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The delicate leverage balance

balance

Once upon a time in the land of dancehall, a ‘bad man’ by the name of Cutty Ranks got our attention with his song introduction, six million ways to die, choose one. Suffice to say, the song became a 90s classic and arguably expanded it into a genre of its own.

Relating to the subject as an investor, here’s some dark humour: do you know how an investor commits suicide? He climbs on top of his ego and jumps off. Sorry, it’s a rough way of saying be careful of overconfidence. Another way traders and investors alike get killed is over-leverage.

In fact, over-leverage alone has necessitated several industry reviews globally with sweeping outcomes.

A case in point is the announcement by the Australian Securities and Investments Commission (ASIC) in 2020 to reduce forex leverage from 500;1 to 30:1 (for major currency pairs) and 20:1 for exotic and minor currency pairs - a whopping 94 percent reduction.

The same has been witnessed in the United Kingdom, Japan and the wider European region in recent years.

In a sign of a growing trend, the big question is; will the Capital Markets Authority (CMA) bring its regulations in line with protections in force in comparable markets elsewhere?

First off, it’s important to understand why these decisions are being made. Most regulators have been worried at the high levels of loss ratios in the industry. I am sure you’ve come across this disclaimer; over 80 percent of traders who trade currencies and contracts for differences (CFDs) lose their money.

This was highlighted during the Covid-19 pandemic period when heavy losses were sustained by highly leveraged retail clients owing to extreme market volatility.

Resulting interventions helped curb this. Overall, there has been a reduction in the size and speed of retail clients’ CFD losses like in the case of Australia. Since limiting leverage to 30:1 back, the industry has so far witnessed a 91 percent reduction in aggregate net losses by retail client accounts.

In addition, there have been 51 percent fewer loss-making retail client accounts per quarter on average. This is huge considering most regulators' main mandate is to protect retail investors.

But are product interventions the only way? Are they long-term effective? I take note that the industry has voiced concerns against tighter regulations. Chiefly, the reduction of leverage may negatively impact the appeal of forex trading and could lead to a further decrease in customers.

A case in point is that when the Financial Conduct Authority (FCA) introduced leverage caps in the UK, local brokers saw a 6.7 percent decline in net income.

Suggestions such as deepening investor education have been mentioned as an alternative to revising down leverage limits. Others include upping minimum account deposits.

In the end, at 400:1, Kenya has one of the highest leverage offers compared to markets such as Japan, the UK, the United States, Canada and Cyprus but considerably lower to the wild wild west South Africa.

The rainbow nation is the only well-known regulated market where brokers offer higher leverage at 1000:1 and without any negative balance protection.

In the event CMA goes ahead to reconsider its leverage limits, the decision to cut or not to cut will have to be a well-considered one. If this happens, I have full trust in the regulator to make the right judgement.

The writer is managing director, Canaan Capital