The Emkay Global Financial Services Ltd fiasco has brought to the fore the issue of margining institutional trades in the cash equities market. While the size of Emkay’s losses didn’t pose a big threat to the clearing corporation, the Securities and Exchange Board of India (Sebi) shouldn’t miss the opportunity of addressing the long-standing difficulty of margining institutional trades in the cash market. If a very large institution defaults, it can cause systemic risk, and policymakers must put in place adequate risk controls to avert such a possibility.
Soon after the global financial crisis, when it became clear that large financial institutions can go bankrupt overnight, a large number of trades started getting settled through central clearing parties. In addition, policymakers world over have been trying to put in place additional risk controls within central clearing parties, given the systemic risk they pose.
Emkay’s erroneous trade exposed the risk of not margining institutional trades in the cash market. A month ago, Emkay entered an order worth nearly Rs.1,000 crore erroneously on the National Stock Exchange, causing the market to drop sharply in seconds. When trading resumed, the broker reversed these trades, incurring large losses, which it eventually paid the exchange’s clearing corporation. Because Emkay had entered the order on behalf of an institutional client, there wasn’t any margin posted with the exchange. Institutional trades attract margins only on a T+1 basis, i.e. a day after the trade has been executed.
Much of the policy debate since then has been restricted to trading structure, with Sebi reportedly considering narrowing price limits to address problems related to erroneous orders. But the impact on clearing corporations should not be ignored in all this.
In early 2008, Sebi had issued a circular stating that all institutional trades in the cash market would be subject to payment of margins just like the transactions of other investors. To begin with, institutional trades were margined on a T+1 basis from April 2008 onwards, and two months later, the margining was supposed to be upfront. But institutional investors successfully lobbied and got the upfront margining proposal scuttled.
To be fair to them, there are challenges in bringing upfront margins for some categories of investors. Institutional investors already post upfront margins in the derivatives segment, but these are mostly hedge funds and investors who trade regularly. Expecting a long-only pension fund, which trades in the Indian market infrequently, to post upfront margins is quite another thing.
But what about the fact that major clearers in overseas markets such as Eurex Clearing, LCH.Clearnet Ltd and European Multilateral Clearing Facility margin cash trades in the same way futures contracts are margined, i.e. through a combination of initial margin and variation margin? The Australian market, too, is moving towards upfront margining of cash market trades by next year. It must be noted here that there is full capital account convertibility in these markets. India, on the other hand, has a number of restrictions on foreign exchange transactions under its Foreign Exchange Management Act (Fema).
So, for instance, a foreign investor’s broker or custodian can not post margins on its behalf under the Fema guidelines. Given the challenges related to Fema, Sebi has little alternative but to work with the central bank in resolving this issue. Reserve Bank of India (RBI), at the same time, should realize that unmargined foreign institutional investors (FIIs) pose a systemic risk and given its objective of maintaining financial stability, it must act on this front. In Australia, for instance, risk management activities of central counterparties are overseen by Reserve Bank of Australia.
One solution RBI could consider is to allow custodians of FIIs to post margins on their behalf in exchange for a fee. Policymakers can also consider other solutions, such as allowing FIIs to deposit upfront margins in an escrow account with a large deposit-taking entity in their home jurisdiction, on which their local custodian could have a lien. Needless to say, there can be an endless debate on the pros and cons of these solutions. But what’s more important is that Sebi and RBI initiate a discussion and start working towards a solution.
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