Raise liquidity, but don’t make markets more risky

Deena Mehta & Himanshu Kaji

Individual stock futures, introduced in Indian stock markets recently, are said to be substitutes of badla or Automated Lending and Borrowing Mechanism (ALBM)/Borrowing and Lending Security Scheme (BLESS)(that was an acceptable market mechanism till the ban on July 2, 2001.

Badla was an indigenous product that performed three functions:
n It was a financing mechanism for investors who wished to buy shares by borrowing funds,

* It was a lending and borrowing mechanism for stocks, and
* It was a hedging mechanism for those who wished to guard against short- term movements and fall in the markets.

Margin trading has now been introduced by the Reserve Bank of India for meeting the financing needs of investors. As widely reported, this scheme has been a non-starter. The markets continue to be without any deferral product. Lending and borrowing is also not successful as authorised lenders are wary of lending stocks due to fear psychosis. A vital mechanism of short sale is absent from the market.

The hedging mechanism is available through options and futures in specific stocks and index. Volumes are slowly picking up and it remains to be seen how soon the turnover issue is addressed so that mass participation is available from brokers in derivatives market. Further, there is no clarity from the income tax department as to the treatment that will be given to gains and losses from hedging in derivatives.

Today, stock futures are looked upon more as a speculation tool then a hedging mechanism. If this is perceived as a speculation tool, then we need to take a good look at the risk management that has been introduced in stock futures. ALBM/BLESS were banned because they fuelled speculation, we now have a product that is more speculative and with lesser stringent risk management.

The Value at Risk (VaR) model has been accepted for risk management by the Securities and Exchange Board of India (Sebi) both for the cash and derivatives segments. Over and above VaR, some add-on margins are prescribed in both segments to make them safer.

The accompanying table gives comparative margins on the 10 most active stocks in rolling segment and on the options/futures contracts of these stocks in the derivatives segment. The table speaks for itself. Margins charged in the cash segment are 100 per cent higher then those charged in the derivatives segment. This is despite the fact that there is limited scope of speculation in rolling segment compared to derivatives. Contracts in the derivatives segment are cash-settled and not delivery-based and can be kept open for as long as three months. Low margins may result in excessive positions being built by operators and make the market risky. In addition, if one takes position in the rolling segment, he pays a 6.67 per cent upfront margin by way of gross exposure limit, while in derivatives, he pays 5 per cent.

Sebi has prescribed position limits in derivatives. The client-wise limit is higher of 1 per cent of free float of the scrip or 5 per cent of open interest in the scrip. There was no client-wise limit in ALBM/BLESS. The broker-specific limit was Rs 40 crore; in derivatives there is no overall broker-specific limit across all scrips. Against the Rs 5 crore limit per scrip, the limit in derivatives is 7.5 per cent of open interest in the scrip or Rs 50 crore. There is a concept of overall market-wise limit of lower of 10 per cent of free float in the scrip or 30 times the average number of shares traded daily in the previous month in the rolling segment.

It is not difficult to note that limits in derivatives are much higher than those allowed in ALBM/BLESS. Readers may recall that ALBM/BLESS were accused of excessive speculation and therefore banned. With limits as high as these, derivatives could do the same, if not worse.

Another important aspect is that VaR as a means of risk cover takes care of volatility, not concentration. Past experience shows that it is concentration, whether broker-specific or scrip-specific, that brings danger to the market. In ALBM/BLESS, in order to take care of broker-specific concentration; a limit of Rs 40 crore was specified. To take care of speculation being concentrated in a few scrips, a scrip-specific limit of Rs 5 crore was prescribed. The concept of concentration is absent from derivatives risk management.

In addition, in ALBM/BLESS, the Incremental C/F Margin (ICFM) was levied if outstanding position in the market in any one scrip exceeded Rs 75 crore or 3 per cent of paid-up capital (number of shares) in graded fashion. This extra margin ranged from 5 per cent to 30 per cent and was over and above the 12.5 per cent carry-over margin. There is no such extra margin if positions go beyond a particular threshold in derivatives. This could lead to concentration of positions with few traders due to high leverage and low margins and could, in turn, pose a danger to the market.

It is, therefore, necessary, that there should be a system of surveillance across the exchanges. The problem that happened in the March crisis was because there was huge position build-up since each exchange looked at its own outstandings and not the overall market positions. It is necessary for regulators to devise a system that will throw an alert when the positions across markets enter the danger zone. Permitting multiple exchanges and listings have certain responsibilities, and these need to be addressed.

The modified carry-forward system had a requirement of paying 100 per cent of carry-forward margin in cash. The ALBM/BLESS system diluted the requirement to 50 per cent and then 30 per cent only in cash. This led to huge volumes being transacted and carried forward with less investment of cash. Bank guarantees were easily available and leveraging was very high. This led to excessive speculation. The cash component in derivatives is abysmally low and can be used for fuelling excessive speculation.

Risk management, therefore, needs to be more stringent. The following measures are necessary to make the markets safer:
l The overall limits in the derivatives segment need to be suitably reduced at all levels i.e., client, broker and market level.

l A graded structure of margin needs to be put in place to avoid excessive concentration.

l The minimum cash component of initial margin in derivatives needs to be increased from 10 per cent (assuming 20 per cent cash margin and 20 per cent margin in form of shares on bank guarantee which can be up to 50 per cent of the total initial margin) to the same as in cash markets i.e., 30 per cent at least.

l Considering that the circuit limit in the rolling segment for these stocks is 10 per cent per day, the minimum margin in derivatives should be kept at 20 per cent to cover two days of maximum movement permitted in the rolling segment.

The success of futures lies in not only raising trade volumes, but also in ensuring a safe market. India is the only country in the world where in derivatives, the Trade Guarantee Fund is extended to cover the risk of broker defaults. In the cash segment, we provide investor protection through the Investor Protection Fund. However, safety is much higher in the derivatives segment. While there may be honourable intentions of increasing liquidity in the market, balancing of risk is equally important.

(The writers are former office-bearers, The Stock Exchange, Mumbai)