Hedge Fund Treasury Trading and Funding Fragility 

Doug Nolan

Last week’s CBB focused on a fundamental flaw in contemporary central bank doctrine – using securities markets as the primary mechanism for managing system financial conditions. 

What began with Greenspan’s liquidity assurances following the “Black Monday” 1987 stock markets crash – soon stretching to interest-rate and yield curve manipulation to bolster market-based Credit in the early-nineties - has morphed into $120 billion monthly liquidity injections in an environment of manic securities, housing and asset markets. 

Greenspan’s policy shift was instrumental in generating extraordinary returns and rapid growth for the hedge fund industry, and leveraged speculation more generally. 

Fed and GSE backstops were key to the leveraged speculating community surviving the bursting 1994 bond/derivatives Bubble. 

Speculative leverage expanded rapidly, ensuring only greater backstops and bailouts during the 1998 Russia/LTCM fiasco. 

And following the collapse of the “tech” Bubble, the Fed aggressively slashed rates and resorted to stoking unprecedented mortgage Credit growth and associated leveraged speculation in the name of system reflation. 

The resulting Bubble collapse in 2008 was met with the introduction of QE to the tune of $1.0 TN. There’s been no turning back, as the Federal Reserve holdings have surpassed $8.0 TN – ballooning almost ten-fold since 2007.

This week saw an interesting addition to the Federal Reserve staff working papers in The Finance and Economics Discussion Series: “Hedge Fund Treasury Trading and Funding Fragility: Evidence from the COVID-19 Crisis” (Mathias S. Kruttli, Phillip J. Monin, Lubomir Petrasek and Sumudu W. Watugala).

I noted last week the omission of hedge fund leveraging in Loretta Mester’s “Financial Stability and Monetary Policy…” presentation. 

This week’s Fed paper helped fill in a few analytical holes.

“Hedge fund gross U.S. Treasury (UST) exposures doubled from 2018 to February 2020 to $2.4 trillion, primarily driven by relative value arbitrage trading and supported by corresponding increases in repo borrowing… 

Since 2018Q2 there has been a significant increase in repo borrowing, indicating a marked increase in long UST securities holdings.”

Data in the report are illuminating (i.e. “exposures doubled from 2018 to February 2020”), while corroborating the Bubble Thesis. 

Still, the research only covers a segment of the global leveraged speculating community. 

“The hedge fund data used in this paper are primarily from Form PF. In our analysis, we use the set of qualifying hedge funds (QHFs) that file this form quarterly.”

 Unregulated and “offshore” entities are excluded, including the massive “family office” complex. 

Clearly, the past few years have witnessed a tremendous expansion in leveraged speculation. 

While this paper focused on levered trading in Treasury securities, March 2020’s volatility throughout fixed-income (i.e. high-yield and investment-grade corporate Credit, MBS, municipal bonds…) indicated the historic Bubble in speculative leveraging has seeped into every nook and cranny. 

This particular Fed research focused on hedge fund activity in the Treasury market and, more specifically, in the popular “basis trade” strategy (leveraging long cash Treasuries primarily financed in the repo market, while simultaneously shorting Treasury futures/derivatives). 

With meager spreads/arbitrage opportunities available in these types of Treasury trades, they become enticing only through significant leverage. 

And extreme leverage creates fragility and vulnerability to systemic shocks and market dislocation, as was experienced early in the pandemic.

“In March 2020—as investors around the world engaged in a flight to cash and liquidity amid an unprecedented, sudden economic shutdown—there was a sharp divergence in the UST spreads that hedge funds generally bet will converge.”

“While UST securities play a vital role in the global financial system, hedge funds’ impact on UST market functioning is not well understood because they are less regulated than traditional broker-dealers and provide few disclosures. 

Further, compared to other asset managers, hedge funds employ substantial leverage coupled with investment strategies that are less liquid.”

“Compared to other UST trading funds during the March 2020 turmoil, the subset of UST hedge funds that predominantly engaged in the cash-futures basis trade faced greater margin pressure stemming from their short futures positions, requiring immediate liquidity infusions or position liquidations.”

This Fed paper included a number of illuminating charts that confirm the extraordinary increase in speculation that commenced in 2018 – in hedge fund “Gross Assets,” “Long Exposures,” “Repo Borrowing,” “Brokerage Borrowing,” and “Repo Securities & Other Collateral.” 

The most dramatic growth is displayed in the parabolic rise in “Basis Traders” “US Treasury Exposures” and “Repo Borrowing” – with Treasury exposures and repo borrowings more than doubling in 2018 to almost $750 billion (“Gross Assets” doubling to about $1.7 TN).

Recall the new Fed Chair’s hope for normalizing interest rates and somewhat weening the markets from Fed backstopping was DOA following the late-2018 eruption of market instability. 

Powell’s dovish “pivot” reversed what would have been a destabilizing de-risking/deleveraging episode. 

The Fed’s charts confirm that speculative leverage was expanding again by early-2019, only to begin a downturn during that summer’s bout of repo market instability.

Rather than tolerate a much overdue – and greatly needed - adjustment for a dangerously over-leveraged marketplace, the Fed resorted in September 2019 to so-called “insurance” stimulus – QE in the face of near-record stock prices and multi-decade low unemployment. 

This is key, and I doubt history will get this right. 

The Fed used extreme monetary stimulus to bolster an increasingly fragile leveraged speculating community - and not to support either a weakening economy or a problematic Credit slowdown. 

Simply, the Fed moved to sustain the Bubble. 

The predictable outcome is apparent in the Fed’s charts. 

Hedge fund Long Exposures, Repo Borrowing, and Brokerage Borrowing all quickly recovered and inflated to record highs right into the March 2020 crisis. 

Ditto for “Basis Traders” Treasury Exposures and Repo Borrowing. 

From the Fed paper: 

“Compared to these [“tech bubble”, August 2007, September 2008] crisis episodes, the March 2020 shock is unprecedented, particularly in the speed at which extreme moves occurred and in its impact on otherwise safe and liquid markets such as the UST market.”

“This indicates that during the COVID-19 crisis in March, these hedge funds were under a significant amount of stress, to a greater extent than at any point since Form PF reporting started in 2012. 

Clearly, the current crisis unfolded more precipitously than the global financial crisis in 2007-2009, which was characterized by relatively longer periods of a buildup of uncertainty from 2007 onward.”

Recall that the Federal Reserve’s initial March 2020 crisis measures failed to reverse a powerful “risk off” de-risking/deleveraging dynamic. 

The Fed was forced to rapidly employ open-ended QE, increasing holdings by over $2.0 TN in five weeks ($2.85 TN in 12 weeks). 

In addition to massive liquidity measures, the Fed established numerous financing vehicles (i.e. PMCCF, SMCCF, MMLF, CPFF, MSBLP, TALF…) to direct liquidity to specific markets. 

Moreover, the Fed announced it would begin purchasing corporate debt and fixed-income ETFs. 

“The March 2020 extreme market stress period lasted less than three weeks until the Fed’s intervention, too brief a period for hedge fund investors to redeem their shares at a significant scale during the stress period itself, given the share restrictions of the typical fund.”

In my March 20, 2020, CBB, I wrote: 

“I understand we can’t allow the system to collapse, but Please Don’t Completely Destroy the Soundness of Central Bank Credit and Government Debt. 

Does anyone realize what’s at stake?”

Too many times over recent decades, my worst fears have been realized. 

And over the past 15 months, the worst-case scenario has materialized. 

The Fed’s March 2020 system bailout reversed speculative deleveraging, and then almost $4.0 TN of QE fueled historic Bubble blow-off excess. 

“…Although there is no evidence of significant deleveraging, the results suggest that hedge funds actively managed the risk of their portfolios in March 2020. 

Despite significant negative returns depleting NAV, hedge funds held leverage ratios unchanged by scaling down their gross exposures proportionately to their capital base.”

“The March 2020 shock to the UST market was unprecedented in scale, but due to the speed and extent of Federal Reserve interventions, relatively short-lived.”

Rather than self-reinforcing and destabilizing outflows from an impaired leveraged speculating community, booming markets and strong performance spurred inflows, risk-taking and only more speculative leverage.

“Our findings indicate that the quick intervention of the Federal Reserve to stabilize Treasury markets likely prevented a deleveraging spiral where hedge funds further sold off exposures in a declining market, realizing more losses and further depleting their equity. 

Compared to previous crisis episodes, the March 2020 shock was unprecedented, particularly in the speed and scale at which extreme moves occurred and in its impact on otherwise safe and liquid markets such as the UST market.”

“In contrast, we show that hedge funds, while experiencing large losses in March, experienced relatively low outflows and shored up the liquidity of their holdings. 

Their use of long share restrictions were largely stabilizing.”

It is a central tenet of Credit Bubble Theory that unchecked speculative leverage has a propensity to turn highly destabilizing. 

It is a grave development when liquidity associated with a Bubble in levered speculation becomes the marginal source of system liquidity. 

The Fed should not be in the business of managing financial conditions through market liquidity injections. 

QE has significant effects on market perceptions for both the risk and potential return from leveraged speculation - therefore should be employed only temporarily for system stabilization in the most extreme crisis backdrops. 

Open-ended QE is reckless. So-called “insurance” QE is policy negligence. 

Sticking with $120 billion of QE in today’s circumstance of robust economic recovery and manic market Bubbles is a policy abomination.

It’s being called a “mixed” June payrolls report. 

With a stronger-than-expected 850,000 jobs added – strongest in 10 months – I’ll downplay the bump in the unemployment rate (and small decline in Average Weekly Hours) and label this a robust report. 

It follows on the heels of the lowest weekly Initial Jobless Claims since before the pandemic; the Challenger, Gray & Christmas job cuts report at the “lowest level since June 2000”; and Wednesday’s much stronger-than-expected ADP employment gain (692k).

Meanwhile, 10-year Treasury yields dropped 10 bps this week to a near four-month low 1.42%. 

Where would yields be today without Trillions of levered hedge fund and derivatives trades? 

Without QE? 

Without the emboldened leveraged speculating community fearless that the Fed will have no alternative than to move immediately with massive support in the event of market instability? 

July 2 – Bloomberg (Simon Kennedy): 

“Former Treasury Secretary Lawrence Summers said the surge in U.S. house prices is ‘scary’ and questioned the wisdom of the Federal Reserve continuing to purchase mortgage-backed securities as part of its stimulus campaign. 

Three days after data showed home prices jumped the most in 30 years in April, Summers told Bloomberg… that such gains are inflationary and would likely drive other prices higher. 

‘This is scary,’ said Summers… 

‘Rising house prices in most people’s common sense of the world represents inflation… 

I cannot understand why the Federal Reserve, in the face of this, continues to be every month a major buyer of mortgage backed securities…”

When it comes to today’s scary markets, housing is but one of many. 

And this notion gaining traction associating the Fed’s MBS purchases with surging home prices is misplaced. 

It is the awry Treasury market – the foundation of market prices - that has become the epicenter of dangerous levered speculation and epic market distortions that feed through the asset markets. 

I just can’t shake the notion that Treasuries have one eye on Chinese financial fragility. 

It’s worth noting that Chinese stocks took it on the chin late in the week after the communist party’s 100-year anniversary powwow. 

From my vantage point, it sure appeared hubris aplenty for a system hoisted by one of history’s most spectacular Credit Bubbles (with cracks abounding). 

The ‘Cornwall consensus’ is here

Leaders gathering at the G7 now accept that globalisation creates vulnerabilities as well as efficiencies

Gillian Tett

© Efi Chalikopoulou

Three decades ago, the British economist John Williamson coined the phrase “Washington consensus” to describe a collection of free-market, pro-globalisation ideas that American leaders (among others) were promoting around the world.

Now, however, a new tag is in the air: the “Cornwall consensus”. 

Don’t laugh. 

That is really the title of an advisory memo circulated ahead of the G7 leaders meeting in Cornwall on Friday. 

Written by a committee of academics and policymakers from each of the seven countries, it sets out an “ambitious agenda to build forward better from the pandemic”. 

The document contains some vague and grandiose-sounding ideas, such as “greater equity and solidarity in global health responses”. 

But it also makes more detailed proposals, such as the creation of “a ‘Data and Technology Board’ akin to the Financial Stability Board” to oversee the global internet and a “CERN (European Organization for Nuclear Research) for climate technology”.

Either way, the memo suggests that the recent G7 corporate tax accord should herald a new phase of western collaboration along new ideological lines.

What should investors conclude? 

Many might scoff. 

After all, G7 meetings tend to be purely ceremonial affairs, and the accompanying memos mere ritual symbols. 

And the “Cornwall consensus” proposals are, in any case, unlikely to be adopted in the near future, however sensible they seem.

But it would be foolish for any business, or investor, to ignore this ritualistic display. 

As anthropologists often point out, symbols matter, even when they appear “empty” or divorced from reality, since they reflect and reinforce group assumptions about how the world should work. 

As such, this latest memo offers a thought-provoking snapshot of how such assumptions are changing.

This matters, particularly since some investors and corporate leaders are struggling to respond to the changing zeitgeist, having started their careers when the Washington consensus reigned supreme. 

We humans are always creatures of our cultural environment, yet we treat our beliefs as if they were the “natural” way to think.

There are five key points to note here. 

First, western leaders today fear political pitchforks. 

Thirty years ago, political figures such as Margaret Thatcher and Ronald Reagan took it for granted that free-market globalisation would benefit everyone. 

Today’s leaders fret that free-market fruits are so unevenly distributed that it is sparking a popular (and indeed populist) backlash. 

“Inclusion” is one of the new buzzwords.

Second, G7 leaders also now acknowledge that globalisation and free-market competition create vulnerabilities as well as efficiencies. 

Previously, they hoped that individual corporate incentives would create an optimised cross-border supply system. 

Now they know that global supply chains are threatened by a collective action problem, since businesses tend to concentrate activity in nodes that make perfect sense for each individual, but create havoc if they break. 

“Resilience”, therefore, is another buzzword.

Third, G7 debate is haunted by a fear of China. 

Beijing is not mentioned by name in the Cornwall consensus memo. 

But there are multiple calls to diversify global supply chains, not just for advanced technology, but for medical equipment and minerals too. 

Belatedly, western governments have accepted that it was a terrible strategic mistake to allow global chip production to be concentrated in the hub of Taiwan. 

They do not want to repeat the mistake.

Fourth, there is a subtle, but nonetheless profound, reset under way of the relationship between business and government. 

In the Washington consensus companies were regarded as independent actors competing with one another, without state involvement. 

Now all the talk is of “partnership” between government and business.

Free enterprise is still lauded, but “partnership” is the framework for facing the big societal challenges of the day, whether it’s the hunt for a vaccine, climate change or tech competition with China.

Finally, economics is being redefined, in Biden’s White House and elsewhere. 

In place of a narrow focus on refined quantitative models, there is now an emphasis on issues previously treated as mere “externalities” — the environment, say, or health or social factors.

Cynics (or free-market enthusiasts) might say that all this merely reflects a temporary leftward lurch in American politics, or a short-term reaction to the pandemic.

Possibly, but I suspect not. 

After all, what is driving this ideological shift is not just Covid-19, but also the rise of China, the threat of climate change and the evaporation of the western hubris around free-market ideas that followed the collapse of the Soviet Union. 

And adherents of this new dispensation can be found across the political spectrum. 

It was a Conservative British government, after all, that organised the advisory group that produced the Cornwall consensus memo.

So whether you love or hate the new zeitgeist, you cannot ignore it. 

History shows that when intellectual assumptions change, they do so in slow, elliptical pendulum swings that can last a long time. 

And sometimes ritualistic artefacts matter deeply. 

That Cornwall consensus memo may be one.

Chasing pots of gold

Foreign asset managers are eyeing China’s vast pool of savings

Do they stand a chance against home-grown competitors?

Zhang kun is the rock star of Chinese fund management. 

His name often makes headlines; whole articles are dedicated to his investment calls. 

Investors vie to get into his funds, one of which has reportedly delivered a return of 700% since it was launched eight years ago. 

He is among a growing number of managers who generate more hype than the firms that employ them. 

With personalities like Mr Zhang on its payroll, e-Fund, a state-owned investment group, hardly needs to advertise.

Now a swathe of foreign firms hopes to take on Mr Zhang and his ilk by entering China’s asset-management industry. 

Last month Goldman Sachs, a Wall Street bank, announced a wealth-management venture with icbc, China’s largest commercial lender by assets. 

BlackRock, a giant American asset manager, will join forces with China Construction Bank (ccb). 

Amundi, a French firm, has linked up with Bank of China and Schroders, a British investment group, with China’s Bank of Communications. 

In March JPMorgan Asset Management said it would buy a 10% stake in China Merchant Bank’s wealth business. 

Nearly 20 global investors are setting up fund-management firms; others are launching private securities funds.

The prize is access to a pot of money worth 120trn yuan ($18.8trn), which includes investments made by everyone from the average saver to the ultra-rich in mutual funds, trusts, wealth and other asset-management products. 

Though the pool of funds is smaller than in the West—asset managers in North America oversaw $59trn last year, according to pwc, an accounting firm—it is expected to expand rapidly. 

As more people grow comfortable giving their money to managers instead of picking stocks or buying property, China’s pot could nearly treble, hitting 320trn yuan by 2030, reckons Oliver Wyman, a consultancy (see chart 1). 

But foreigners’ attempts to crack other parts of China’s financial market have yielded underwhelming results. 

Could this time be different?

For China’s regulators, the new ventures are a high-stakes experiment meant to transform how savers think about investing. 

For years retail investors ploughed cash into deposit-like investment products sold and backed by state banks. 

The principal on such products was considered guaranteed, but the banks funnelled the cash towards high-risk borrowers such as small property developers or coal-mining outfits. 

By 2016 the banks’ wealth-management arms oversaw around 13% of total banking assets (see chart 2). 

But regulators cracked down, no longer willing to see banks and ordinary savers exposed to the intensifying risks.

Guaranteed products have been banned. 

Meanwhile banks’ wealth assets have been spun into new subsidiaries. 

These must wind down the old deposit-like products and design new ones based on net asset value. 

In 2020 the new units had 26trn yuan in assets under management, reckons cicc, an investment bank. 

It is with them that foreign investors have been invited to establish joint ventures.

The call sounds familiar. 

Foreign financiers have been knocking at China’s door for generations, with an eye to every corner of the industry, from retail banking to securities. 

In 1995 ccb and Morgan Stanley, another Wall Street bank, set up cicc; in 2004 Goldman was allowed to establish the first foreign securities joint venture. 

But when you look back over the past two decades, the developments seem underwhelming and the returns meagre.

That was largely because China opened up only when home-grown firms were big enough to withstand competition. 

Some foreign retail banks launched gung-ho expansion plans only to quit the market later, defeated by domestic giants’ extensive branch networks. 

Securities joint ventures have taken more than a decade to pass majority control to foreign investors. 

Payments firms such as Visa and Mastercard were shut out until mobile payments became dominant and competition futile.

Wealth management could be different. 

For one, the foreigners do not face a mature market with insurmountable competition. 

Regulators’ sweeping reforms mean that they are in fact entering what could become the world’s largest market for retail wealth at an early stage.

This is evident in the financial products on offer today. 

China’s mutual-fund industry has grown at a fantastic pace in recent years. 

Many firms now oversee 1trn yuan in assets. 

Money-market funds are ubiquitous. 

But product design is still in its infancy. 

Global firms are expected to bring a new level of sophistication. 

Tuan Lam of Goldman says his group will offer quantitative products such as algorithmic and factor-based strategies, and cross-border and alternative-asset investments. 

“These are not present in China right now,” he notes.

Another benefit of the joint ventures is their links to China’s largest financial firms. 

The banks and their tens of thousands of branches were key intermediaries during the first era of wealth management and, say experts, may also define the next. 

Their wealth-management subsidiaries have vast portfolios and huge numbers of clients. 

Take ccb. 

It has more than 14,700 branches; last year it managed 2.2trn yuan in wealth-management products and attracted more than 4.4m new investment and wealth-management clients. 

Access to customers is “one of the benefits of partnering with one of the largest banks in China”, says Susan Chan of BlackRock.

Yet success will depend on foreigners’ ability to establish and market themselves. 

Goldman and BlackRock have some name recognition in China by virtue of their size. 

Amundi and Schroders, by contrast, are unknown outside financial circles. 

And teaming up with home-grown banks has some downsides. 

A potential customer at a bank branch will be offered a suite of products, which will include those designed and branded by the joint ventures, but also those designed solely by the bank. 

Online, joint-venture offerings will probably appear on smartphone apps on a list of commoditised products. 

The foreign groups will therefore have to make sure their offering is advertised sufficiently to clients—no easy task given that tens of thousands of banks’ relationship managers will be responsible for sales. 

It can be done, but only with hefty investment in staff training, says Philip Leung of Bain, a consultancy.

Another problem is competing with superstars such as Mr Zhang, who often manage money for giant mutual funds. 

Financial news in China is abuzz with stories on the performance of star managers. 

Many retail investors make decisions based on such information. 

Few clients are interested in a fund’s risk controls, notes Fabrice Maraval, an executive who has worked at two Sino-foreign financial ventures. 

Instead, they ask, “What’s your ranking on the list of top fund managers?”, he says.

Executives at several joint ventures bristle at the idea of hiring stars who market their funds. 

“It’s just not our culture,” says one. 

Instead they must slowly build trust with clients through solid performance and prudent risk controls. 

Zhong Xiaofeng of Amundi describes his group’s strategy in China as a “long-haul effort”. 

If foreigners are to give the stars a run for their money, it will have to be. 

Here Come the Teens: They Can’t Vote, but They’re Old Enough to Buy Stocks.

By Daren Fonda

Ronak Davé, 16, started trading stocks a year ago. The high school junior now spends a few hours a day on the market between classes and at night./ Photograph by Evan Jenkins

Like many teenagers, Ronak Davé enjoys the videogame Roblox. 

But he doesn’t play much these days, preferring to trade the stock instead. 

He recently sold a stake in Roblox after holding it for a few weeks, notching a 25% gain, or about $200. 

“I saw a pullback after looking at the technical patterns,” Davé says. 

“I noticed some resistance coming back and thought it would go down.”

At 16, Davé isn’t your typical trader. A high school junior outside Chicago, he started trading a year ago and now spends a few hours a day on the market—checking his portfolio on his phone between classes, studying charts at night, and writing about stocks for other teen traders, posting articles like “Top 6 Reasons Teens Should Learn to Trade.”

Before making a trade, he often consults his chief investment officer—his dad—who helps him with the fundamentals and technical set-up.

“I like cars, so I have a lot of interest in car stocks,” says Davé, who is now eyeing Tesla (ticker: TSLA) and Nio (NIO). 

His goals: saving for college, getting a golf scholarship, and eventually earning enough to buy his dream car, a Lamborghini Huracán Performante, which goes for about $330,000.

Teenagers aren’t allowed to do many things, but trading stocks isn’t one of them. 

A new crop of mobile apps is making it a cinch to invest, trade, and follow the market, using custodial accounts or tunneling in through other means. 

While teens might not have much to invest, brokerage firms are eagerly courting them.

Fidelity Investments introduced a “youth account” product last month for those ages 13 to 17. 

The accounts come with a debit card, unlimited trading, and access to nearly the entire U.S. market, overseen voluntarily by parents.

“We created this with teens in mind,” says Jenn Samalis, a Fidelity senior vice president. 

“We wanted to make sure we had an easy, simple learning experience for them to get started.”

Teaching financial literacy is a worthy goal, and teenagers—inspired by social media and meme stocks—may be eager to learn. 

High schools now promote a “growth mind-set,” teaching students to view mistakes as opportunities. 

Investing even small amounts can help demystify the markets and teach a bit about its mechanics.

But giving a trading app to kids might be like handing over the keys to a Porsche, without even a learner’s permit. 

Formative experiences in the market could backfire, leading to more risk-taking later in life, or the opposite: fear and risk aversion.

Teens may also be vulnerable to the so-called gamification of stock trading and to stocks hyped on social media—the same forces fueling trading frenzies (and losses) among adults.

“Without custodial oversight, this is basically a bad idea,” says Laurence Steinberg, a professor of adolescent psychology at Temple University. 

“There are all kinds of reasons why we don’t let 16-year-olds do certain things—because we don’t think they have the judgment, impulse control, and maturity.” 

Young people take more risks when they’re with peers than on their own, he adds, and social media extends those influences well beyond a close circle of friends.

“If social media encourages people to invest with their peers, that will contribute to more risky decision-making,” he says.

Esha Singaraju, above, started investing last summer after noticing that friends were day trading on TD Ameritrade and Robinhood and talking about stocks like GameStop and Tesla. “I wanted to learn about it and have more fruitful conversations,” says the 16-year-old, who lives outside Charlotte, N.C.

How are young people trading these days? 

Quite easily. A common way is through a custodial account opened by a parent, older sibling, or other adult. 

Parents may also let their children trade by sharing login credentials for their accounts.

Minors aren’t allowed to open accounts until at least age 18, under state laws. 

Yet there is no age minimum to trade once an account is open, and no federal regulations stop teens from owning securities or trading, according to Barry Barbash, a securities lawyer who once served as the top fund regulator at the Securities and Exchange Commission. 

If a parent signs off on an account, as Fidelity requires, and signs a waiver, the parent is on the hook if any liability issues arise.

Fidelity’s youth accounts are like a standard brokerage account with training wheels. 

Teens can trade all they want, but Fidelity restricts the types of stocks to U.S.-listed companies, doesn’t allow options or margin trading, and recommends capping annual deposits at $30,000.

Fidelity isn’t the only financial firm angling into the youth market. 

Start-ups like Greenlight Financial Technology, Stash, and M1 Finance are also seeking to attract young investors. 

Greenlight, a savings and investing app for the young, allows parents to open an account and add a child for access to trading.

“We wanted kids to do the research and propose an investment, and the parent then approves or declines it,” says CEO Tim Sheehan. 

The subscription-based model has attracted three million accounts, he says. 

The company recently raised $260 million in private financing, valuing it at $2.3 billion.

Financial-technology apps for the young raised $344 million in financing last year, according to Crunchbase, up from $98 million in 2019. 

Stash CEO Brandon Krieg says the company now has tens of thousands of custodial accounts, set up for parents to invest for their children and help them learn. 

M1, another investing app, launched custodial accounts last year and now has several hundred thousand accounts. The business is worth nearly $1 billion, according to CEO Brian Barnes.

Equity-market investors can tap into the trend with Acorns, a family investing and savings app that is planning to go public through a special purpose acquisition company. 

The SPAC, Pioneer Merger (PACX), is valued at $2.2 billion.

Established brokerage firms and start-ups are marketing to teenagers for the same reasons that banks have long pitched accounts to children: building loyalty and acquiring the next generation of clients.

“It’s a customer-acquisition play,” says Nikhil Sharma, managing principal at the financial consulting firm Capco. 

The educational tools and convenience help get parents and kids in the door, but the business model is based on a customer’s long-term value.

Customers are worth varying amounts, depending on how much they trade or invest. 

While equity commissions aren’t major revenue sources anymore, brokerage firms still make money from securities lending, payments for order flow, and cash held in money markets or other types of accounts.

For brokerage houses, the long-term value of a customer is in providing financial advice or managed accounts. 

As mass market customers move upstream, their lifetime value can be anywhere from $2,000 to $5,000, an industry consultant says. 

Once they reach the mass affluent or high-net-worth segment, the lifetime value ranges from $15,000 to $100,000.

The younger a brokerage starts building the relationship, the greater the potential payoff.

“A lot of your brand loyalty—whether it’s to Fidelity, Cocoa Puffs, or Marlboro—will be based on how much you enjoy the experience when you’re young,” says Steinberg, the Temple professor.

Custodial accounts transfer automatically to a teenager at ages 18 to 25, depending on state laws. 

If brokerage firms can build goodwill with the young, they have a better shot at capturing a customer at later life stages—going to college, getting a job, and saving for retirement. 

The progression opens doors to fees on mutual funds, exchange-traded funds, and other financial products, along with advisory fees on managed accounts.

Once a customer reaches $1 million in assets, the lifetime value ranges from $43,000 to $83,333 in revenue, according to Michael Kitces, head of planning strategy at Buckingham Wealth Partners.

The stakes are high for brokerage firms, since they are facing more competition from fintech apps, banks, and others. 

Square’s (SQ) Cash App has gained traction with millennials who use it to trade stocks and Bitcoin. 

JPMorgan Chase (JPM) is marketing debit cards to children as young as 6.

“The earlier you build a customer relationship, the longer you have it,” says Cait Lamberton, a marketing professor at the Wharton School. 

Even if a child has a bad experience on an app or doesn’t trade much, there is brand value in the familiarity. 

“When it’s easy for our brains to process something, we misattribute that familiarity to liking it. 

Your brain sees it and says, ‘This is easy,’ and that feels good.”

For Fidelity, opening accounts for young customers might help protect and expand a revenue moat, worth $21 billion in 2020. 

It could build relationships with young people before they enter the workforce and start saving for retirement—a huge market for Fidelity as the largest administrator of 401(k)s, overseeing 33 million workplace plans overall.

Fidelity also has a branding problem it needs to overcome. 

Teens’ loyalties may lie elsewhere—in apps and online platforms that didn’t exist a decade ago but are now surging in popularity. 

“No matter what Fidelity does, it will be hard to be hip or trendy,” Lamberton says.

Indeed, Fidelity has long cultivated an image of financial rectitude. 

Robinhood was heavily criticized for showering traders with confetti in its app (a feature that has now been eliminated), but Fidelity has never rewarded trading overtly.

And while apps like Cash and PayPal are expanding into crypto, Fidelity hasn’t started a platform for trading digital assets. 

It is, however, seeking regulatory approval for a Bitcoin ETF, and it does provide crypto custody services for institutional clients.

“Showing up with a Fidelity app as a teenager is like wearing a bow tie to a rock concert—it just doesn’t work,” says Jim Lowell, editor of the independent Fidelity Investor newsletter.

Yet Lowell views the youth accounts as a smart move. 

They could be a way for Fidelity to gather transgenerational assets in reverse—rather than targeting grandparents, going after kids, and building from there. 

“Fidelity is playing very long ball, like hitting a home run from Boston until it reaches San Francisco,” he says.

One consideration for parents is taxes. An adult can gift up to $15,000 to a child each year, tax-free, but investment gains in a custodial account might be taxed at a parent’s ordinary-income rate, after an exemption on the first $1,100, and the next $1,100 taxed at the child rate. 

Beyond the tax liabilities, there could be implications for college financial aid: custodial accounts may count as student assets, reducing need-based aid, while money in a 529 savings plan reduces eligibility to a lesser degree, up to 5.6% of the account’s asset value.

If there is an overarching challenge for teens and parents, it’s finding a balance between righteous investing and the thrill of trading. 

Educational tools and demos are like eating the kale; inspiration may come from the Candy Crush: seeing an actual stock in your portfolio take off.

“You want to educate them? 


But you have to tantalize them with something sexy, which is large profits, not wisdom for the long term,” says Gary Schatsky, a financial advisor in New York.

By age 15 or 16, children tend to make decisions as well as adults under “cold” conditions—when they aren’t pressed for time or stressed in the moment, says Candice Odgers, a developmental pzsychologist at the University of California, Irvine. 

But under pressure or influence of peers—conditions known as “hot cognition”—they are more likely to make risky choices. 

And it isn’t until well into adulthood that decision-making becomes more rational and long-term oriented.

“Teens tend to be more shortsighted and focused on rewards than adults, and more likely to ignore the costs,” Steinberg says. 

“If you put people in a brain-imaging scanner and show them piles of money, you see the reward center light up more in adolescents than adults.”

Even with guardrails, the influence of social media may be hard to manage. 

TikTok, Reddit, Twitter, and other conduits are flooded with traders claiming to make fortunes. 

According to a recent Wells Fargo survey, 45% of 318 teens said they were more interested in investing this year because of GameStop (GME).

“It won’t grab much attention if someone tweets a 1% gain in an index fund, but if it’s 40% in GameStop, that will get a lot of teens into it,” says Cary Frydman, a behavioral-finance economist at the University of Southern California.

Ideally, the young will learn the basics about diversification, investing for the long term, and avoiding risky trades. 

But those lessons might have to overcome behavioral biases; we tend, Frydman notes, to absorb more knowledge about stocks we own than those we don’t, in part because of familiarity bias.

“If you’re biased to a volatile stock like GameStop, you’re less likely to learn about the advantages of index funds,” he says.

Some advisors say a better way to teach financial literacy would be to start kids off with a bank account, getting them in the habit of saving first. 

“That will help them live financially literate lives as adults,” says Susan Zimmerman, founder of Mindful Asset Planning, an advisory firm in Minneapolis. 

“They can then move from money-market accounts to conservative mutual funds.”

She adds that she’s “leery” of Fidelity’s youth accounts, partly because parents themselves might not have the tools to guide their kids. 

“Some parents can be good mentors, whereas others might be hands-off, and this could become a lesson in how to lose money.”

Ronak Davé, in his room in Illinois, spends a few hours a day on the stock market. / Photograph by Evan Jenkins

Davé’s father, Amarish, says he opened a TD Ameritrade custodial account for Ronak partly to thwart information that his son was gleaning from social media.

“When I saw he was being influenced by TikTok and meme stocks, I wasn’t crazy about it,” says Amarish Davé, a neurologist. 

“I’d rather know what information he’s getting and what he’s doing.”

The brokerage apps, of course, aren’t just tough for kids to resist. 

Trading took off in the pandemic as people stayed home, received stimulus checks, and started dabbling in the market. 

Trading volume soared at Fidelity, Charles Schwab (SCHW), and other brokerage houses.

And most apps are now commission-free, making it a snap to buy or sell without upfront costs. 

With fractional trading, kids who might not have $3,350 for a share of Amazon.com (AMZN) can invest for $5. Schwab says that 15% of its “stock slice trades” are made through custodial accounts. 

Investors can also buy fractional shares on Robinhood for as little as $1.

“The meme stocks pulled a lot of traders like me into the market,” says Noah Oxley, a 21-year-old college student in Florida. 

Oxley started trading Apple (AAPL) after his 16th birthday, using a custodial account. 

He recently helped his younger brother, 16, open a Schwab custodial account. 

“I’m letting him run with it, but I help out,” says Oxley, who doesn’t recommend GameStop or other meme stocks.

Advisors say that giving kids freedom to lose a bit may be the biggest benefit. 

Teens can test the waters with minor consequences if they fail, assuming they aren’t blowing their college savings. 

Racking up early losses may eventually deter gambling with larger sums later in life.

“The sooner they learn that lesson, the better,” says Kathleen Malone, a senior advisor with Wells Fargo Advisors. 

“That will stick with them far longer than the wins.”

Trading feedback is also instant with an app, and with real money at stake—rather than the tutorial and demos used for learning—the results can hit home. 

“You don’t know what it feels like to lose 20% on a stock until you’ve experienced it,” says Lamberton, the Wharton professor. 

“It’s tempting to say teens are irrational and don’t care about risk, but if they lose $45 of their $50 due to some advice from someone on Twitter, that’s a really nice quantitative signal. 

Many other things that kids do have no immediate consequences.”

Esha Singaraju, 16, started investing last summer after noticing that friends were day trading on TD Ameritrade and Robinhood and talking about stocks like GameStop and Tesla. 

“I wanted to learn about it and have more fruitful conversations,” says Singaraju, who lives outside Charlotte, N.C.

She now shares a Robinhood account with her older brother, owning stocks like Alphabet (GOOGL), Apple, and Microsoft (MSFT). 

The portfolio was up 21% in the past year, she says. And she was bitten by the investing bug, joining a financial advisory firm as an intern and winning the Wharton Global High School Investment Competition with friends from school.

Brewer Timmerman, 14, owns shares of cryptos and at least one Covid reopening play. Brewer’s father says the Woodstown, N.J., teen has notched a 23% gain since he started trading. / Courtesy of Dr. Daniel Timmerman

For Daniel Timmerman, a surgeon near Philadelphia, trading has helped form a bond with his son. 

Timmerman started a year ago, opening a Robinhood account and making some money in Tesla. 

That inspired his son Brewer, a rising 10th-grader, so Timmerman gave him access to his account and let him trade with $1,000.

Today, Brewer, 14, has positions in Tesla and American Airlines Group (AAL), along with some Bitcoin and Dogecoin. 

He says he bought the Tesla and cryptos mainly because of Elon Musk’s influence. 

His rationale for American Airlines was that it would be a good reopening play. 

“I just thought that, after Covid, people would try to get out of the house,” Brewer says.

Daniel Timmerman says that his son has notched a 23% gain since he started trading.

More important, he adds, it’s a way for father and son to connect. “It gives us something to talk about on the ride to school,” he says.