| To prevent another crisis, and to help the common investor rather than fat-cat institutions, Sebi must change the ugly and insane risk system it has adopted.
|
| |
| On January 22, the Indian stock market was open for one minute and 13 seconds and the Nifty stock index was down 10 per cent. The exchange was shut for an hour. It is quite possible, indeed likely, that the speed of decline towards a 10 per cent loss is a record among all stock exchanges and all periods of time. And if some simple changes are not made to our regulations concerning margins, India is likely to repeat this feat in the near future.
|
| |
| But before the evidence is presented, some points of reference. For many people, especially SMOBs (Senior Members of the Bureaucracy), the rather rapid decline in the market was healthy and "just desserts". After all, the market had gone up so much that a correction was inevitable. So what if it happened in one minute? And index futures just mean leverage, and leverage caused the decline, so why complain? More variations are heard, but all of them are less complimentary to the SMOB thinkers.
|
| |
| Let me make clear my concern. It is not the magnitude of the fall that is bothersome, but its speed. This week world stock markets have been in crisis and panic mode. Steep price declines have been observed everywhere. What makes the Indian market unusual is the speed of the decline (fastest) and the slowness of the recovery (slowest). This "special and ugly" nature of the Indian market has nothing to do with what happened before, as most SMOBs believe. Rather, it has everything to do with the rather special and insane margining system for index (and stock) futures that we have in place.
|
| |
Financial markets across the world are traded on an exchange and presided over by a regulator. For each contract there is a system of margining and leverage. For example, in the US market, one needs to pay only 50 per cent of a stock for purchase, that is, a leverage of two is allowed. Our concern is with index futures "" for the US markets, the margin to contract value ratio is around 6 to 7 per cent; for India, 10 to 15 percent and on January 24, it was a whopping 17.3 percent for Nifty futures. Index futures on stock indices around the world typically require a margin of 8 per cent (or a maximum leverage of 12). It is important to emphasise, especially for SMOBs who think otherwise, that the margining/leverage system is not unique to India, or even the 20th century.
Country/
Exchange | Margin requirements1 | Margin Ratio2 | Dec 13,
2007 | Jan 18,
2008 | Jan 22,
2008 | Dec 13,
2007 | Jan 18,
2008 | Jan 22,
2008 | | Europe/Stoxx | 3,300 | 3,300 | 3,300 | 7.5 | 8.2 | 8.7 | | Germany/DAX | 14,603 | 14,603 | 14,603 | 7.3 | 7.9 | 8.5 | Hong Kong/
H-Shares | 136,780 | 120,590 | 120,590 | 16.9 | 16.7 | 20.1 | Hong Kong/
Hang Seng | 170,100 | 159,850 | 159,850 | 12.3 | 12.8 | 14.7 | | India/NIFTY | 32,964 | 29,955 | 40,154 | 10.7 | 10.1 | 15.4 | | Japan/Nikkei | 5,000 | 5,000 | 5,000 | 6.4 | 7.4 | 7.7 | | Korea | 18,109 | 16,598 | 15,368 | 15.0 | 15.0 | 15.0 | | Malaysia | 4,600 | 4,600 | 4,600 | 6.6 | 6.4 | 6.9 | | Singapore | 5,875 | 5,000 | 5,000 | 6.9 | 6.6 | 7.1 | | Taiwan | 2,625 | 2,500 | 2,500 | 8.2 | 7.9 | 8.8 | | UK/FTSE | 3,000 | 3,000 | 3,000 | 4.7 | 5.1 | 5.2 | | USA/Nasdaq | 12,500 | 12,500 | 12,500 | 5.9 | 6.8 | 7.0 | | USA/S&P 500 | 22,500 | 22,500 | 22,500 | 6.1 | 6.8 | 6.9 | 1: All figures are in local currency units for contract lots, which differ from country to country
2: Margin ratio is the ratio of required absolute margin value to the size of contract value |
|
| |
| What is not realised, let alone appreciated, is that the increasing frequency of sharp moves in a few minutes of opening (the P-notes crisis in October 2007, and other crises in May 2006, May 2004, and so on) is not due to the market being too far up, or excessive speculation, or even the erroneous assumption of low margins required for trading. It is due primarily to the dud system of margining that we in India have adopted. As always, we have instituted a policy "in the name of the aam aadmi"; and as always, the policy hurts them the most.
|
| |
| On January 23, a news flash came across the TV screen: margin requirements for futures contracts for five stocks had increased to more than 100 per cent of the contract (cash) value! Most regulators/exchanges would be embarrassed by the sheer stupidity of such a system "" in India, SMOBs believe that what goes up must come down, so what is the problem? The reason the problem of stupid regulations has not been solved to date in India is precisely because of this glib SMOB reasoning. Whenever the market comes down violently in India, the problem is swept under the SMOB carpet by the refrain: what goes up must come down.
|
| |
| A financial crisis is the ultimate, and only, test of whether the regulatory systems in place are working. A crisis separates the good from the bad, and the bad from the downright ugly quite efficiently. As pointed out below, no matter what the crisis, or the criteria, the Indian regulatory systems pertaining to margins are the ugliest.
|
| |
| Verification for this admittedly strong conclusion "" that the Sebi/exchange margining system is bereft of all logic "" is obtained by comparing our markets to those prevailing in the rest of the world (more than 30 stock exchanges). How have they coped with the recent crisis inducing sharp declines in stock market values?
|
| |
| The Indian simplistic (and wrong) assumption is that the absolute value of margins must go up with volatility "" hence the bizarre recommendation of a 100 per cent-plus margin requirement, that is, negative leverage! Out of 33 stock index future contracts around the world, only one raised the margin on Tuesday, January 22 relative to Friday, January 18. For 28 contracts, the margin was kept the same, and for four it was actually lowered. The maximum decline in margins was for Korea where it fell 7.4 per cent. The only country to raise margins was India, and it increased these by a whopping 34 per cent on January 22 and by another 12 per cent on January 24!
|
| |
| The average margin ratios (value of margin to value of contract) in India, at over 15 per cent, is the second-highest in the world, after China's H-shares index at 20 per cent. While India was raising margins to bleed the system, the H-share margins were kept constant.
|
| |
| There is a standard belief (as peddled by the regulator and SMOBs via gullible pink newspapers "" one recent headline: "Low Margins can keep F&O volatile") that the SPAN (Standard Portfolio Analysis of Risk) system used in India is used by "stock exchanges across the world for purposes of risk management." As shown above, this belief is horribly wrong. India has one of the most, sorry the most, insane risk system in the world, a system so insane that it is guaranteed to bring about financial panic and systemic collapse.
|
| |
| Unlike other exchanges, the Indian system calculates margin requirements four times on any given day! This is garbage. The whole system should, and can, be easily revamped. For index futures, a flat margin should be charged (the margin varying across stocks and indices). When the market goes down, and when the system is most at risk, a flat margin means an automatic increase in the fraction of price required for margin. This is the system adopted by most equity exchanges in the world.
|
| |
| At Davos, Finance Minister P Chidambaram declared that the sub-prime crisis in the US was because of "poor regulation". Perhaps he should look inward. Our ugly regulation of margins meant that margins for a Nifty futures contract rose by 50 per cent between January 18 (Rs 29,955) and January 24 (Rs 45,000). F&O positions were approximately $25 billion on January 18, or margin collected about a third or $8 billion (average ratio of margin collected to contract value being substantially higher for stock futures, and stock futures account for about 80 per cent of total exposure). With the 50 per cent increase in margins, our poor and ugly regulation forcibly sucked out approximately $4 billion extra from the investors over three trading days. It is rumoured that domestic institutions have purchased stocks worth about $2.5 billion (Rs 10,000 crore) in the last few days, or only about half of the amount that the poor common woman was forced to sell to the fat-cat institutions. Which brings the net injection of liquidity into the system by our regulators at times of panic "" minus $1-2 billion.
|
| |
| SMOBs, asleep at the crisis wheel?
|
| |
| The author is Chairman and Managing partner, Oxus Investments, a New Delhi-based asset management company. He can be reached at surjit.bhalla@oxusinvestments.com |
| |
