How a recent SEBI order sounds the death knell for intra-day leverage

The Securities Exchange Board of India’s (SEBI) new margin framework has practically put an end to the intra-day leverage provided by brokers to their clients. While SEBI has always insisted on collecting the margins upfront, many brokerage houses provided intra-day interest-free loans in both cash and derivatives segments.

These leveraged trades using intra-day loans meant additional trades could be done without additional margins.

These trades were then closed at the end of the day.

The intra-day loans were made possible because the current practice is that the trading members (TMs), ie, brokers and clearing members (CMs), reported the margin amount due and margin amount collected from their clients only at end of the day. Since these intra-day trades were squared off within the same day, there was unlikely to be any margin shortfall towards the end of the day.

Importantly, the intra-day leverage contributed to higher volatility as huge volumes were transacted with very less capital.

What did SEBI do now to change this?

The new framework will penalise brokers if they fail to collect margins upfront for intra-day trades. This is done by mandating the CMs to communicate the client-wise margin amount that should have been collected upfront by the brokers at a minimum of four times a day, rather than at the end of the day’s trade.

Any shortfall or non-collection of margins by brokers will attract a penalty. The same will be verified by the exchanges on a weekly basis.

Consequently, this will discourage brokers from offering the intra-day leveraged trading facility to their clients.

Margin types

For cash market, the initial margin will be VaR (value at risk) margin, plus Extreme Loss Margin (ELM).

For the derivatives segment, the initial margin will be SPAN (standardised portfolio analysis of risk) margin, plus exposure margin.

VaR margin intends to cover the largest loss that can be encountered for 99 per cent of the days. This can vary for each stock depending on its volatility and liquidity. For instance, VaR margin for SBI is 35.12 per cent, but for YES Bank, it is 65.4 per cent. This proportion signifies the loss that can be encountered on 99 per cent of the days on the two stocks.

]ELM collected in addition to VaR margin is like a second line of defence.

The SPAN margin and the exposure margin for derivative contracts are like the VaR margin and ELM for the cash segment.

Additionally, there is a mark-to-market (MTM) margin applicable on both cash and derivative trades. This is calculated at the end of the day by comparing the transaction price and the closing price of a particular stock. Apart from these, the exchanges can ask for a stock-specific special margin, called an ad hoc margin, if there is any abnormal volatility. For example, exchanges have slapped an ad hoc margin of 11.1 per cent on YES Bank.

So, the upfront margin adds to 80 per cent, including VaR margin of 65.4 per cent and ELM margin of 3.5 per cent.

Margin obligation

Consider that someone buys shares of HDFC Bank worth ₹1 lakh in the cash market. The applicable upfront margin for the stock is 18.19 per cent and so the margin obligation would amount to ₹18,190, ie, with this money a trader or investor can buy shares of HDFC Bank worth ₹1 lakh. This is without intra-day leverage and this margin would be sufficient to carry this position overnight.

Suppose the broker offers an intra-day leverage of, say, 2x (an intra-day margin requirement of 50 per cent on the upfront margin), the margin obligation here will be only ₹9,095 for the same HDFC Bank shares worth ₹1 lakh. This is commonly referred to as Margin Intra-day Square-off (MIS), which might vary for each client depending on the experience, relationship with the broker, etc.

This is offered on the condition that the trade will be squared off by the end of the day. In case the trader wants to carry-forward the trade overnight, the margin to be maintained will be ₹18,190.

Similarly, for the futures contracts, the margin varies based on volatility or liquidity of the underlying asset, and it is calculated on the notional value of the contract. For instance, the upfront margin to enter a trade in Reliance Industries futures is currently about 27 per cent. The notional value is ₹10,60,500 (current market price multiplied by the lot size of the contract). So, the margin obligation will be ₹2,86,335 for RIL. In case the broker offers an MIS margin of 40 per cent on the upfront margin, the margin obligation will drop to ₹1,14,534.

However, SEBI’s new margin guidelines will be implemented in four phases, with three monthly rests, starting from December 1, 2020, and the intra-day leverage might not be available from August 1, 2021.

Traders can be at a disadvantage as this can significantly reduce their intra-day return on investment as more capital will have to be deployed to execute a similar transaction. However, this can bring down the highly leveraged trading that can potentially lead to huge losses.