Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Margin Changes in Exchange Traded Derivatives

Surjit Bhalla wrote a provocative
piece
in the Business Standard yesterday describing the system of
automatic revision of margins in Indian stock exchanges as ugly and
insane – the first adjective is quite appropriate, but the
second is not. Bhalla is right in saying that the Indian system is
different from what the rest of the world does, but it does not follow
that the system is wrong, much less that it is insane.

Most exchanges around the world change margins infrequently and in
a discretionary manner. Everywhere in the world, market turbulence
does lead to a rise in margins. Last week itself when the Chicago
Mercantile Exchange (CME) left margins unchanged on stock index
futures, it raised margins on interest rate futures sharply in
response to increased volatility. What the Indian system does is (a)
to take the discretion out of the system completely and (b) to make
the revisions more frequent.

The system adopted in India is similar to the internal models that
banks and securities firms use to monitor and control the risk of
their trading positions. Like any other sound margining system, it does
have the potential to create a vicious cycle of falling prices, margin
calls, unwinding of levered positions and further price falls. It is
ugly but it can hardly be called insane.

It is also true that there is significant over-margining in the
Indian system. Partly, this reflects a greater risk aversion on the
part of Indian regulators and the broader political system. As Indian
regulators and politicians become more comfortable with well
functioning derivative markets, the risk aversion should decline. The
over-margining is also due to the lower level of capitalization of
securities firms in India which forces exchanges and brokers to rely
almost entirely on margins to ensure solvency. As Indian brokerages
consolidate and shore up their capital base, this problem should also
get attenuated. Over a period of time, therefore, the margining system
could become more relaxed – both in terms of lower quantum of
margins and in terms of lower urgency in raising margins in response
to volatility spikes.

What India does need urgently is an abandonment of informal and
ad hoc margin tightening in times of crises. One keeps hearing
anecdotes about members being asked to reduce positions or deposit
more margins than is mandated by the regular margining system. A
greater degree of transparency in this regard would also be welcome so
that false rumours do not circulate about this.

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