My thoughts regarding IB safety and VIX products margin:
Brokers can fail for 3 reasons:
Re 2 - Due to IB’s automated business model, it is highly profitable even when offering one of the lowest commissions and rates in the market. Their overhead is small compared to both the gross profits they are generating, and their equity. During a market crisis, trading volumes would jump, increasing their profits, not decreasing it. Unless you think they are Enron and faking their accounts, the possibility of operating losses (excluding absorbed customer losses, see point 3) large enough to threaten their equity is essentially nil.
With reason 1 and 2 virtually impossible, IB is wise (and indeed, as customer, I expect them to) to control reason 3 so that no single event, instrument or scenario will cause their equity to be materially depleted.
One such scenario would be a sudden spike in VIX affecting all linked securities.
I strongly suspect that, with articles like https://www.nytimes.com/2017/08/28/business/dealbook/vix-trading.html (How to become a multi-millionaire shorting VIX products), the popularity of „short VIX“ trades in all variations has exploded, and to make matters worse, those accounts that do use the strategy seem to be essentially „all in“ on these trades. That would mean that there’s a fair amount of accounts that would go from a +50K account balance to a -200K balance in a heartbeat during a serious VIX spike. Or from a +2M balance to -5M… Think about that. Add all these potential losses together among IB’s customer base and you arrive at the potential loss.
And, I guess it is not just individual traders that are „blind“ to the risk as they do not look further back than over the recent, benign history. I guess there are also „professionals“ that know the risk full well, but they don’t care because they handle other people’s money in a limited liability structure. As long as things go well, they earn a percentage of profits to finance their lavish lifestyle. If things go bust, their investors will eat the loss up to the fund’s asset base, while the broker (and potentially you and me and it’s other customers) will have to eat the remainder.
That’s the situation IB is in. The popularity of these trades has skyrocketed so much that the potential aggregated loss to IB has crossed a certain threshold, and to their credit, they have acted before other brokers. The increase in margin is designed to (1) reduce the amount of customers who hold these positions and (2) reduce the concentration of these short vol positions in a customer’s account - both would lower the potential aggregated loss.
They are willing to forego short term commission revenue to protect their long term stability. Had every financial firm this kind of foresight and DNA, the financial crisis would not have happened.
The problem is that not every firm has the luxury to do that. If you only have a 5 percent profit margin and a high fixed cost base, you cannot afford to be conservative. You have to chase business, risks be damned. But if you have a 50 percent profit margin with a largely variable cost base, you can afford to take a long term view (you also have much more to lose, namely your fantastic business, if you don’t).
So IB’s margin increase re volatility products shows both their financial strength as well as their long term thinking.
(Please do not answer this with examples how IB miscalculates margin on certain instruments/ sides. I did not look at it in this detail. Obviously, margin should not be higher than maximum possible loss.)
Brokers can fail for 3 reasons:
- Losses or funding shortfalls on proprietary trading (this is what happened at MF Global)
- Operating losses of the business (this is what happened at PFG. Wasendorf essentially used customer cash to fund operating losses)
- Customer losses resulting in negative equity in their accounts, and the sum of negative equity account balances exceeding the firm’s own equity.
Re 2 - Due to IB’s automated business model, it is highly profitable even when offering one of the lowest commissions and rates in the market. Their overhead is small compared to both the gross profits they are generating, and their equity. During a market crisis, trading volumes would jump, increasing their profits, not decreasing it. Unless you think they are Enron and faking their accounts, the possibility of operating losses (excluding absorbed customer losses, see point 3) large enough to threaten their equity is essentially nil.
With reason 1 and 2 virtually impossible, IB is wise (and indeed, as customer, I expect them to) to control reason 3 so that no single event, instrument or scenario will cause their equity to be materially depleted.
One such scenario would be a sudden spike in VIX affecting all linked securities.
I strongly suspect that, with articles like https://www.nytimes.com/2017/08/28/business/dealbook/vix-trading.html (How to become a multi-millionaire shorting VIX products), the popularity of „short VIX“ trades in all variations has exploded, and to make matters worse, those accounts that do use the strategy seem to be essentially „all in“ on these trades. That would mean that there’s a fair amount of accounts that would go from a +50K account balance to a -200K balance in a heartbeat during a serious VIX spike. Or from a +2M balance to -5M… Think about that. Add all these potential losses together among IB’s customer base and you arrive at the potential loss.
And, I guess it is not just individual traders that are „blind“ to the risk as they do not look further back than over the recent, benign history. I guess there are also „professionals“ that know the risk full well, but they don’t care because they handle other people’s money in a limited liability structure. As long as things go well, they earn a percentage of profits to finance their lavish lifestyle. If things go bust, their investors will eat the loss up to the fund’s asset base, while the broker (and potentially you and me and it’s other customers) will have to eat the remainder.
That’s the situation IB is in. The popularity of these trades has skyrocketed so much that the potential aggregated loss to IB has crossed a certain threshold, and to their credit, they have acted before other brokers. The increase in margin is designed to (1) reduce the amount of customers who hold these positions and (2) reduce the concentration of these short vol positions in a customer’s account - both would lower the potential aggregated loss.
They are willing to forego short term commission revenue to protect their long term stability. Had every financial firm this kind of foresight and DNA, the financial crisis would not have happened.
The problem is that not every firm has the luxury to do that. If you only have a 5 percent profit margin and a high fixed cost base, you cannot afford to be conservative. You have to chase business, risks be damned. But if you have a 50 percent profit margin with a largely variable cost base, you can afford to take a long term view (you also have much more to lose, namely your fantastic business, if you don’t).
So IB’s margin increase re volatility products shows both their financial strength as well as their long term thinking.
(Please do not answer this with examples how IB miscalculates margin on certain instruments/ sides. I did not look at it in this detail. Obviously, margin should not be higher than maximum possible loss.)
