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Why Sebi's pre-expiry margin rule for commodities is a much needed safety vest

2020 has taught that anything is possible. In a world where your hard-earned money is exposed to so much unpredictability, it is better to be safe than sorry. One black swan event is powerful enough to separate you from profits earned over many patient-years.

February 27, 2021 / 04:04 PM IST

In a move to strengthen the risk management framework, the Securities and Exchange Board of India (Sebi) is going to introduce a pre-expiry margin on cash-settled contracts wherein the underlying commodities are deemed to be susceptible to possible near zero or negative prices. The said rule will be effective from April 1, 2021, and is aimed to encourage significant reduction of open interest as the contract approaches the expiry date.

Albert Einstein said, "the true measure of intelligence is the ability to change." Stephen Hawking said, "intelligence itself is the ability to adapt to change." Sebi's recent plan to introduce a pre-expiry margin is both a welcome change and an intelligent move.

The past year has been a roller coaster ride; one that has proven the importance of adapting and preparing for change. Over the past year, we have seen worldwide lockdowns, a scuba styled market crash, the euphoria of a bull market and crude oil testing negative. Sebi's move is a step in the right direction.

Market volatility & the rise in new retail investors

2020 has made us realise that we are vulnerable. We live in an unpredictable world. We must constantly evolve and adapt to survive. The financial ecosystem is no different and it too has had to change with the winds.

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A few months ago, Sebi increased the margin requirements for intraday unhedged positions, thereby protecting retail investors from highly volatile movements in the market (VIX at 20+ has been the norm since COVID began.)

As more and more Indians begin participating in the markets, improving processes, rules and regulations have become paramount. Just to set the context, over 3 million trading accounts were opened at online brokerages alone between March and July 2020. That number has only grown exponentially over the past 5-6 months.

Protecting investor interests & mitigating risk

We needed a new approach to risk management. Sebi's recent decision to increase margin requirements in commodity contracts that are near zero before expiry is a much-needed fix.

This change will come into effect from April 1, 2021. As per the circular, in case of these contracts, pre-expiry margin will be levied during the last five trading days before the expiry date and will increase by 5 percent each day.

In a world where checks and balances are crucial, it ensures that a fiasco like the one we saw in crude trading last year is not repeated. Furthermore, this is a great move when it comes to protecting the interest of investors.

Understanding Sebi's new rule

Going back to what led to this new rule: Whenever the futures price of a commodity falls, the buyer of that futures contract, who has promised to accept delivery at a predetermined price, is looking at a loss. This is because the commodity's futures price has gone below their pre-determined buy price.

Interestingly, in the case of commodities like WTI oil, one can't even accept delivery, hence, the contracts are settled in cash. Now, the buyer has effectively paid part of the predetermined price in the form of a margin.

However, that margin is calculated based on the assumption that the price of the underlying asset cannot fall below zero. It's nearly impossible for a buyer to preempt such an event and their capital could get wiped off in such cases.

2020 has taught that anything is possible. In a world where your hard-earned money is exposed to so much unpredictability, it is better to be safe than sorry. One black swan event is powerful enough to separate you from profits earned over many patient-years. After all, it takes hours to build a house of cards but only seconds for it to fall apart.

Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
Siddharth Kothari is the Chief Investment Strategist at Om Kothari Group.
first published: Feb 27, 2021 03:34 pm

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