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Basel III Capital Requirements Affect You

The investor is beginning to feel the impacts of increased capital requirements under the Basel leverage ratio according to FIA President and CEO Walt Lukken in his testimony to the members of the U.S. House of Representatives.

The capital requirements simply mean that the futures commission merchants (FCM), banks, and broker dealers (BD) must maintain more money to help cover the positions held on behalf of their clients. The goal is to protect our banking industry, and our end investors.

As with all things, there may be unintended consequences. Consider the following:

You buy 100 contracts of jelly beans to be delivered in 6 months. You bought them on margin and that cost you 100 per contract in margin for a total of €10,000.  You have these funds on deposit and you paid your broker €100 for commissions on that position.

Your broker now has to put up €1,000 in additional funds out of their pocket to meet the capital requirement associated with this position.  This means that for €100 in commissions, the broker committed €1,000. The broker has lost the opportunity to invest their €1,000 in favor of you holding your position. Therefore, the broker only made 10% on that money.

The broker’s perspective differs. For that €100 in commission they have to cover their costs of running a business. The following shows a simplistic view of their operations.

+100   Commission charged to account holder       

 -20   Commission paid to sales person

 -20   Fees paid to the exchange

-20 BD operating costs

-20 Electronic trading vendor cost

 Total

 €20

 In other words, the broker has paid €80 in expenses to make €100 in commission.

€20 dollars in profit, right?  Not so fast. Let’s get back to the €1,000 that the broker has set aside to hold your position.   Where did your broker get the €1,000 to hold in reserve for your position?  The broker most likely got that from their bank. Their bank wants a return on their investment (loan) to the broker too.  Say the bank wants a 5% ROI.  

5% of €1,000 is €50 (per year).  This equates to €25 for the 6 months that you are holding your position in jelly beans.

For you to hold that position means that the broker has to lose €5. How long will a broker stay in business if everyone who holds a position cost them money? 

This example is very simplistic in order to highlight the challenges that BDs have in the new regulatory capital requirements.

What is a BD to do?

Simply put, a number of things are being discussed and even implemented. Consider some of the following steps that I am aware:

The biggest challenge is knowing enough about each and every client, trader, sales group, and more to be able to properly make informed decisions, and to move to suitable actions for the BD and client, including those shown above.

Other resources:

 

 

 

 

 

 

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