Margin Changes in Exchange Traded Derivatives

Surjit Bhalla wrote a provocative piece in the Business Standard yesterday describing the system of automatic revision of margins in Indian stock exchanges as ugly and insane – the first adjective is quite appropriate, but the second is not. Bhalla is right in saying that the Indian system is different from what the rest of the world does, but it does not follow that the system is wrong, much less that it is insane.

Most exchanges around the world change margins infrequently and in a discretionary manner. Everywhere in the world, market turbulence does lead to a rise in margins. Last week itself when the Chicago Mercantile Exchange (CME) left margins unchanged on stock index futures, it raised margins on interest rate futures sharply in response to increased volatility. What the Indian system does is (a) to take the discretion out of the system completely and (b) to make the revisions more frequent.

The system adopted in India is similar to the internal models that banks and securities firms use to monitor and control the risk of their trading positions. Like any other sound margining system, it does have the potential to create a vicious cycle of falling prices, margin calls, unwinding of levered positions and further price falls. It is ugly but it can hardly be called insane.

It is also true that there is significant over-margining in the Indian system. Partly, this reflects a greater risk aversion on the part of Indian regulators and the broader political system. As Indian regulators and politicians become more comfortable with well functioning derivative markets, the risk aversion should decline. The over-margining is also due to the lower level of capitalization of securities firms in India which forces exchanges and brokers to rely almost entirely on margins to ensure solvency. As Indian brokerages consolidate and shore up their capital base, this problem should also get attenuated. Over a period of time, therefore, the margining system could become more relaxed – both in terms of lower quantum of margins and in terms of lower urgency in raising margins in response to volatility spikes.

What India does need urgently is an abandonment of informal and ad hoc margin tightening in times of crises. One keeps hearing anecdotes about members being asked to reduce positions or deposit more margins than is mandated by the regular margining system. A greater degree of transparency in this regard would also be welcome so that false rumours do not circulate about this.

Posted at 8:47 pm IST on Sun, 27 Jan 2008         permanent link

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