The recent surge in speculative retail trading poses a threat to the brokerage sector, but Canada’s more consolidated industry is less vulnerable, says DBRS Ltd.
In a new report, the rating agency said that the Covid-19 pandemic has been a “perfect storm” for increased retail trading.
“While a prolonged bull market has been a factor in increasing investor participation in the equity markets, the increased market volatility that began in early 2020, caused by the onset of the coronavirus pandemic, has spurred on the practice of trading individual stocks,” the report said.
A host of factors — including lockdowns that have curbed consumer spending and provided investors with more time to engage in trading; fiscal stimulus that has boosted disposable incomes; coupled with low rates that underpin a search for yield, and a prolonged bull market — are all conspiring to encourage retail trading, the report said.
Indeed, in 2020, the number of new discount brokerage accounts in Canada rose by 159% compared with the previous year, it noted.
The rise in retail trading has also led to a sharp increase in volatility for certain stocks, which can pose a threat to brokerage firms due to rising collateral and capital requirements.
“Any risk arising from irrational retail trading would be harmful to the online brokerage where these activities are taking place,” the report said.
Ordinarily, one troubled firm wouldn’t pose a systemic risk, but DBRS said a problem could arise “if multiple market participants were faced with rapidly increasing collateral requirements that they were unable to meet, potentially causing a systemic liquidity issue.”
The risk has been most evident in the U.S. where Robinhood Markets, Inc. had to raise US$3 billion to meet its collateral obligations, but DBRS warns that there is still potential for the same situation to occur in Canada.
That said, compared with the U.S., Canada’s online brokerage sector is more consolidated, and is largely controlled by the big banks. There are exceptions, such as Virtual Brokers and Wealthsimple Trade, but the Canadian market isn’t as competitive, or as frictionless as the U.S. market.
“While this can provide fewer choices for retail investors, an advantage of this arrangement is the potential availability of capital if the need unexpectedly arises,” the report said.
As a result, DBRS sees the threat in Canada as relatively modest.
“In DBRS Morningstar’s view, the likelihood of a default situation occurring in which a broker is unable to meet liquidity requirements is fairly low for Canada, given the ownership of most online brokerages by well-funded banks,” the report said.
“Nonetheless, as retail trading appears to continue generating interest, leading to more do-it-yourself traders and online brokerages to serve their needs, it becomes imperative that risk management practices at these firms consider this risk, especially in a more uncertain and volatile equity market environment,” it said.
Additionally, the continued buildup of the risks could eventually attract regulatory attention too, DBRS noted.
“If retail trading manages to disrupt the broader financial markets to a larger degree, it may catch the attention of regulators, possibly resulting in tougher regulation for small investors and brokerages,” the report said.