Upfront margin: Game-changing reform needs its wrinkles to be ironed out

(Photo by Ravi Roshan/Pexels)

One of the most talked about reforms that the market regulator introduced this year was mandating upfront collection of 100 percent margin for trading.

Market participants generally believe this requirement cuts off money supply for highly leveraged trades, significantly reducing the risk that traders and brokers took.

Also read: How traders, brokers use 'prop' route to dodge SEBI margin rules, evade GST, IT

The Securities and Exchange Board of India (Sebi) initially formulated a peak-margin rule—under which the highest margin requirement from four random periods in the day would need to be maintained. However, the market regulator tweaked it after representations from brokerages and traders.

Currently, the margin requirement is calculated at the beginning of the day and at the end of the day. The broker must ensure a trader’s account has 100 percent of the margin to cover positions held at the start of the day, besides checking if the margins are sufficient at the end of the day.

“Upfront collection is a healthy development for the market, especially with the growing investor base and volatile market conditions,” said Kamlesh Shah, president of the Association of National Exchanges Members of India. “Upfront collection will protect the investor’s interest and is in the overall safety of the market.”

The margin is the money or securities that brokers keep as collateral to allow a trader to buy a security of much higher value. If the margin on a Rs 100 security is 20 percent, then by paying a broker Rs 20, the trader can buy a unit of the security. The broker lends Rs 80 to the trader, or a leverage of five times (Rs 20 times 5 is Rs 100).

Every stock or derivative has a different margin requirement, which is decided based on its volatility and is set by the exchange. The higher the volatility, the larger the margin. For various reasons, including to attract customers and increase trade volumes that earn them commission, brokers used to over-extend themselves.

“Smaller brokers mainly differentiated from larger ones by offering higher leverage (charging less intraday margin requirements) and by accommodating their clients in other ways,” said Tejas Khoday, CEO and cofounder of FYERS.

For example, if the margin on a security was 20 percent, some brokers would allow a trader to pay only 10 percent, or Rs 2, to buy a Rs 100 security. The trader would get a 50x leverage and square off the position to reduce the margin requirement by the end of day.

Thus, a trader could take high-risk bets with very little capital. This was a big risk for the broker because, if a bet went wrong and the trader ended up with a huge loss, then the latter could vanish, leaving the broker in a mess. Thus, such highly leveraged bets would become a systemic risk.

In 2020, Sebi said it would require brokers to collect margins upfront and that this reform would be implemented in four phases. In phase 1, a minimum of 25 percent of the margin requirement would have to be met; in phase 2, it would be 50 percent; in phase 3, it would be 75 percent, and in phase 4, which started on September 1, 2021, it would be 100 percent.

This caused a lot of heartache in the beginning. For one, smaller brokers lost their edge.

“It (margin funding) was their primary differentiator, so many resisted the change,” said Khoday. For another, traders were unfairly penalised. How?

The regulator had said the highest margin requirement of any of four random period would need to be maintained by the broker. But these margin requirements could change in a day without the trader taking any new position, so the trader might be caught by surprise when the broker made a margin call.

This was happening in the derivatives market, where a trader has to pay two kinds of margins – the Standard Portfolio Analysis of Risk (SPAN) and the Exposure margins. The SPAN margin is generated using a trademarked software, which the trader cannot track. So, traders who didn’t have enough funds to meet a sudden margin shortfall could end up being penalised.

After several representations were made, Sebi relented in August 2022 and said the margin requirements in derivatives would be based on the beginning of day SPAN report and end of day SPAN report. The collection and reporting of margins in the cash segment were retained.

Also read: Sebi allows brokers to extend margin-trading facility to equity ETFs

There are still some impracticalities in upfront-margin collection, according to market participants. ANMI’s Shah said the reporting on margin collection should be done on a post-trade basis.

“Pre-trade reporting (of margin collection) is difficult to manage,” he said. “There are millions and millions of trades happening and it is very difficult to report every time a client pays the margin on a pre-trade basis. Once he takes the trade, it is easier to report, (as it is done now) at the end of the day. But if margins have to be reported real-time, it will be difficult,” he added.

According to Shah, pre-trade margin reporting inconveniences investors/traders in another way too.

“Now a person can sell shares worth Rs 1 lakh and buy shares worth the same amount (immediately) but that will not be possible after February 1, 2023. This is because for buying you need upfront margin but the sale proceeds are available to you only after you do the early pay-in,” he said.

“We are not against upfront margin or the peak margin system… The only problem is with the reporting on a pre-trade basis,” said Shah.

Under the new rules, a trader may be encouraged to take riskier bets, according to Shreyas Bandi. A full-time trader, Bandi said that while the higher margin rule probably does better than worse and while the intention may be right, the rule does not really protect the trader from a higher leverage.

“The highest leverage is in option buying, if you consider the exposure a trader is taking (and not the leverage that margin trading provides). If you buy a future or option of the stock, you get 5x leverage (if the margin requirement is 20 percent),” he said. “Also, the margin requirement for an intraday trader and an investor should not be the same. While an intraday trader does not hold his position overnight, the investor or positional trader does and therefore has a higher risk from external events.”

The margin rule has hit seasoned traders hard and even reduced their profit by half, according to Bandi.

“It has been a big blow to us. I do trading for a living and I don’t punt, but my CAGR has fallen by 50 percent since the rule,” he added.

Some people online have shown how to reduce margin requirements by hedging positions—before selling a call at a strike rate, buying a call at a higher strike rate. But Bandi said this just means incurring additional costs when your trading style—for example, of exiting a trade at 0.5 percent or 1 percent loss–may not require this at all.