Should Retail Investors' Leverage Be Limited?

Does the provision of leverage to retail traders improve market quality or facilitate socially inefficient speculation that enriches financial intermediaries? This paper evaluates the effects of 2010 regulations that cap the provision of leverage to previously unregulated U.S. retail traders of foreign exchange. Using three unique data sets and a difference-in-differences approach, we document that the leverage constraint reduces trading volume by 23 percent, improves high-leverage traders' portfolio return by 18 percentage points per month (thereby alleviating their losses by 40 percent), and reduces brokerages' operating capital by 25 percent. Yet, the policy does not affect the relative bid-ask prices charged by the brokerages. The announcement of pending leverage restrictions has no effect on the traders or the market. We reconcile these findings with a model in which traders with heterogeneous and dogmatic beliefs take speculative positions in pursuit of high returns, and a competitive brokerage sector intermediates these trades subject to technological and informational costs. The model is largely consistent with our empirical findings, and it suggests that the leverage constraint policy generates a sizable belief-neutral improvement in social welfare by economizing on the productive resources used to intermediate speculation