The Rise of Retail

The global capital markets are usually understood to be the domain of large pools of capital and institutions. Mergers and acquisitions are increasing the consolidation and concentration in the financial sector. While this is clearly one theme, there is a second one that runs in the opposite direction. For various reasons, there has been an increased role of individual and retail investors. While this may not be a universal phenomenon, there are several markets where the role of retail participants is noteworthy. This short note looks at two such markets: Chinese equities and the foreign exchange market.

Retail investors account for an estimated 60% of the turnover in the Chinese Shanghai stock exchange. In contrast, retail investors account for about 5% of the turnover in the US equity market, which is dominated by institutional players.

There are a number of forces at work. In addition to all the textiles, steel, toys, electronics and widgets China produces, it is also creating a growing middle class. The basket of goods that Chinese citizens receive from the state is very limited. The lack of serious health, pension and unemployment benefits are among the factors that encourage the country’s high savings rate.

However, there are two disincentives for placing the savings at Chinese banks. First, Chinese banks are reportedly saddled with bad loans and although there have been a number of re-capitalization and partial sales to foreign investors, confidence appears fragile at best. Second, real and nominal interest rates are abysmally low. When adjusted for inflation, the yield on deposits is negative. Even in nominal terms, the 3.06% yield on one-year deposits does not seem sufficient to draw savings.

Individual investors have been busy opening up equity trading accounts. In the second quarter Chinese investors opened an average of more than a quarter of a million accounts a day. The gross number of accounts probably overstates the actual number of retail investors as different accounts are needed to trade in the different exchanges. Reports indicate there are some 3000 equity exchanges in China.

China’s savings total more than $4 trillion. The stock market capitalization is less than half of that and even less when the government’s stakes are excluded. The incredible rally in the Chinese stocks seems to be a function of a shortage of supply relative to demand. Given the high valuation (at nearly 40, the price-earnings ratio is more than twice as high as other regional markets including Korea’s Kospi and Hong Kong’s Hang Seng). Outside of stocks and government bonds there are few other financial assets to absorb Chinese savings.

Among the challenges retail investors face in China, perhaps the most significant is opaque transparency. This is partly a function of a weak regulatory regime for both corporate activity and investment advisory. The lack of a free press compounds these difficulties.

Japanese retail investors are also flexing their muscles, but not in the equity market. The Nikkei is the worst performing stock market in H1, up a mere 5%, despite a weak currency (which some have argued should be a favorable development for equities) and record corporate profits.

Retail investors in Japan are actively involved in the yen-carry trade. That is retail investors in Japan are selling the yen and buying higher yielding currencies, like the New Zealand and Australian dollar, the South African rand and of course the US dollar.

According to data from the Tokyo Financial Exchange (TFE), net short yen positions against the US dollar by margin accounts (using borrowed funds) reached $1.1 bln on July 4th. Overall, using the Bank of Japan’s estimate of the market share of the TFE, it is estimated that the total outstanding short yen positions amount to a little more than $19 bln, which is roughly the same value of the net short yen position at the Chicago Mercantile Exchange’s IMM as of June 26.

While Chinese retail investors have been busy opening up stock accounts, Japanese retail investors are busy opening up margin accounts for trading currencies. According to Yano Research Institute, which is based in Japan, retail investors have opened more than 664k of these margined foreign exchange accounts. This is almost double last year’s pace.

It is common for retail foreign exchange traders to leverage their position 10-30 times. While this may strike one as high, retail platforms grant investors mind-boggling leverage of anywhere between 50:1 and 400:1. However, such leverage often proves ruinous. Although hard and fast numbers are difficult to find, some industry experts suggest there is a burn-out rate in the US of over 50%. A comparable estimate for the burn-out rate for Japanese retail foreign exchange traders is not readily available, but the persistent weakness of the yen and the lower leverage would suggest a lower burn-out rate.

On July 2nd, BOJ board member Kiyohiko Nishimura became the first official to comment about the increase in retail margin currency trading. “The arrival of Japanese households as major investors seems to have affected foreign exchange markets, he told a Brookings Institute conference.

Yet ideas that some how Japanese retail investors are stabilizing the foreign exchange market, as some observers have opined is misleading on two counts. First, these retail investors are putting on carry-trades and therefore are pursing the same strategy as other speculators, and financial institutions like those two investment banks that recently issued large Samurai bonds (yen-denominated bonds sold in Japan and the proceeds of which are likely converted into other currencies). More investors putting on the same strategy does not promote stability, but seems to warn of the breadth of those that will be caught in the eventual un-wind.

Second, even if the Japanese retail investor has greater staying power than the higher leveraged players, in aggregate they still seem too small to make much of a difference in influencing foreign exchange prices, even if supporting a vast network of brokers and dealers. Some estimates suggest the retail sector as a whole accounts for something on the magnitude of 2% of the roughly $2.5 trillion dollar a day foreign exchange market. The $50 bln that this amounts to is not chump change, but neither is it a significant fraction of the market.

Even with a free press, retail foreign exchange traders are at a distinct disadvantage compared with institutional operators. Judging from the paring back of proprietary operations at a number of investment banks, and the poor showing for the last few years by currency hedge funds as a group, even institutions find it difficult to trade currencies profitably. And they have access not only to the public information that retail investors can have (even if processed less efficiently), but many institutional investors have access to private information, like that which is contained in their order books.