Firstly, the upfront VAR+ELM margin requirement for trading stocks that was introduced is new, but the upfront margin for F&O had always existed. Just that brokerage businesses including us had taken a view which was business-friendly. Let me explain -
For those who didn’t know - when a client buys 1lot of Nifty with only Rs 25k using an intraday order type (BO/MIS/CO) when the NRML (SPAN+exposure) margin is Rs 1lk, the exchanges block Rs 1lk from the broker. What this means is that the broker ends up funding the customer for the remaining 75k. If you are wondering why the broker allows the client to leverage, it is obvious - higher brokerage. Most traditional brokers charge a % fee, so the higher the value of trade, the more the fees. Even the flat fees broker (like us) will see a higher number of trades and hence revenue if the client has this additional funding/leverage. There is also the pressure to offer additional leverage fearing customers would move to the competition.
There are two issues with this -
- What if the 75k didn’t belong to the broker, but was of another customer? We as Zerodha have always put our own capital whenever a customer had traded without sufficient margin. But the recent issue with BMA and Karvy revealed to SEBI that they were blatantly using one client funds to fund another.
As you would imagine, if one client’s fund is used for another to trade F&O with high leverage, money can be lost really fast. If the broker isn’t sufficiently capitalized, this brings a big risk to all the customers with the broker.
For example, assume a client is long 10lots of stock future of contract size 10lks (lot size 10000, price 100), whose SPAN+Exposure is 20% or Rs 2lks. Assume this broker is allowing intraday trade with 5 times leverage or asks for only 4% or Rs 40k per lot or Rs 4lk to take a position worth 1 crore. Assume there was bad news on this stock and it fell 20% or Rs 20. Stop losses didn’t trigger as the fall was instant. This client would have lost Rs 20lks with only Rs 4lks present in the account, a debit balance of Rs 16lks. What if the client didn’t make good of the loss? What if it was not one client, but many clients? What if the broker didn’t have his own capital but was using another client’s idle funds to fund this client position? As you’d imagine, it creates a systemic risk. Even with 20%, there is no guarantee that it is enough when shit hits the fan (like in 2008), that is a risk every brokerage firm runs at all times, but SPAN+Exposure margin covers for majority of the risk and it also helps that it is updated 5 times a day to cover for even the intraday volatility of the stock.
- Regulations don’t allow brokers to fund clients for F&O. So you might have a question, how was it offered until now then?
All brokers are required to report client margin at the end of the day to the exchange. This reporting also ensures that one client funds can’t be used by another client, at the end of the day. If clients margin is lesser than the margin required to hold the position, there is a short margin penalty levied. So if a client held one lot of Nifty with just 25k while the required margin is 1lk at end of the day, there would be a short margin penalty on 75k which is quite a bit. This is where the brokerage industry took a view which favoured the business. Since the reporting is at the end of the day, there is no issue if there wasn’t sufficient margin intraday, as long as by the end of the day the position was squared off. Since no regulation specifically blocked this, everyone offered intraday products like MIS, BO, CO, etc with higher leverage or lesser mandated minimum margin requirement. This got fixed when exchanges put out the clarification maybe on behest of SEBI after the Karvy, BMA incident -
They now say margin has to be collected before the trade along with saying upfront margins leaving no more ambiguity. Hence the entire margin (SPAN+Exposure) for any type of derivative trade has to be present in the trading account before a trade. I am guessing there will be a penalty structure on this very similar to how it is for the end of the day basis in the future.
Going forward, the margin and reporting system for equity will be exactly like F&O explained above. So while trading stocks instead of SPAN+Exposure, the client will need to have the VAR+ELM margins.
I guess over the next few days. The exchange guideline is already out and on their website.
We have the largest community of retail traders, we will probably be the most affected brokerage in terms of revenue. But if you go through the explanation above, there is no real way to oppose it, is it? Also once it is put out as a rule, the penalty for breaking rules for brokerage firms is quite high. Us discussing it openly is atleast getting all brokers to put an effort to see if the rule can be changed. Keeping quiet isn’t a solution, it would eventually end up being stopped without anyone getting a chance to protest.
One of the things that SEBI has done with the recent circular on margin collection and through this clarification from the exchanges is to ensure that a client can only trade with his/her own funds only to the extent allowed. Forget other client funds, but the broker can’t put his own funds to fund the client as well. Maybe the broker should be allowed to intraday fund using their own capital if they are ready to take the risk and that is something we have been asking for. But this requires changes in derivative product design at SEBI, which is extremely tough, especially in an environment where the industry is hurting due to regulatory pressure after the incidents at Karvy and BMA. Hopefully we will soon have the good news of margin requirement dropping drastically for F&O positions that hedge each other.
Hopefully, this helps.
Cheers,