Upfront margins on stock trades in cash segment are a good thing

There was an uproar towards the end of last month over market regulator Securities and Exchange Board of India’s new rules on collecting margins beforehand in the cash segment. The spin was that this will cause serious problems to investors and constrict the volume in the cash segment considerably.

As is the wont these days, the hardship caused by the Covid-19 pandemic was also cited as a reason why the market regulator should not be imposing such new guidelines at this juncture. SEBI became nervous at the uproar and backtracked, postponing the implementation of the rule by a month.

But the regulator is in fact right in trying to control trading activity in the cash segment. Volumes in this segment have been surging since the lockdown began in April and deliverable volumes have fallen, indicating that most of these trades are speculative, being transacted by smaller retail investors. Curbing trading volumes will be in retail investors’ interest.

It also needs to be noted that only the margins had to be deposited upfront and not the entire amount, thus not depriving clients from leverage completely. Also, phased implementation of rules prevents unwanted disruptions.

The regulator, however, needs to pay heed to the operational difficulties caused by the new rules to brokers and investors and try to smoothen them.

What SEBI did

The cash segment of capital markets is typically for delivery-based transactions only, where investors transact to buy or sell shares, commodities, and so on. Speculative trades are meant to be done in the derivative segment, where traders deposit an initial margin to do leveraged trades.

While ideally trading should not take place in the cash segment, some trading activity is common in the cash segment of most exchanges. This is not such a bad thing as markets need all kinds of participants to provide liquidity that is essential for efficient price discovery.

The problem arose when trading members allowed extra leverage to their clients to trade in the cash segment by waiving a part, or all, of the margin requirement, provided the trade was squared off by the end of the day. Since the margin requirement for a client was determined only towards the end of the day, it allowed clients to trade without depositing margins and brokers benefited by earning brokerage on the higher turnover.

In the aftermath of the Karvy Stock Broking episode, the market regulator decided to rectify this anomaly. SEBI, through a circular issued in November 2019, stipulated that the Value-at-Risk margin and Extreme Loss Margin in the cash segment shall be collected before the trade is transacted. Such rules for upfront margin collection is already in place for derivative transactions.

To ensure that the rules were followed, SEBI laid down that the clearing corporations should send client-wise margin requirements four times during the trading session. The broker shall be penalised for non-collection of margins based on the shortfall between the maximum margin requirement and the actual margin collected.

Many trading members have been up in arms over these rules, claiming that this will throttle the cash segment. But that is not correct.

Restraining retail investors

The Covid-induced lockdown has attracted many wannabe traders to the stock market, who are looking at stock trading not only as an avenue to make a quick buck but also for the adrenalin rush.

With futures and options being more complicated, many of these new traders seem to have gravitated towards trading in the cash market.

This is borne out by two sets of data. One, the turnover in the cash segment has been sharply higher since this April. The average daily turnover between April and July was around ₹55,000 crore on the NSE, 53 per cent higher than the daily turnover in FY20.

That most of these trades are speculative is evident by the percentage of trades that result in delivery. Only 15-16 per cent of the trades resulted in delivery in June and July, down sharply from an average delivery volume of around 22 per cent in FY20. With brokerage rates being higher in the cash segment, compared to derivatives, it is not surprising that trading members would want this trend to continue.

But this is far from ideal for smaller investors. They are better off trading in options where the capital loss is limited rather than in the cash segment.

Hardly the end of leverage

It would also be wrong to state that SEBI’s move will result in ending leveraged transactions in the cash segment, since only the initial margins (VaR and ELM) have to be deposited upfront. Depending on the volatility of the stock, the client needs to deposit only a part of the total cost initially. If he/she wanted to hold positions for a longer duration, then derivatives is the better route.

Also, SEBI intends to enforce the upfront margin rule in a staggered manner. In the first three months after implementation, only 25 per cent of peak margin needs to be available before trading. In the next three months, 50 per cent of peak margin needs to be collected upfront, 75 per cent in phase three, and 100 per cent thereafter.

It is, therefore, not likely to hurt market volumes immediately and will give brokers time to coax clients to deposit the required margins with them. After all, collection of adequate margins is a good risk-management practice for the entire trading ecosystem.

Remove the glitches

That said, SEBI needs to ensure that some of the procedural hassles due to the new rules are addressed. For instance, if a client sells a stock and has made delivery, he will be unable to buy another stock using the proceeds until the settlement, when the funds come into his trading account.

Similarly, a client who regrets buying a stock, immediately after the transaction and wants to switch to another stock, will not have the flexibility to do so. A way out of such problems can be to move towards real-time settlement where banks, clearing corporations and exchanges are interlinked to allow instantaneous settlement so that the need for upfront margins does not hamper investors.

The regulator also should not paint all stock brokers with the same brush and pay heed to operational difficulties faced by them to ensure an efficient trading ecosystem.

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