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The recent crisis surrounding liability-driven investing (LDI) strategies in the UK’s pension industry have cast light on hidden leverage in the financial system. With this in mind, we review traditional and new forms of leverage available to retail and institutional traders.
Borrowing leverage
Leverage isn’t the preserve of pension funds. Borrowing leverage, also known as margin trading, is the process whereby an investor borrows to invest in a financial instrument. Leverage is embedded within the foreign exchange markets, an asset class that has traditionally experienced low volatility.
For example, a retail investor looking to trade $100,000 worth of the EURUSD currency pair could open such a position with a low $200 deposit by opening an account with one of many high leverage Forex brokers. This would amount to a 1:500 leverage ratio. In return, the trader pays interest on any amounts borrowed on positions held open overnight, and agrees to maintain a certain level of collateralisation.
Of note, regulators in all developed markets have placed limits on the amount of leverage that Forex and CFD brokers can extend. In the UK and the European Union, leverage is capped at 1:30 across major currency pairs, and 1:20 across non-major currency pairs, gold and major equity indices. However, no such limits apply to brokers established in offshore jurisdictions.
Leveraged ETFs
Investors can also turn to leveraged ETFs in order to magnify their potential gains. These ETFs use borrowing and derivatives to deliver a return 2 or 3 times the daily change in their reference asset. Leveraged ETFs are available across the major indices and most sectors of the S&P.
Leveraged ETFs usually come in two forms: bull ETFs are positively correlated with their reference asset, and bear ETFs negatively so. In other words, leveraged bear ETFs make it possible to short their reference asset by going long. This could appeal to investors whose trading account prohibits shorting.
Importantly, these ETFs aren’t suitable for long term investors. Their return is marked-to-market at the close of every trading day, which means these ETFs will start the next trading day with a clean slate. It also means that their value tends to decay towards zero over long periods of time, regardless of the performance of their reference asset.
Notional leverage through options
Leverage isn’t limited to borrowing. It can also come in the form of notional leverage, whereby an investor opens a position in an underlying asset with only a fraction of that asset’s notional value. This is possible through derivatives, like options and total return swaps.
For example, the buyer of a $10 call option on a stock with a $100 strike price only needs to pay $10 upfront for the opportunity to acquire the stock once its price has risen above $100. This amounts to a 1:10 leverage ratio. The same also applies to buyers of a put option.
Options trading volumes on the S&P 500 have risen steadily since the depths of the pandemic, according to data compiled by the CBOE. And in the third quarter of 2022, S&P 500 options expiring within one day represented over 40% of total options volume, almost double the percentage recorded six months ago, according to Goldman Sachs.
Short dated options have the potential to deliver large profits or losses because of the manner in which options are priced. The shorter the time to expiry, the greater the change in an option’s price from changes in that of the underlying asset – this is known as an option’s delta.
Notional leverage through swaps
A total return swap is a contract between a seller of protection and a buyer of protection, over an underlying asset. The underlying asset may be a stock, stock market index or a bond.
In the case of a stock or stock market index, the seller of protection agrees to pay the buyer of protection regular interest payments based on a predefined rate, as well as any fall in value of the underlying asset. In other words, the seller of protection agrees to take on the underlying asset’s credit risk.
In return, the buyer of protection agrees to pay the seller of protection any return generated by the reference asset. In the case of a stock, or stock market index, the total return includes dividends and any price appreciation. In other words, the buyer of protection agrees to forfeit any market returns.
Hedge funds have emerged as major players in the market for total return swaps, as they enable them to get upside exposure without having to buy the underlying asset, thereby minimising cash outlays. In some cases, they’ve also been known to leverage even their initial investment.
In 2021, total return swaps enabled the Archegos Capital Management family office to build large positions in ViacomCBS and other publicly listed companies, without acquiring shares in the open market. However, Archegos eventually defaulted on margin calls issued by several investment banks to whom it had sold protection.
Once the banks realised how little cash Archegos held, they rushed to sell the shares they’d acquired through block trades. This brought about a 60% fall in Viacom’s share price over 3 trading sessions, the implosion of Archegos and billion dollar losses at Credit Suisse.
Conclusion
These losses are a reminder that leverage works both ways: it can magnify gains and losses. It can also cause investors to lose everything if their options expire out-of-the-money, or they’re unable to meet margin calls. As central banks continue to raise rates in their fight against inflation, some industry participants question where the next crisis will arise.
