Should Retail Investors’ Leverage Be Limited?

Heimer, Rawley Z.; Simsek, Alp

doi:10.1016/j.jfineco.2018.10.017

Journal of Financial Economics 132 (3): 1–21

Should Retail Investors’ Leverage Be Limited?

Rawley Z. Heimer and Alp Simsek

Lead article. Best Paper Finalist in Asset Pricing, SFS Cavalcade.

Abstract. Does the provision of leverage to retail traders improve market quality or facilitate socially inefficient speculation that enriches financial intermediaries? We evaluate the effects of 2010 regulations that cap leverage in the U.S. retail foreign exchange market. Using three unique data sets and a difference-in-differences approach, we document that the leverage constraint reduces trading volume by 23%, alleviates high-leverage traders’ losses by 40%, and reduces brokerages’ operating capital by 25%. Yet, the policy does not affect the relative bid-ask prices charged by the brokerages. These results suggest the policy improves belief-neutral social welfare without reducing market liquidity.

Keywords: leverage limits, retail forex trading, Dodd-Frank, speculation, financial regulation, market liquidity, brokerages, difference-in-differences.

JEL codes: D84, G11, G12, G18, G24.

In brief

Capping how much leverage retail traders can use made them better off without harming market liquidity.

The paper studies 2010 U.S. rules that limited leverage in the retail foreign exchange (forex) market. The cap cut trading volume by 23%, reduced high-leverage traders’ losses by 40%, and shrank brokerages’ operating capital by 25%, yet brokerages did not raise the bid-ask spreads they charged. The authors conclude that the policy improved (belief-neutral) social welfare without reducing market liquidity.

**Table 1.** Study at a glance
Panel A. Design
Question	Does giving retail traders access to leverage improve market quality, or does it mainly fund speculation that enriches intermediaries?
Setting	2010 U.S. regulations capping leverage in the retail foreign exchange market
Data	Three unique data sets
Method	Difference-in-differences
Panel B. Reported effects of the leverage cap
Trading volume		−23%
Losses of high-leverage traders		−40%
Brokerages’ operating capital		−25%
Relative bid-ask prices charged by brokerages		No effect

Summarized from the paper. See the paper for exact estimates and specifications.

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Published version, Journal of Financial Economics
Working paper version, SSRN
Accepted manuscript (open access), MIT DSpace
Earlier version, NBER Working Paper 24176
DOI: 10.1016/j.jfineco.2018.10.017

Heimer, Rawley Z., and Alp Simsek. 2019. “Should Retail Investors’ Leverage Be Limited?” Journal of Financial Economics 132 (3): 1–21. https://doi.org/10.1016/j.jfineco.2018.10.017.

@article{heimer2019leverage,
  author  = {Heimer, Rawley Z. and Simsek, Alp},
  title   = {Should Retail Investors' Leverage Be Limited?},
  journal = {Journal of Financial Economics},
  volume  = {132},
  number  = {3},
  pages   = {1--21},
  year    = {2019},
  doi     = {10.1016/j.jfineco.2018.10.017},
  url     = {https://www.sciencedirect.com/science/article/pii/S0304405X18303076}
}

Topics: Retail investing and brokerage; Consumer protection and financial regulation
Related papers: Dynamic Inconsistency in Risky Choice: Evidence from the Lab and Field; Biased by Choice: How Financial Constraints Can Reduce Financial Mistakes; Peer Pressure: Social Interaction and the Disposition Effect; Friends Do Let Friends Buy Stocks Actively

In brief

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