A little over a year ago, this column had looked at the issue of intra-day margin calls in the equity derivatives market.
On days of high volatility, exchanges pressed members to bring in the shortfall in margins on an intra-day basis. Members who weren’t quick enough to beef up deposits with the exchange got some of their positions forcibly squared off and/or terminals deactivated. These forced trades further increased volatility.
Also Read Mobis Philipose’s earlier columns
While there have been no settlement failures in the equity derivatives market owing to the stringent margining system followed by the National Stock Exchange, the problem caused by intra-day margins calls for a relook at the current risk management framework.
Some experts have argued that one part of the solution lies in improving information technology infrastructure in the banking system for quicker funds transfer. But there are others who feel that the more important and pertinent issue is that member brokers need to have buffer funds to respond to margin calls on short notice.
It would be foolhardy to expect brokers to keep funds idle for such a requirement. They would rather deploy it and try and earn some return on it.
The only way would be to get brokers to post these buffer funds with exchanges, which can be tapped into for emergency situations. J.R.Varma of the Indian Institute of Management, Ahmedabad, has a working paper titled “Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges” which addresses this issue, among others.
Varma suggests an alternative margining system for the stock index futures segment, which is based on analysis using data of the Nifty index for the 18-year period from August 1990 to August 2008. This covers the most volatile trading sessions witnessed in the Indian markets.
The proposed system does away with the current practice of levying an initial margin and then having an additional margin as a second line of defence. It proposes a shift from the Value at Risk method of calculating margins to the globally practised method called Expected Shortfall (ES).
Margins are revised only once a month, and in order for margins to be kept constant for such a long period, volatility estimates in the model have a lower weight for the last few days and more weight on longer stretches of data.
Back-test results in the sample of over 4,300 trading sessions show that the margins collected under the proposed system would be insufficient on only one instance, 17 May 2004, where the index movement of 12.24% exceeded the margin of 11.34%.
The Nifty dropped by as high as 8.63 standard deviations during that session, thanks to statements made by the leaders of the Left parties, soon after the formation of the Union government. With that exception, the proposed system throws up required margins that are sufficient to avoid intra-day calls.
The second highest movement, in terms of standard deviations, was during 24 March 1992, when the Nifty rose by 7.1 standard deviations, but since the proposed margin is set at 8 standard deviations, there would be no margin shortfall.
For times when the market has been flat, Varma proposes a minimum margin requirement of 8%.
Needless to say, the new system would mean more capital is locked in, but the benefits are significant. Many brokers and their clients suffered huge losses owing to their inability to quickly respond to intra-day margin calls. This kind of pain was last felt in the markets in January 2008, memories of which may have faded. But that shouldn’t stop the regulator from pursuing a change in the risk management framework.
Benefits of competition
A number of participants in the equity derivatives market have been asking for calendar spread contracts as a tradeable contract.
Currently, those wishing to create a calendar spread position need to place two orders separately, which is not only cumbersome but also involves the risk that one leg of the transaction may get executed while the other may not, leaving an unhedged position.
Interestingly, this facility is now available for participants in the currency futures segments of National Stock Exchange (NSE) and MCX Stock Exchange. It’s not yet available in NSE’s equity derivatives segment. MCX seems to have introduced the feature first, perhaps forcing NSE to follow suit.
Whatever the sequence of events, this is evidence that participants in the currency futures segment are benefiting from competition.
There’s no reason why NSE shouldn’t introduce this in the equity derivatives segment as well, except that there’s no pressure on them to do so.
One of the benefits of a calendar spread contract for traders would be to roll over their positions in the current month series to the next month.
Instead of doing two separate transactions—first of squaring off the current position and then creating a new position—buying a calendar spread would do the task in one trade. It’s much more cost-effective and eliminates the risk that only one leg of the transaction will be executed.
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