Risks of running a brokerage firm

03 Apr 2021

The big news from last week was the blow-up of a leveraged hedge fund Archegos & how it caused $billions in losses to its bank/broker. A primer to what it means to be a brokerage for such trades, the risk to reward, and more.

Being a broker is almost like running an insurance business, you keep earning brokerage income (like premium) & are always one black swan or mega volatile day away from giving it all back and more if one large client or many small clients default at the same time.

For all those who don’t understand, when customers trade with leverage or trade by keeping a portion of the value of trade as margin, if the customer loses more money than the margin, that is on the broker.

Unlike equity delivery trades where the customer would have given full money before the trade and brings no risk, with intraday and F&O every trade brings a little bit of risk to the broker.

The risk of such blow-ups causing brokers to lose large amounts of money is lesser if the customers are retail where the risk from individual customers is much lesser as compared to HNIs/Institutions who take large positions.

The broker has to make sure that the earnings compensate for the risk being taken. Very similar to insurance businesses taking a premium every time they cover a risk. Higher the risk, the higher the premium/brokerage.

For the same reason, like you can’t get an insurance policy without paying a premium, I don’t think you will be able to trade speculative positions (intraday, F&O) without brokerage, unless of course if some VC/PE decides to bankroll this in the future. :)

Btw, the chances of an Archegos happening in India are much lesser than in the US because our regulations ensure that all types of derivatives can trade only on the exchange and there is a restriction on how much leverage can be taken/offered.

If you aren’t aware of the Archegos episode, check this from Finshots.

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