of their collateral immediately are at risk of forced liquidation.
In contrast, longer-term securities-based financing offers a more stable source of capital, allowing investors to raise funds for investments and other purposes without sacrificing the upside potential of their core holdings.
With EquitiesFirst’s approach to securities-based financing, accredited investors, sophisticated investors, professional investors, and otherwise qualified investors (who have sufficient knowledge and experience in entering into securities financing transactions) are protected from rising interest rates and from forced liquidation by more favorable terms than those typical in margin financing.
EquitiesFirst’s prudent approach to risk management has enabled it to navigate all market conditions over the past 20 years while protecting the interests of investors and the broader markets. The peace of mind offered by that approach becomes especially valuable in times like these, when heightened economic and geopolitical uncertainty means that little else is certain.
Past performance does not guarantee future returns, and individual returns are not guaranteed or warranted.
This Document is intended solely for accredited investors, sophisticated investors, professional investors, or otherwise qualified investors, as may be required by law or otherwise, and it is not intended for, and should not be used by, persons who do not meet the relevant requirements. The content provided herein is for informational purposes only and is general in nature and not targeted to any specific objective or financial need. The views and opinions expressed in this Document have been prepared by third parties and do not necessarily reflect the views and opinions of EquitiesFirst. EquitiesFirst has not independently examined or verified the information provided herein, and no representation is made that it is accurate or complete. Opinions and information herein are subject to change without notice. The content provided does not constitute an offer to sell (or solicitation of an offer to purchase) any securities, investments, or any financial products (“Offer”). Any such Offer shall only be made through a relevant offering or other documentation which sets forth its material terms and conditions. Nothing contained in this Document shall constitute a recommendation, solicitation, invitation, inducement, promotion, or offer for the purchase or sale of any investment product by First Holdings, LLC or its subsidiaries (collectively, “EquitiesFirst”), nor shall this Document be construed in any way as investment, legal, or tax advice, or as a recommendation, reference, or endorsement by EquitiesFirst. You should seek independent financial advice prior to making an investment decision about a financial product.
This Document contains the intellectual property of EquitiesFirst in the United States and other countries, including, without limitation, their respective logos and other registered and unregistered trademarks and service marks. EquitiesFirst reserves all rights in and to their intellectual property contained in this Document. The Document should not be distributed, published, reproduced or otherwise made available in whole or in part by recipients to any other person and, in particular, should not be distributed to persons in any country where such distribution may lead to a breach of any legal or regulatory requirement.
EquitiesFirst make no representation or warranty with respect to this Document and expressly disclaim any implied warranty under law. You acknowledge that EquitiesFirst is not liable under any circumstances for any direct, indirect, special, consequential, incidental, or punitive damages whatsoever, including, without limitation, any lost profits or lost opportunity, even if EquitiesFirst has been advised of the possibility of such damages.
EquitiesFirst makes the following further statements that may be applicable in the stated jurisdiction:
Australia: Equities First Holdings (Australia) Pty Ltd (ACN: 142 644 399) holds an Australian Financial Services Licence (AFSL Number: 387079). All rights reserved.
The information contained on this Document is intended for persons located in Australia only and classified as a Wholesale Client only as defined in Section 761G of the Corporations Act 2001. The distribution of information to persons outside this criteria may be restricted by law and persons who come into possession of it should seek advice and observe any such restriction.
The material contained in this Document is for information purposes only and should not be construed as an offer or solicitation or recommendation to buy or sell financial products.
The information contained in this Document is intended to be general in nature and is not personal financial product advice. Any advice contained in the Document is general advice only and has been prepared without considering your objectives, financial situation or needs. Before acting on any information, you should consider the appropriateness of the information provided and the nature of the relevant financial product having regard to your objectives, financial situation and needs. You should seek independent financial advice and read the relevant disclosure statements or other offer documents prior to making an investment decision about a financial product.
Hong Kong: Equities First Holdings Hong Kong Limited is licensed under the Money Lenders Ordinance (Money Lender’s Licence No. 1780/2022) and to carry on the business of dealing in securities (Type 1 licence) under the Securities and Futures Ordinance (“SFO”) (CE No. BFJ407). This Document has not been reviewed by the Hong Kong Securities and Futures Commission. It is not intended as an offer to sell securities or a solicitation to buy any product managed or provided by Equities First Holdings Hong Kong Limited and is only intended for persons who qualify as Professional Investors under the SFO. This document is not directed to individuals or organizations for whom such offers or invitations would be unlawful or prohibited.
Korea: The foregoing is intended solely for sophisticated investors, professional investors or otherwise qualified investors who have sufficient knowledge and experience in entering into securities financing transactions. It is not intended for, and should not be used by, persons who do not meet those criteria.
United Kingdom: Equities First (London) Limited is authorised and regulated in the UK by the Financial Conduct Authority (“FCA”). In the UK, this Document is only being distributed and made available to persons of the kind described in Article 19(5) (investment professionals) and Article 49(2) (high net worth companies, unincorporated associations etc.) of Part IV of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (‘’FPO’’) and any investment activity to which this presentation relates is only available to, and will only be engaged in with, such persons. Persons who do not have professional experience in matters relating to investment or who are not persons to whom Article 49 of the FPO applies should not rely on this document. This Document is only prepared for and available to persons who qualify as Professional Investors under the Markets in Financial Instruments Directive.