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Margin in the 21st Century

Margin in the 21st Century and the New Role of Brokers

Margining has historically been one of the traditional sources of income for the capital markets. When brokers purchase an asset, they sell it for a higher price. This price difference is the margin.

Margining, in its traditional form, was simple. The client would instruct the broker on the phone. They, in turn, would coordinate with the bank or the investment services provider. Finally, the broker adds their own margin on top when reporting the price back to the client. Once the markets became primarily electronic, traders could follow prices through their own platforms around the clock. Consequently, this type of activity took a back seat.

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It didn’t completely disappear. Instead, the process changed. People no longer trade over the phone in the era of modern markets. Now they place their trades themselves through their own system. In turn, Brokers had to find a way to automate margining, giving birth to a new speed-based system.

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Margin and High-Frequency Trading Systems

Most retail trading systems show prices fluctuating in 0.5-1 second periods. The size & interval of these changes on the actual markets is much smaller, especially in currencies. It’s to the point where it becomes difficult to display. Furthermore, while currency pairs previously used to be calculated up to the 4th decimal, they can go up to the 5th or 6th decimal today. This is due to both the higher trade volume as well as the increasing sophistication of trading systems. This is especially true in dealings between banks & brokerages. They go as far as locating their servers as close as possible to those of their clearinghouses to decrease execution speed, even if it’s just by a few microseconds.

One second is a million microseconds. The execution time of the quickest systems is approximately 0.0025 seconds or 2,500 microseconds. In practice, this means that when the trader places an order for $100,000 USDJPY at say 109.73, it’ll only be updated a second later. On the other hand, the execution system sees 109.7255 and has 0.9975 seconds to determine what price the trader will receive.

How the System Works in Practice

To get a better idea of the difference in magnitude, imagine a hypothetical task that could be completed in one day. In this case, the system has 399 days to fulfill its obligation towards the trader, meaning it can decide whether to purchase immediately or wait for a better price. Following the earlier example, most systems would decide to purchase at 109.7255 then sell to the trader for 109.73. That’s how the system effectively margins the trader. Although 0.0045 or 450 yen (4 US dollars) may not seem like much, the currency market has a daily volume of approximately 5.3 trillion USD. Margining that amount by just 0.00002 points would result in a profit of 106 million dollars, free of risk.

That level of income more than justifies the development costs of a system to facilitate it. It’s worth noting that while this setup seems like it’s designed to profit at the user’s expense, it actually has a lot less impact on the trader than one would assume at first glance. For one thing, it’s not something that would necessarily influence the decisions of retail traders. That’s because they’re already dealing with spreads, commissions & other costs that merit much more consideration. Instead, it’s more like a tug of war between the banks and the brokers. Faster systems will naturally earn more than slower ones, leading both sides into a kind of arms race since that’s where they have the highest profit potential.

The incredible expansion in the size & scope of trading brought with it the appearance of High-Frequency Trading systems. These HFT systems are responsible for the majority of market turnover. They are the subject of much dispute. However, that’s a topic for another time.