The Effectiveness of Margin Requirements: Agent-Based Modeling Approach

The stock market crash in 1929 has raised many discussions about the causes and the ways to prevent the financial markets from large fluctuations. The role of the margin loan has usually been regarded as the source of instability in financial markets. The view that low margin infused excessive funds into the stock market was widely accepted at that time. Therefore, the Board of Governors of the Federal Reserve System was authorized by the Securities and Exchange Act to impose initial margin requirements on stock markets in October, 1934, which was previously set by the New York Stock Exchange and other private-sector exchanges. The original purposes of this regulation are three-fold: (1) to reduce excessive credit, and lead more credit toward productive uses, (2) to protect investors from speculative losses due to too much debt, and (3) to reduce price fluctuations caused by margin buying and short selling. In the literature, the discussion of the effectiveness of margin requirements has continued for more than forty years. Besides the controversy of academic research, both the Government and the Fed also possessed different opinions in the past twenty years. The reason that margin loans are believed to increase price volatility is described as a ``pyramiding-depyramiding'' process. The pyramiding-depyramiding process seems to be reasonable but can not be easily justified. The implicit assumption behind this process is that speculation is the source of instability. In this paper, we examine the effectiveness of margin requirements based on the times series properties of price and return volatility as well as their relations with trading volume under the framework of agent-based artificial stock market in which trader' behavior is modeled by genetic programming