The solution to the problem of margin calls, which exacerbated the fall in the Indian markets, could be, well, higher margins.
It’s simple: the higher the margins brokers and exchanges keep, the lower the frequency of margin calls and the related panic selling.
“That’s an outrageous suggestion,” you must be thinking. “Isn’t the Indian equity derivatives market already over-margined?” Well, yes and no.
The fact that we haven’t heard of a default at the exchange level despite extremely sharp price movements does suggest that our margins are high. Indian policymakers hate defaults and prefer to play it safe. So, we have three lines of defence—a value-at-risk margin which takes care of potential losses on 99% of trading days, an extreme loss margin as a second line of defence and then the broker’s capital deposited with the exchange.
Over and above that, exchanges have a settlement guarantee fund, but given the overtly strong risk management system there’s hardy a need to dip into that pool.
Yet, that’s not to say that our margins are totally out of whack. It doesn’t make sense to compare the margin of around 15% on the Nifty index futures with the single-digit levels in developed markets. Indian equities are far more volatile. At one point during the recent crash, the Nifty was down 14.5% from the day’s high. If the market had ended the day 15% lower, the margin deposited for a long position may have completely been wiped out.
What about instances where the margin on certain stock futures contracts exceeded 100%? Could a trader’s losses ever be higher than 100% of the contract value? They could, if he has taken a short position. Consider the trader who sold the Reliance Natural Resources Ltd’s January futures contract on 22 January at the day’s low of Rs78.8 per contract. If the futures price were to rise to Rs157.6, the trader would stand to lose Rs78.8, or 100% of the contract value. Given that Reliance Natural had traded at Rs201 just the previous day, a margin of more than 100% wouldn’t be out of order. For a market that thrives on excesses, both on the way up and down, we need to be prepared for high margins.
In fact, the only way to alleviate the horror of desperate intra-day margin calls by brokers and the blocking of broker terminals by exchanges is to have higher margins.
J.R. Varma, chairman of the Securities and Exchange Board of India-appointed committee on risk containment in the derivatives market, explains that if the initial margin is set slightly higher than the desired maintenance level, it will act as a cushion, as margin calls will be triggered only when the maintenance level is breached. Such a concept is practised in developed markets; Indian markets, too, can benefit from it, and more so because of the higher volatility and the frequency of margin calls.
Having said that, there is one area policymakers must move on quickly so that traders and brokers aren’t needlessly burdened with high margins—cross-margining between various segments of the market, as well as between the two leading stock exchanges. Margins are high for trades that involve two related positions—take, for instance, an arbitrage trade between Nifty futures and CNX 100 futures.
The two indices have a high correlation, and losses on one would, at worst, be largely offset by profit on the other. But, such trades don’t get much relief on the margin front, which increases the cost for traders and results in pricing inefficiency in the market. If margins are computed based on the gross position across various segments of the equities market, significant capital will get freed for traders and brokers and price discovery would improve.
The froth is off
Trading in single stock futures had reached a frenzy just before the markets peaked in early January, with open interest reaching an all-time high of Rs83,700 crore. But thanks to the ensuing correction, outstanding positions halved to Rs40,200 crore in just 14 trading sessions. After the expiry of the January series, positions are now even lower at Rs34,300 crore, levels last seen during August 2007, figures collated by Edelweiss Securities Ltd show. The market may have corrected just 16% from its highs, but what’s heartening is that a whole load of mindless speculators have backed off.
When the markets had corrected sharply in May 2006, it had taken more than a year for the markets to build similar open interest. Given the way traders have burnt their fingers in stocks such as Reliance Natural and IFCI Ltd, this time could be no different.
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