The Peak Margin circular goes into effect from December 1, 2020 and despite increased rumblings from the industry, SEBI is yet to show any signs of leniency and its possible that it may introduce some procedural changes – but not the spirit of the circular- towards the end of November 2020.
What is the circular about
SEBI has been grappling with some issues in recent years amongst which were of course broker corruption, network effects of one failure on others, and then there was the severe discomfort with the extremely high percentage of derivatives turnover versus cash.
Because of the way derivatives are- a synthetic instrument, it has attracted not only strategy based players but also heavy speculation by retail investors. To control this, SEBI has been increasingly raising margins and the size of the contracts but this effort was neutralized as brokers gave ever increasing multipliers to counter it. In effect , raising risk to their balance sheets in an era of decreasing brokerage and sources of funding.
By its peak margining circular, SEBI has effectively capped the exposure that’s possible in derivatives – to 4x of margin in Phase 1 (Goes down to 1x of margin by Sep 1, 2021) – and that’s where the effects will be felt as that’s where more than 90% of the turnover is.
On the other hand, while the same 4x principle applies to cash as well, its possible that volumes from derivatives –for stocks and especially better quality stocks like Reliance where margins in cash are lower than in derivatives – will move to the cash segment and provide some kind of balance to overall turnover. Which is probably what SEBI wants.
No surprise then that it rolled back some of the increased margins on non FNO stocks so that leverage returns to the cash market – beyond FNO stocks- and in turn there is increased activity in a larger spectrum than just the derivatives markets. Of course, by nature index derivatives will offer high multipliers (Even at full margin applied you get to buy almost 6x value of an index so why ask for more?) so that’s where derivative trading may continue. Random speculation on options may come down as multipliers reduce but then, that’s by design. Also what may happen is that option writers start looking at farther contracts or more out of money contracts to earn/save on margins thus possibly bringing liquidity into these sections of the market. Which is good.
SEBI’s mind is clear – by nature, the margin system provides leverage. For Rs 25, you can buy Rs 100 worth of a stock in derivatives and carry it for many days. This means you are leveraged anyways. So why have additional leverage on top of that. Example, a 10x leverage on margin means you could buy Rs 100 worth of Reliance for just Rs 2.5 (10% of Rs 25)- a big risk in derivatives as the contract could go either way till expiry!
Overall, it seems like a well considered move and the semi final before the one final hassle / difference between cash and derivatives is removed – T+1 settlement. That , combined with further decrease in cash margins may be what SEBI is targeting next.
So how will the peak margin system work?
In concept its very simple. So far the exchanges never knew (remember that they work with members on upfront and peak margins anyway- it’s the extension to the client that was the issue) what the broker allowed clients to do intraday as measurement of obligation versus client margins was on an end of day basis. This meant that brokers could, to wean away volumes , offer higher and higher multipliers intraday and create risk for the entire system if something went wrong– across the chain of the clearing member, the exchange and in certain situations, other clients as well. To cut this effect, and ensure that the member allows clients to trade only with their own money, they had to know what was the maximum margin intraday utilized for any specific client versus the actual margin.
The peak margin attempts to do that – it tries to estimate the maximum intraday margin used by a client and compares to his actual margin available – to identify if the broker gave additional limits. And if the broker did, then he has to prove it was his money and not someone else’s. because someone elses money means risk of one default can still spread to other innocent parties.
But then that means brokers would take risk and put more capital behind speculation – so the next step? Reduce intraday to clients own capital! This is what will happen by next September.
The calculations are fairly simple – lets say you had Rs 100 in your account today – beginning of day – and you used lets say Rs 500 as margin (In cash it would mean VAR+ELM and in derivatives, Initial Margin) to buy Rs 2000 worth of a derivative – some of which you did intraday and some you took delivery. Lets say you retained Rs 90 with the broker at end of day and your end of the day margin obligation for this derivative is Rs 80.
From December 2020, for such a trade, the formula would run something like this : The exchange would consider the higher of the two calculations below as your shortfall:
- 25% of your peak margin of Rs 500= Rs 125 was required but you had only Rs 100 during the day. So shortfall of Rs 25
- EOD margin of Rs 80 was required but you had Rs 90 at the end of the day DESPITE the cash withdrawal. So there is no shortfall as per the EOD formula. This is how it has worked so far.
- Higher of the two? Rs 25! So even if you had no obligation at end of day and you had fully paid for the position and the broker graciously returned Rs 10 to you at end of day because he was covered, there would be a shortfall! And a penalty!
So how would the broker cover this risk? He would not allow you in the above example to have more than Rs 400 (4x of 100) of margin leverage in Phase 1 – because then there cant be a shortfall as per 1 above. It was the extra Rs 100 that created the Rs 25 shortfall! And by September 2021, the client would be required to have Rs 400 if he wishes to utilize Rs 400 of peak margin. Remember that even then, the leverage stays at 4x-5x as margins are 20%. So no big damage!
The second problem – how would the exchange communicate to the broker various peak margins of various clients – no such technology linkages exist today between the CPs and brokers. So the exchanges would do a random pick of snapshots – 4 times a day- and pick out the maximum of the 4 for each client! Remember its random so you cant fool the system J
There are further complications around this – meaning the peak margin sticks to the client till T+2 days in the cash segment – and till the trade is settled, the peak margin will continue to reduce leverage for T+1 and T+2 days as well!
Clients of Prabhudas Lilladher can expect a detailed circular on the various scenarios and what clients should do once further clarity comes in the next couple of days. There still remain a lot of doubts on the peak margin itself – example , is it a flat 20% for all stocks or is it based on VAR+ELM – and so on. For now, cash intraday multipliers are likely to remain similar as earlier during Phase 1 though derivatives multipliers will be capped at 4x.
In the meanwhile, one thing is sure- If you are a client of Prabhudas Lilladher, learn how to transfer money via the PL Mobile App (www.plindia.com/plmobileapp) or via www.plclients.com as no longer will your officers be able to give you additional limits beyond what the 4 phases allow. Or park your stock that is currently with other brokers with PL to enjoy hasslefree trading – remember that opportunities come only once a while and its ideal that you have margin available at PL.
Happy Peaking in 2021!