Filling a gap

The Securities and Exchange Board's discussion paper on margin trading, issued in December 2002, mentioned the ambivalent status of margin trading in the country.

In November 2001, based on the recommendations of the RBI-Sebi Standing Technical Committee, the RBI had issued instructions to bank boards to formulate detailed guidelines on margin trading subject to certain limitations, such as an overall ceiling of 5 per cent of advances for banks' exposure to the capital market.

Nevertheless, despite the enabling provisions, margin trading had not taken off, due to the ambiguities in the guidelines, the most important one probably being the lack of clarity about the role of brokers in the mechanism.

Sebi has now clarified that role, and corporate brokers with a minimum net worth of Rs 3 crore can lend upto five times their net worth to their clients by way of margin against shares.

This will be extremely beneficial to their clients, because they can now pay only 50 per cent (the currently stipulated minimum margin) of the price to buy the stock. While some brokers have complained that the margin is too high, it seems to be justified during a bull run, and could be relaxed in less exciting times.

The new arrangement should work because brokers usually know their clients and should have no difficulty assessing the credit risk, especially with Sebi's safeguards in place.

At the same time, now that Sebi has given its nod to the scheme, banks should have no difficulty funding creditworthy brokers, of course within the overall ceiling of exposure to the capital markets. Margin trading through brokers is a model that is being followed in stock markets the world over and there is no reason why, with proper safeguards, it shouldn't work in this country.

It will increase volumes and liquidity in the market, making for more efficient price discovery. Further, with shorter settlement cycles, margin trading and stock lending become essential mechanisms to ensure smooth settlement and prevent failed trades.

Sebi has also strengthened the existing stock lending mechanism by allowing clearing corporations of stock exchanges to borrow shares, thus doing away with auctions of securities. This will facilitate lending and borrowing of securities, although a real pick-up in this activity will not take place so long as the restrictions against short selling remain in place.

More importantly, both margin trading and stock lending are necessary for a transition to physical settlement for the derivatives segment of the market. At present, all transactions in the derivatives markets are settled in cash, which has the effect of de-linking the cash and derivatives markets.

With physical settlement, the cash and derivatives segments are more closely interlinked, which helps price discovery, and that is why Sebi has announced its intention of moving towards physical settlement. But with physical settlement, players must also have access to funds and to borrowed stocks to meet the needs of physical delivery.

The margin trading and stock lending mechanisms will cater to these needs. In short, both margin trading and stock lending are standard operating mechanisms in developed markets across the world, and their introduction will fill a gap in the Indian market.