On 17 May 2004, the nation watched with disbelief as stock prices dropped 10 per cent within minutes after trading started for the day. A Sebi official later said that the ‘‘velocity of the fall in stock prices was second only to the great crash in America in 1929’’.
That our bourses emerged without a single broker default that day signalled the robustness of India’s risk management systems. Even without a proper government in place, sanity was restored in the later half of the day and the rally that followed signalled the start of a long bull run that was only disrupted by last week’s savage correction.
The handling of the 2004 shocker led to a lot of self-congratulation among regulators and exchange officials as everybody chipped in to restore sanity — the RBI released funds, banks (mainly HDFC Bank) worked hard to help brokers, politicians temporarily gagged themselves and Indian institutions stepped in to buy at lower levels triggering a recovery.
Sebi’s top management was overseas, but it did not seem to matter.
However, 22 May 2006 was a different story altogether. First, the ‘correction’ was not a surprise; in fact there was a consensus that a correction was necessary and overdue.
Even a recent entrant like Nomura Securities’ research said, ‘‘the degree of financial leverage (open interest of derivatives) relative to equity market capitalisation has risen from five times to 20 times over the past 20 months, creating considerable systemic risk for investors in an economy with an open capital account’’.
Even leading speculators were quietly expressing concern about low margins encouraging extreme leverage in the derivatives segment and warned that the correction, when it happened, would be dangerously sharp.
That is exactly what happened when the Sensex fell 1,803 points in the last two weeks from its peak of 12,612. Volatility increased sharply and the Sensex often swung a dangerous 300 to 400 point each way, within a trading session.
The May 14-19 period was tough on brokers, who struggled hard to stay afloat and keep their terminals from being switched off by the bourses. They forced small speculators to liquidate positions and bring in funds to meet margin demands. Then on Monday, 22 May, the market simply caved in around noon and the Sensex dropped 10 per cent (1,100 points) to hit a circuit break.
This happened mainly because the extreme market volatility triggered an increase in the Value at Risk margins that are calculated on the basis of a pre-fixed algorithm. Brokers struggling to bring in margin money suddenly discovered that even the cushion available with the bourses was wiped out by this increase and their terminals began to shut down.
At one time hundreds of broker terminals were reportedly shut at least for a few minutes. In fact, the events of Monday can only be described as a ‘panic manufactured by the system,’ which was completely at odds with the finance minister’s reassurances, the Sebi chairman’s effort to prevent rumour mongering and the Reserve Bank’s exhortation to banks to release liquidity to brokers.
What was happening on the ground was the exact opposite. Brokers found that banks were suddenly refusing to honour guarantees and reducing or refusing to honour over-draft facilities.
Ironically, a lot of panic occurred at HDFC Bank, which has the largest exposure to the capital market.
The bank turned jittery about brokers’ ability to pay and refused honour guarantees without additional security.
The National Stock Exchange’s (NSE) pay-out for the previous settlement, that occurs post noon, was delayed because of technical difficulties. Consequently, the money that ought to have been released to brokers was delayed.
The bank official (who was apparently standing-in for the officer who normally dealt with brokers) appears to have panicked and made some silly statements about ‘‘not depending on NSE’s payout’’. This set off blind panic among brokers clamouring for funds and there were rumours of a default. In retrospect, the bank had no reason to worry, because stock exchanges have a trade guarantee mechanism that offers complete protection.
This panic was allayed after the intervention of the Sebi chairman and the NSE managing director, who spoke to the bank.
This time around, the NSE’s systems also appear to be creaking under pressure of high volumes.
When the settlement file became available before midnight on Monday, brokers discovered that the time-stamp on all transactions showed 9.22 a.m. while the bourse opens for trading only at 9.55. a.m. NSE officials admit that there was a problem with the time-stamp but insist that everything else was in order.
However, the fact remains that on a day of extreme volatility, investors were in no position to know the precise time of their trade and if transaction were executed. The date and time stamp on transactions is key to maintaining proper audit trails in the market.
Even after trading resumed many trading terminals were being manually re-activated causing them to lose precious trading time. Ironically, a large industry house which turned an aggressive buyer after the circuit-break was running out of brokers who could buy on its behalf.
Thanks to the stringency of Know-Your-Customer rules it could only trade with brokers where it was already registered as a client and with several hundred brokers logged out of the system even buying was a problem.
What was missing last week was co-ordination, ground-level market intelligence and quick decision making.
The question that the regulators have to answer is whether the sudden increase in volatility margins, made market safer last Monday or exacerbated the fall in prices and triggered off needless panic. A mechanical implementation of volatility margins does not make the markets safer.
What is clearly needed is some kind of multi-disciplinary crisis management team that ensures a constant flow of information from the ground up with appropriate emergency powers for making decisions in a crisis.
There must also be a formal process of briefing the media to avoid misunderstandings caused by off-the-record statements from regulators and bourses.