At its next board meeting scheduled for November 10, the Securities and Exchange Board of India (SEBI) may, at long last, clear new guidelines for margin trading. This column appeared in
Divvya Bhaskar in Gujarati on Monday, 3 November 2003.
Margin trading may finally debut in November
By Sucheta Dalal
At its next board meeting scheduled for November 10, the Securities and Exchange Board of India (SEBI) may, at long last, clear new guidelines for margin trading.
SEBI, especially under its current leadership has been extremely reluctant to encourage anything that is prone to misuse and excess; and nobody can argue that margin trading is not a much-misused financing instrument.
Hence, the debate leading up to the board meeting has been long and lively. While the regulators were reluctant, the broker community lobbied hard and argued that margin trading is imperative for infusing liquidity in the market.
So a comprehensive report on margin trading was first prepared by its supporters and posted for discussion on SEBI’s website in 2002. The report, as well as the public comments that SEBI received, were then put before the Secondary Market Advisory Committee (SMAC), whose views in turn were again posted for debate, before taking the final proposal to the SEBI board.
A reading of the SMAC’s report makes it clear that several members disagreed that margin trading was imperative for enhancement of liquidity. One member even called it a form of vyaj badla. It supporters however insisted that it improved market efficiency.
Ironically enough, the present bull run may have ended the debate by establishing that liquidity is no longer an issue. In fact, derivatives trading volumes have shot beyond Rs 10,000 crore a day on the major bourses, adding to the overall liquidity of the market. Banks too have turned bullish about funding margin trades. In fact, media reports suggest that HDFC Bank, always an aggressive financier of stockbrokers, may have been asked to reduce its exposure to the market (the bank has denied the report).
The 2002 paper on margin trading proposed five models.
The first had the broker as the prime financier, who would lend to his clients under a specific contract/agreement covering the rights, margins and collateral for both parties, especially in case of default. Since the broker took care of the client’s credit risk, there would be no settlement risk on the system.Some SMAC members felt that although this model was globally popular and provided trading flexibility, it was not transparent enough.
In the second model, the clearing corporation or the stock exchange would be the financier.However, the clearing corporation would not extend its own funds, it would act as an intermediary for funding by banks/institutions and private financiers, who would naturally find it safer and more convenient to transfer their counter-party risk to the clearing houses and thus on to all investors.The funds were to be lent through the on-line trading platform of bourses. This model was shot down by the SMAC, especially by stock exchange representatives.
The third model wanted banks and institutions to lend more to brokers by modifying the Reserve Bank of India’s (RBI) November 2001 rules.It suggested that the overall ceiling of five per cent on exposure to the capital market be doubled by providing an additional five per cent only for margin trading. It also wanted the central bank to clarify how banks should ensure that no nexus develops between borrowing brokers and banks. It also recommended that the Rs 20 lakh limit for lending to individuals be increased and the 40 per cent mandatory margin hiked to encourage the business.
The fourth model suggested the creation of a “limited purpose bank” for the margin trading. It would raise deposits from financiers and lend it to borrowers. The bank would finance clients directly, or though brokers, in which case it would manage the risk directly. Or, it would lend funds through the clearing corporation, which would manage the risk for the bank. The fifth model was a variation through the Depository Participants and Depository. Both these were however rejected, for the moment, because they would involve huge infrastructure costs.
Having debated the alternatives, the traditional margin-trading model found favour with the SMAC subject to some important variations and with additional safeguards. This is that banks and finance companies would actually finance the margin trading and brokers would only act as facilitators by bringing clients to the lenders.
The SMAC also cleared the broker-financed model, but said that only corporate brokers with a Rs three crore capital can finance margin trading based on a clear model agreement with their clients. Also, that brokers could lend their own funds, or those borrowed from banks and qualified institutions approved by SEBI --there will be no private financing of margin trading by individuals or investment companies. The total indebtedness of the broker would have to be less than five times his networth and there would be mandatory separation of accounts and daily client-wise disclosures to the bourse.
If SEBI clears the new margin trading rules in November, it would put an end to the misuse of SEBI’s 1997 guidelines covering lending and borrowing of funds by members, which have been used by brokers to fund margin trades despite their doubtful legality.