Should Retail Investors’ Leverage Be Limited?

The Harvard Law School Forum on Corporate Governance and Financial Regulation 2019-06-13

Posted by Rawley Heimer (Boston College) and Alp Simsek (Massachusetts Institute of Technology), on Thursday, June 13, 2019
Editor's Note: Rawley Heimer is Assistant Professor at the Boston College Carroll School of Management and Alp Simsek is Rudi Dornbusch Career Development Associate Professor of Economics at Massachusetts Institute of Technology. This post is based on their recent article, forthcoming in the Journal of Financial Economics.

Financial markets feature considerable speculative trading that can harm uninformed investors. Consequently, financial market regulators have long grappled with how to prevent investors from making harmful speculative trades, while preserving markets for useful trades. Leverage is a major catalyst for speculative trading. Our article examines the impact of leverage limits on the retail foreign exchange (forex) market. We find that leverage limits result in smaller losses for the most aggressive traders without harming market liquidity. Further, the policy improves belief-neutral welfare and reduces excessive financial intermediation. Our approach can be applied to other markets, and will be a useful framework for regulators as they try to curb speculation without impeding well-functioning markets.

The retail forex market is an ideal venue for our analysis because leverage limits in this market are new (introduced in 2010, compared to e.g. the market for U.S. equities, which has had a leverage limit of 2:1 since 1934). In October 2010, under the authority of the Dodd-Frank Act, the Commodity Futures Trading Commission (CFTC) capped the amount of leverage brokers can provide to U.S. traders at 50:1 on all major currency pairs and 20:1 on others. Meanwhile, European regulators did not impose any leverage limits, and the maximum leverage available almost always exceeded 50:1. These market features—time-series variation in available leverage and a suitable control group of unregulated traders—allow us to use a difference-in-differences design to evaluate the costs and benefits of the leverage-constraint policy.