A Fresh Look at Margining In India's Equity Markets

Margins are necessary for a robust capital market. While margins help in mitigating systemic risk, adopting the appropriate margining methodology is a challenge. Since June 2000, when derivatives were introduced, Indian clearing corporations have adopted a conservative, risk-averse margining approach. With increasing sophistication of Indian equity markets, it is time to take a fresh look at the margining approach to ensure that the liquidity of clearing members and their clients is not unnecessarily tied up while at the same time not being detrimental to overall systemic risk.

The clearing corporation acts as a central counterparty to both legs of a trade executed on an exchange. This enables counterparties to a transaction to concentrate on the commercial aspects of the trade and make decisions independent of the party with whom they deal. Additionally, this limits counterparty risks to a single contractual partner – the clearing corporation. This innovation of counterparty risk is one of the cornerstones for enforcing systemic discipline. In order to enforce commitment by every party, the mainstay of the system is margins – the funds or securities that are deposited by the clearing member as collateral against positions taken on the exchange. Clearing corporations charge margins from clearing members for positions taken by their clients.

Clearing members, in turn, collect margins from their clients who could be executing members or end-clients. Margins should be set at a level that is neither excessive nor very low. Over-securing a position through excess margins would unnecessarily tie up the liquidity of the clearing member. Under-securing a position could represent a potential threat for contract fulfilment by the clearing member. The job of an efficient margin system is to find the right measure of protection for every market participant without causing undue burden on any of them and unnecessarily blocking liquidity.

Margin required should be computed based on the greatest projected net loss in an account given various scenarios of price increases and decreases and changes in volatility. Ideally, the greatest potential net loss of the entire portfolio (across cash and derivative markets) of a clearing member should be subject to margin. This means that the correlation of all positions across securities is taken into account to arrive at potential loss. Value-at-risk (VaR) is one such measure on which margins could be based. However, in practice, clearing corporations do not adopt principles of cross margining where potential loss is calculated for the whole portfolio, across securities and asset classes. The current margining approach adopted by clearing corporations worldwide is sub-optimal.

Margining In India

In June 2000, at the time of introduction of derivatives in the Indian securities markets, the clearing corporations associated with the Bombay Stock Exchange (BSE) and the National Stock Exchange of India (NSE) followed a gross margining system where margins were determined based on the client-wise gross exposure levels of clearing members. The BSE had a system of index-linked margining system for the carry-forward positions during the days of the badla system. However, end-of-day margins were not rigorously imposed on clearing members.

In June 2000, the Securities and Exchange Board of India (SEBI), as well as the clearing corporations, adopted a very conservative margining approach. The highlights of the approach were:
(a) All clearing corporations would have uniform margins. The philosophy behind the uniform margining system was to prevent exchanges from competing on the basis of lower margins for clearing members, thus destabilizing the entire system.
(b) As a matter of utmost caution, it was decided that gross margins would be charged, i.e. margins would be charged for each client position. This is also called ‘position margining’ where margins are on a gross basis for each clearing member without providing any relief for any offsetting positions between different clients for the same clearing member.
(c) Individual clearing members had the liberty to apply higher margin requirements to their clients than was required by the clearing corporation.

The National Securities Clearing Corporation (NSCCL) and the Bank of India (BoI) Shareholding, the clearing corporations associated respectively with NSE and BSE, had to adopt this conservative margining approach.

Gross margining was probably appropriate in June 2000 when the concept of derivatives was new to India and the associated risks were unknown. However, gross margining has now outlived its utility as over the past four years there has been a considerable increase in trading volume and a corresponding increase in the experience of brokers, exchanges and the regulator. It is time to adopt a newer margining approach that is more efficient.

Net Margining

Gross margining, being a very conservative approach, is comfortable for the clearing corporation, but excessively taxes investors and is disadvantageous to the interest income of clearing members. It over-collateralizes the clearing corporation, offering more than an adequate buffer for systemic risk management. The clearing organization has collateral from both longs and shorts but in the event of a default, will need to only liquidate net positions in the marketplace. Clearing members should be allowed to offset positions of their clients when margins are collected, i.e. they should be allowed to net client positions.

Since the clearing corporation chooses to deal only with the principal (clearing members), the task of dealing with the constituents (investors) should be left to the good practices of the principal. Today the clearing corporation is managing risk for the clearing member, a task that is best left to the clearing member’s middle-office. This is in the best overall interest of market efficiency.

The clearing member has a vested interest in setting margin levels high enough to offer meaningful protection from a default by his constituent. The clearing member would otherwise be taking higher risk by offering non-commercial subsidies in margin requirements to favoured investors or by setting margin levels low for marketing considerations. The clearing corporation has to consider the financial integrity of the market place as a whole while promoting transaction volumes and ensuring success of new products. The risk management practices at clearing members have also become sounder due to the better understanding of risk management.

Cross Margining Within A Margin Class

A margin class is a segment of securities in which positions taken can be offset for the purpose of calculation of margins. Cross margining is netting of positions across asset classes of the same underlying asset. In India, the clearing corporations treat the cash and the derivatives markets as two different margin classes and hence collect separate margins for these two margin classes. In the current approach, margins are offset for positions in futures and options contracts on the same underlying asset in the same or different calendar months. But a position on the underlying in the spot market is treated as a naked position and separated margins are collected. This defies economic reasoning.

If a client holds positions in a number of contracts that are all based on the same underlying asset, it is likely that risk components of these contracts partially offset each other. A typical example is when a long position is taken in the cash market and a short position is taken in the futures market. The role of cross margining is to reflect this partial offset when margin calculations are made so that liquidity is not blocked unnecessarily. Margin should be charged only to the extent of the uncovered risk in the portfolio.

Clearing corporations should provide such cross-margin relief. Clearing members should be subject to portfolio margining on the basis of economic risk characteristics of their entire portfolio, and not on the basis of the markets in which they and their clients trade.

Cross Margining Within A Margin Group

If several underlying assets and thus several margin classes are subject to the same risks then they could be bunched into a ‘margin group’. For example, a margin group could consist of stocks and derivatives of the same industry like the automobile industry. Another classification could be based on the beta of the margin class. Correlations and extent of potential losses should be considered for securities within a margin group based on different classifications.Cross margining within a margin group helps in offsetting margins for positions that are affected similarly by market factors. These positions could be across various underlying securities. This would ensure that additional liquidity of clearing members would be freed up while systemic risk remains largely unaffected.Another such classification could be based on the beta of the margin class. Correlations and extent of potential losses should be considered for securities within a margin group based on different classifications. Cross margining within a margin group helps in offsetting margins for positions that are affected similarly by market factors. These positions could be across various underlying securities. This would ensure that additional liquidity of clearing members would be freed up while systemic risk remains largely unaffected.

Conclusion

Margining in Indian equity markets has been very conservative. Though the sophistication of the market participants has increased and volumes have grown in both the cash and derivatives markets, the margining system continues to remain conservative. This article advocates a fresh look into the margining approach and recommends the following measures:

• Clearing members should be allowed to offset positions across clients – implying a move from a gross margining system to a net margining system at clearing member level.
• Extension of cross margining – currently futures and options on the same underlying are considered to belong to the same margin class. This should be extended to the cash markets too. Thus equities, futures and options on the same underlying should be considered to belong to one margin class and inter-asset class netting should be permitted.
• Margin grouping – asset classes on different underlying securities that display same economic characteristics should be clubbed. Margin grouping could be on the basis of some parameters like industry of the stock or beta.

These measures of margining would go a long way in increasing the sophistication of the margining system in India and freeing up liquidity of clearing members while not significantly affecting the systemic risk.