Has anything changed in the trading activity due to the new peak margin regulations? Any impact for brokers, traders, and exchanges?
What has been the impact of peak margin regulations on the broking industry, traders, and exchanges?
We had shared this post back in Nov 2020 when the effect of peak margin started kicking in. For those who want to know the background, you could read this post below.
We are in the final leg now. Starting Sep 1st 2021 brokerage firms can’t give any additional intraday leverages for both equity trading and F&O trading. This means you will need minimum margins, VAR+ELM for Stocks SPAN+Exposure for F&O, even if you are trading for intraday. Find below my point of view on all of this, why the regulation was put in place, what has been the positives and negatives.
Reduction of risks brokers take
The main reason for introducing peak margin requirements was because there were few brokers who were offering crazy amounts of leverage to attract business. For example, there were brokers who would allow you to buy a Nifty futures contract whose value is Rs 6lks for just Rs 6000, while the SPAN+Exposure margin required was Rs 1.06lks. Such low margins meant that if there were sudden large moves, the customer could lose more money than the balances with the broker. This would mean the broker had to take the loss. We even had a couple of large brokers going bankrupt mainly because of the excessive risk they had taken.
This additional intraday leverage offered by the broker can be a lot riskier if the funded amount doesn’t belong to the broker but another customer. For example, in the above case, to trade 1.06lks worth of Nifty futures, if the broker allowed the customer to trade with Rs 6000, the remaining Rs 1lk has to be funded. There have been instances where this funding was not done by brokers’ own money but through idle funds of other customers with the broker. Apart from the peak margin regulation, SEBI has done a phenomenal job over the last 3 years in terms of new regulations that now cover all these risks.
As the CEO of a brokerage firm, I can today say without a doubt that the client default risk which can, in turn, cause a brokerage firm to go down is the lowest it has ever been historically. In terms of retail investor interests being taken care of, Indian capital markets are by far the best-regulated market in the world.
Reduction of risks that clients take
The regulation also probably intended to reduce the risks clients take. Lesser the leverage the lesser the chances of customers losing money. But there has also been an inadvertent second-order effect. Intraday traders who seek leverage and who don’t have sufficient margins have moved from trading stocks, futures, and shorting options, to buying options that have much higher leverage and risk. The total number of option trades daily as a percentage of overall trades on the exchange is now at all-time highs.**
We had shared this post on why buying options, even though the maximum loss is the premium paid, is the riskiest type of trade out there.
Shallow market depth & Volumes
Most people don’t consider the value of day traders. Their activity helps improve the liquidity which reduces impact cost and better price discovery. While the markets have grown phenomenally in terms of participation thanks to the bull market, the market depth or total quantity of bids and asks in any stock has only deteriorated over the last year. Most new customers are investors who mostly buy and hold. They aren’t adding liquidity to the markets the way day traders do. The impact cost or what you lose in the bid-ask spread while buying or selling on the exchange hurts all types of market participants. Lower the liquidity, higher the impact cost.
Our take on this?
It is important to have some cap on the intraday leverages provided by brokers. Brokers competing with each other to offer higher leverage to attract customers isn’t good. This broker risk is also systemic. One large broker going bankrupt may not only affect all the other clients who trade with this broker but also the clearing corporations and hence all other brokers as well. But that said the reducing liquidity and shallow market depth should also be a concern. This not only increases impact cost but can also lead to a sharp increase in volatility when there are news events. If we didn’t have this humongous jump in market participation over the last year, the liquidity would have dipped significantly.
The way SPAN+ELM or VAR+ELM is calculated, the risk is considered to be the same for an overnight (SPAN actually covers 2-day risk) and an intraday position. But clearly, the risk differs, intraday is less risky because most large market movements happen overnight. If the risk is lesser, ideally you’d want the margins to be lower as well. ANMI (NSE member association) had commissioned a study that suggested asking for a maximum of 50% of VAR+ELM or SPAN+Exposure for intraday positions, giving some margin benefit. This I think would be the best-case scenario, especially considering that now there is a system in place to ensure if any additional intraday leverage was provided, it can happen only through brokers own funds.
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Another inadvertent second-order effect will be that most likely the minimum margin required will have to be higher even than the SPAN+Exposure for F&O positions. This is because margins for F&O can go up intraday if there’s a sudden spike in volatility. SPAN margin updates 5 times during the day.
If a customer doesn’t have sufficient margin to cover this requirement, there can be a peak margin penalty. In the case of short option positions, margins go up if the market moves against your positions - unlike futures where there is an MTM loss that can be brought in by end of the day. So if there was a large move intraday, margins can go up intraday on short positions that can lead to peak a margin penalty as well.
My guess is that brokers will have to start blocking slightly higher margins than the SPAN+Exposure also to cover for these eventualities, and to avoid peak margin penalties. I think this will be around 5% of the SPAN+Exposure margin additionally. So if Nifty futures has Rs 1lk as a margin requirement, brokers might have to start asking for around Rs 1.05 lks.
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what about hedged positions sir?..for tat also margin ll be increased if there s high volatility?.
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SEBI has taken this decision to help retail traders, by disallowing huge position sizing and thereby limiting their orders.
In a way its good, because the capital will not be lost even if few trades go wrong. In fact SEBI has stepped in and done the position size calculation for you !!!
The downside is the charm of Indian stock markets will be lost. Even today - 99% of traders believe they can make 1 lakh out of 10 thousand committed. These people will be eventually turned away and many will rely on mutual funds or FDs to grow their capital.
Having said this, its going to be a blessing for the option sellers as the volatility will drive up the premiums. Newer option buyers will continue loosing money and exit, further reducing the liquidity and increasing the volatility.
Meanwhile if the market corrects 20 to 25% from here or does not grow more than 5% next year - we can see a mass exodus of “covid period” investors. This will further push down the liquidity - but this time it will be brokers who are impacted the most !!!
As in all businesses - rich will keep getting richer and poor will spiral further down !
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