Negative balance protection in trading accounts. A good or bad thing?

Since the CHF debacle spread betting brokers and CFD trading platforms have been looking for a way to win business by mitigating risk for their clients.  One new feature that was introduced rather swiftly is negative balance protection.

What is negative balance protection?

What this means is that the broker will supposedly not come after you as a client if you over trade, lose money and end up with a cash deficit on your account.

Why negative balance protection is a good thing?

On the surface, this seems like a good thing.  The very nature of spread betting, which allows private clients to take leveraged short-term bets on stocks and other asset classes (like forex trading) could, in theory, result in infinite losses.

What I mean is that if you are long you can only lose to zero.  But, if you are short, a stock or currency price an go up indefinitely.  Of course, that’s what initial and variation margin is there to protected against. Plus, positions are generally closed out via a margin call before they get into negative equity.

However, in some cases, such as the CHF cap removal or a significant bid being placed on a stock, prices can move a huge amount and highly leveraged positions can wipe an account out instantly.  In many cases spread betting clients are trading with a gross exposure of more than their net worth so there is a clear and obvious financial danger to the client and broker.

Clearly then, negative balance protection is a good thing for customers.  It essentially stops them having to pay up on a massive loss.  The broker would take the hit, presumably get a nice bit of PR in the process and win some clients from competitors as they are seen as this month’s nice spread betting broker.

Can negative balance protection be a bad thing?

But it’s also a bad thing.

Spread betting is an investment tool and can be used effectively as part of an overall investment strategy.  But in some cases (or most) it’s used by crazy punters trying to beat the market and make money quickly without really understanding the risks.

By putting negative balance protection in place, it’s going to make inexperienced traders (who now have a safety net) even more prone to taking unnecessary risks under the impression that they can’t make easy money.

Also, with negative balance protection, come increased margin rates. These increases may encourage retail traders who are not really suitable for it, to upgrade to professional trading accounts where they can get lower margin rates, but in turn lose some of the protection from the FCA, including negative balance protection.

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