Sucheta Dalal :Return Of Margin Trading? (26 August 2002)
Sucheta Dalal

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Return Of Margin Trading? (26 August 2002)  

There are many persuasive arguments to back the lobbying to permit margin trading. They are: it will impart more liquidity to the market, improve price discovery and eliminate illegal financing. The Bombay Stock Exchange and the BSE Brokers Forum have already made detailed presentations to the Securities and Exchange Board of India. Sebi too has discussed the issue at several committees; it has also consulted the Reserve Bank of India on bank funding for margin trades. Apart from brokers, the proposal has the support of aggressive private banks that made a lot of money by funding brokers during the Ketan Parekh-led bull run of 2000, but with little success.

However, ever since Jaswant Singh took over as finance minister, the powerful broker lobby thinks its prospects of getting a sympathetic hearing have improved. It has argued that the price discovery mechanism in Indian stock markets is flawed because the financing of buyers is restricted (to Rs 20 lakh per borrower against the pledge of shares) while the bears have an advantage because there are no limits on stock-lending. Also, banks are required to charge a 40 per cent margin on loans to brokers, which offer very little leverage. Private banks who used to lend at a 25 per cent cash margin are making their own effort to persuade the RBI to lower the limit. They argue that a lower cash margin is as safe as a higher margin backed by shares and other collateral. But after the experience of Scam 2000, where several banks were caught colluding with broker-operators, the RBI is in no mood to relent.

The proposals before Sebi promise a transparent and well-regulated margin trading mechanism to be conducted on-line and handled by the clearing corporation of stock exchanges. The shares and money will both be impounded by the clearing-house and it will be charged with risk management through a daily mark-to-market system. Public dissemination of information will make the process transparent. The catch lies in the funding. Sebi is open to discuss a scheme where margin trading is funded only by banks and financial institutions and not by private financiers; it even discussed this with the central bank. The RBI may be open to discussion provided the lending by banks and institutions is backed by a guarantee mechanism. Many banks are also insisting that margin trading should not be open to private financiers and individuals since it will increase the risk involved.

As for risk management, brokers want margin trading to be guaranteed through the settlement guarantee fund; but the regulator says that it is out of the question. Today, stock exchanges take a risk on brokers’ open market positions through a risk management system that includes margins and disabling of trading terminals. This risk is guaranteed by the trade/settlement guarantee fund. If the risk management mechanism were extended to margin funding, it would require real time collateral management, which cannot be covered through the same settlement fund. Moreover, market experts say that it is unfair to conceive of a system where banks and institutions lend money but have no risk at all. Banks as financiers will have to undertake real time collateral management and bear the risk involved –– at best they can outsource the process to stock exchanges. Sebi too has advised brokers to explore the possibility of an insurance cover for margin financiers rather than touch the settlement guarantee funds.

But that is not the only catch. While Sebi is comfortable only with institutional funding, brokers want it to be opened up to private financiers. They argue that if private financiers are kept out, unregulated financiers will continue to endanger the market through reckless funding. That argument too is doubtful. A legitimate funding mechanism will not necessarily stop illegal financing. The Indian financial system has far too much black money sloshing around that will always remain outside any transparent funding mechanism. In fact, by putting out reports that illegal margin funding has caused a panic in the market, brokers have only hurt their own case.

It has led to Sebi starting an investigation into the source of funding and market operations of a large operator who is alleged to speculate heavily through borrowed funds. So far, Sebi has zeroed on two financiers who are neither individual nor deal in black money –– Kotak Mahindra Securities and ABN Amro Bank –– to check if these entities made any attempt at manipulation in the sale of collateral and to find out if it was accompanied by short selling to depress prices. If Sebi does indeed detect short selling, as alleged by some brokers, it would make the possibility of legitimising margin trading even more remote.

Also, while brokers are lobbying so hard for margin trading, they are unwilling to analyse its negative implications. It will indeed give added leverage to investors when prices are rising, but in a falling market, the fall is also accelerated when financiers are forced to sell collateral when investors default on margin calls. This aspect is rarely discussed.

Instead, there has been an attempt to pressure Sebi into considering their proposal. A recent news report had it that the BSE may be planning to abandon its derivatives business altogether. We learn that the regulator has nipped that particular move in the bud. Finally, if all the problems are fixed and every question answered, will Sebi really permit margin trading? Its experience with the Advanced Lending and Borrowing Mechanism provides an answer. Sebi sources have already said that no margin trading mechanism can be devised which does not contain large elements of ALBM, some elements of carry-forward and stock lending. Since Sebi continues to be hauled over the coals by the Joint Parliamentary Committee for permitting ALBM, which was a well-structured mechanism, the answer should be rather obvious.

Sebi officials have been interrogated over every bureaucratic delay, asked to explain compositions of meetings and quizzed over corporates influencing their decision, while those who benefited from ALBM grinned at their discomfiture. It would seem to me that unless the finance minister personally directs Sebi to permit margin trading in India, it is unlikely that any official will either endorse or clear the proposal in a hurry

-- Sucheta Dalal