Making sense of margins
In recent weeks, margins on India's equity market have been substantially changed. Do these initiatives make sense, and how should margins be calculated? In this article, we present a simple conceptual framework that leads to a simple approach to margins. Conceptual clarity on this problem leads to the ideal risk--containment system requiring exactly two kinds of margins.
At the outset, we should carefully define the objective of a risk containment system. The end objective is not to avoid defaults by brokers. The function of a risk containment system is to ensure payouts of funds or securities to those brokers who have correctly done their payin. If a person has brought shares to the clearing corporation, he should always get his funds, on time. A clearing corporation which becomes a legal counterparty adopts a major risk when it assures a payout on a fixed payout date, using its own funds (if need be). The role for margins is to protect the integrity of the clearing corporation.
Financial prices will fluctuate, and until the transition to rolling settlement is complete, there can be as much as 14 days between the day of trading and the day of settlement on NSE. The price movements, and hence the losses, over 14 days can be considerable. The broker now has a choice: (a) to fulfil settlement obligations or (b) to declare bankruptcy. The latter option is often quite attractive when positions are large and prices have moved a lot.
This is partly a problem of structural reform, where these long delays between trading and settlement need to be eliminated. The equity market is now ripe for a complete move to T+5 rolling settlement, even for shares which have not graduated into the depository. With rolling settlement, the scope for price fluctuations is smaller, leverage is diminished, and hence the incentive to default is smaller. An equity market with purely T+5 settlement would require much less knowledge and administrative efficiency in order to obtain smooth functioning.
The second--best alternative to such structural reform is a correspondingly stronger risk containment system. The first step is to move away from 14--day risk to one--day risk. This is done using the "mark--to--market margin" (MTM margin). This margin forces each broker to pay up his notional losses each day. Suppose a person has purchased Reliance at Rs.150 and the price has dropped to Rs.140. If the position was closed out, it would suffer a loss of Rs.10. The MTM margin requires him to pay Rs.10/share even if the position is kept open.
The cleverness of the mark--to--market margin lies in breaking up a (potentially large) 14--day loss into a series of (smaller) one--day losses. Without the MTM margin, the broker faces one question at the end of 14 days: "Should I pay the full (multiday) loss, or should I declare bankruptcy?". With the MTM margin, he faces 14 small questions: "Should I pay up the one--day loss, or should I declare bankruptcy?". The MTM margin elicits better behaviour on the part of the broker.
The MTM margin was first used in India at NSE in late 1995, and it is clearly a major step forward in the design of a risk containment system. The MTM margin ought to be a simple idea, but two unique features have crept into MTM margins in India which are technically incorrect: (a) firms which make losses pay in the MTM margin but firms which make profits do not receive payments, and (b) the MTM margin is calculated on a per--stock basis (and profits are withheld while losses are not) instead of a portfolio basis. These errors should be remedied.
The next question is: Can a broker be induced to not default on the one--day MTM loss? This is where "initial margin" comes in. The initial margin is collateral placed with the clearing corporation to back a position. It should be larger than the MTM losses imaginable on the position on 99% of days. When a broker makes an MTM loss smaller than the initial margin already deposited, there is absolutely no incentive to default. The clearing corporation is then only left with the residual (rare) cases where MTM losses exceed the initial margin, where default can happen.
Given the different speeds of electronic trading and funds movement in India, the only meaningful notion of initial margin is one where it is paid upfront, before the trade takes place. Similarly, the only meaningful notion of initial margin is one where liquid assets are deposited -- real estate, broker cards, etc. cannot be allowable. These policies are used at NSE's clearing corporation, the NSCC. Positions of brokers are evaluated in real--time, to ensure that the initial margin in hand always exceeds the risk of the position. Other stock exchanges do not share these principles, and have hence come to grief. In addition, the levels of margin (i.e. safety) at NSCC are much stronger than those seen with other exchanges.
How much initial margin should be charged? It should depend on two things: (a) the risk of fluctuations of the portfolio and (b) the illiquidity of the stocks in the portfolio. The former is best addressed by the idea of "Value at Risk" (VaR), which is being required by SEBI for initial margin calculations on the derivatives markets. This very principle should be applied on the equity "cash" market also, since the cash market today is more like a futures market than like a true (rolling settlement) spot market. VaR would correctly factor in the volatility of alternative stocks. The recent initiatives to require margins on a per--stock basis, depending upon stock volatility, are incorrect in their computation of risk. The risk of a portfolio is not the sum of the risk of its stocks, so these rules (like those which preceded them) imply incorrect levels of initial margin.
There is a plethora of confusing terms in India today: initial deposits, base minimum capital, initial margin, MTM margin, concentration ratio margin, special margin, ad--hoc margin, etc. We should cut through this complexity and focus on exactly two margins: the upfront initial margin (the VaR) and the MTM margin. Each complexity with margins in India has come about in a situation of crisis, in an attempt to deal with a specific problem which then appeared to be manifestly apparent. Each crisis has left an additional twist in the system of margins. The resulting system is incomprehensibly complex and (more important) generates wrong margin numbers. We now face one of two choices:
- The paradigm of trading on the cash market should be transformed to become rolling settlement. The greatest appeal of moving to T+5 settlement is that these questions would then not need to be completely resolved! It is intrinsically easier to run a equity spot market which uses rolling settlement, and the potential for damage through poor enforcement is much smaller. Alternatively,
- The paradigm of risk containment should be cleaned up. SEBI and NSCC should step back from the system and the exigencies of the moment, think clearly about the basic economics of risk measurement, and set forth a blueprint for how risk containment should function with highly leveraged trading.
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