Margin trading and falling market

Published : Jun 16, 2006 00:00 IST



EVERY bout of speculation in the stock markets has its own unique instruments. Those playing the high-risk game will have their own reasons to justify them, but the fact that they are essentially tools of speculation is ignored - until the next crash. Margin trading, the system by which brokers finance their clients for the purchase of shares in the futures market, has been blamed for having accentuated the market crashes in May.

The practice originated in the U.S. during the stock market boom of the 1920s when brokers encouraged investors to enter the market by lending them money to buy shares. Many ordinary people were induced to speculate.

L.C. Gupta, director of the Society for Capital Market Research and Development, says that the 1929 crash was partly a result of this kind of trading. The Securities Exchange Commission increased the margin money, or money that an investor-client of a broker is required to deposit upfront, after the crash.

Typically, once a client puts up margin money, the broker lends him the remaining portion of the transaction - usually two to five times the margin - and charges interest on it. Margin trading happens under the aegis of stock exchanges because they prescribe a list of securities that can be dealt in this manner.

This kind of trading is essentially meant to facilitate "liquidity" in the exchanges. In effect, it is biased in favour of accelerating the velocity of turnover in the market. In the process, it exposes the system to substantial risk.

The system works fine when the market is moving up, but when it is moving down, as it has been since mid-May, it stands exposed. That is what happened on May 22, when desperate brokers made margin calls on their clients in a market that was caught in a downward spiral.

The broker always maintains a maximum level of exposure vis--vis his client (in the case illustrated here, 85 per cent of the value of the securities at any given time). In an upward market the broker's risks are low. The margin cover is adequate; moreover, since the underlying value of the security is increasing the value of the client's collateral with him is increasing.

Things change dramatically when the market slides. When the share price falls, so does the value of the collateral. In effect, the cushion available with the broker stands diminished.

More important, the amount lent by the broker exceeds the limit set (in this case, 85 per cent of the value of the securities) because the share price has fallen. The broker makes a call on his client, asking him to cover the gap in the margin. This, in market parlance, is a margin call. If the call is not answered, the broker sells the shares to protect himself.

When share prices fall dramatically, as they did on May 22, and if the entire market is in free fall, the broker can be in serious trouble. Normally, faced with a margin call, investors either pay and cover the gap or sell the shares. Between May 19 and 22, when the market was sliding, clients asked brokers to sell their shares instead of covering the gap in their margins. And brokers with unanswered margin calls also liquidated their holdings. The selling pressure, happening as it did in a market that was already sliding, contributed to the free fall on May 22.

Speaking to the media on May 22, Finance Minister P. Chidambaram said funds for covering margin calls would not be found wanting, particularly from banks.

According to a market source, private banks are usually the main financiers of brokers' loans to clients. He said that it was unlikely that they would do the Finance Minister's bidding going against prudent behaviour in a highly risky market. In that eventuality, the task may well fall on public sector banks. But should public institutions venture into this risky field, which is basically a means of letting people speculate with borrowed money? This is especially so in a situation in which they have substantially more important unmet priorities such as providing loans to farmers.

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