Sucheta Dalal :Policy must respond to local conditions
Sucheta Dalal

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Policy must respond to local conditions  

Jun 5, 2006

It is ironic that core systemic issues that ought to have been debated and settled during the three-year bull-run are being discussed when the rally is fizzling out and brokers are struggling to cope with fierce volatility and sharp declines. Interestingly, the debate is based on international academic theory that does not usually take into account domestic realities while crunching local numbers.


Let’s start with our pretence that we successfully run a T+2 rolling settlement, when in fact, the banking system still cannot process payments on a real-time basis without a hefty cost attached. Fact is, that we roll smoothly from one settlement to another because brokers routinely provide two-day financing on behalf of clients and regulators know this and further penalise brokers for it. Mercifully, the Securities and Exchange Board of India (Sebi) has dropped plans to rush into a T+1 rolling settlement recently.


The problem with brokers funding clients for two days is evident during savage market declines of the sort we have witnessed in the manic month of May. For most brokers—large and small—it has been a big struggle to keep bringing in fresh money to fund the pay-in every third day. While banks and non-banking finance companies do offer guarantees, over-drafts and lines of credit to brokers, a substantial chunk of money continues to come from informal financiers. A broker says, “I am running out of sources to borrow from…I can’t keep going back to the same financiers since they turn nervous even though we return the funds after a settlement.” At least one large broker has been on the verge of default and bankers and regulators know this—only the public is clueless, because it no longer affects settlements.


Let us now look at the debate over the extent to which foreign institutional investors (FIIs) influence stock prices. Any market participant will tell you that the large throng of retail investors comprising housewives, grocers, business executives and college students are no investors; most of them are day-traders or small speculators. They have no view on the market, know little about companies they invest in and operate on stock tips. Their rapid transactions are akin to betting at a casino. Unfortunately, many of these punters began to believe they were genius traders in the three-year bull-run and were actively encouraged by brokers/ financiers to leverage their investment and increase their trading volumes.


Consequently, large retail volumes take their cues from FII trades in the cash and derivatives segment. Even penny stock manipulators know this. The quantum of long-term retail holding does not influence prices. Traders look to make money by staying in step with FIIs and FII influence on prices is evident from the turmoil following their $2 billion pull-out in May.


• It is ironic that systemic issues are being debated when the rally is fizzling out

• Theory may not answer why panic was triggered by higher volatility margins

• Convoluted structures are being used to ensure small, regional bourses survive


It is in this typically Indian context that one has to look at the panic triggered by the increase in volatility margins on May 22 that led to a 10% crash at noon and triggered a circuit break. Academic theory may not have all the answers.


A broker illustrates the situation with the example of Sterlite, where a derivative contract comprises 1,750 shares. On May 15, Sterlite traded at Rs 598, making the value of each contract Rs 10.46 lakh. The base margin (SPAN margin) on this contract was Rs 2.46 lakh or 22%.


On May 16, Sterlite dropped to Rs 503. The exchange immediately collected a mark-to-market margin on the Rs 95 fall, while the SPAN margin remained Rs 2.46 lakh and is not reworked at the lower price as was being done in earlier carry-forward systems.


On May 19, Sterlite opened at Rs 380, leading to another hefty mark-to-market collection of nearly Rs 200 in just four days. The SPAN margin remained at Rs 2.46 lakh, even though the price dropped drastically. Now let’s look at what happened on the crucial day of May 22. Sterlite opened even lower at Rs 330 and fell steeply to Rs 255 in intra-day trades. Thanks to increased volatility, the exchange’s standard algorithm now increased the SPAN margin to Rs 2.86 lakh. Add to this the mark-to-market payments.


At Rs 255, the value of a contract of 1,750 shares itself is down to Rs 4.46 lakh on which the SPAN margin alone is Rs 2.86 lakh (up from 22% to 64%) without including the Value-at-Risk M-to-M payments of 10% collected from clearing members.


The combined impact of these margins is extremely harsh on small brokers, who do not have banks or finance companies extending fat lines of credit to them and their clients. One could argue that only large well-capitalised brokers should exist in the Indian capital market, but then that has never been the official policy. In fact, even today, the government and the bourses are working overtime to ensure the survival of small, regional exchanges and their members through dangerously convoluted structures.


Clearly, the policy response to this situation has to be based on Indian ground realities. We cannot have a capital market where the policy makers and bourses work with foreign educated academics while our reality is different. Here, our market is so shallow that a bunch entities working together can cause the Sensex to surge 379 points in a single day (to keep a mega IPO plan on course) even when 601 of the top 900 stocks declined and only 299 posted an increased last Friday.


-- Sucheta Dalal