In its most basic form, a negative balance represents an account balance in which debits exceed credits. A negative balance indicates that the account holder owes money.
A negative balance on a loan indicates that the loan has not been repaid in full, while a negative bank balance indicates that the account holder has overspent.
In the retail brokerage space, this phenomenon occurs when a position’s losses in an account exceeds the available margin on hand from a given trader.
When a trader places a trade that sharply goes against the chosen direction, an account can incur negative balance.
Such exposure is traditionally very risky for brokers.
While the foreign exchange market is the most liquid market in the world, unexpected economic, geopolitical or cataclysmic events can always cause a market disruption and consequently lack of liquidity.
This has occurred during certain events, albeit limited, which have resulted in extraordinarily sharp movements over short timeframes such as the Swiss National Banking Crisis in early 2015.
Negative balances are addressed in many jurisdictions globally and clients in the EU are protected from such risks.
As a consequence, brokers are the ones which are exposed to the risks associated with covering the negative balance with a prime broker or a prime of prime.
New Negative Balance Protections Look to Shield Market Participants
As a countermeasure to the risk associated with negative balances on a wider scale, many brokers now have since adopted negative balance protections.
These mechanisms are an automated adjustment of the account balance to zero in case it became negative after a stop out.
Traders operating with a broker that offers negative balance protection often cannot lose more than deposited as this shields both the trader and broker from wider losses in times of crisis.