Margins are good faith deposits posted by market participants. The Securities and Exchange Board of India (Sebi) announced a sharp increase in margins on April 8, before the present bout of market volatility began but at a time when market risk had clearly risen""and the intention would have been to cool the market before it got even more excited than it already was. Sebi then did a decrease in margins on 25 May, while the current bout of volatility was still under way""perhaps in the hope that distress selling would stop if margin pressures were eased (and this certainly was what the finance minister wanted). That seemed to implicitly accept that the sudden wave of selling on the market was the result of Sebi's earlier action. Whether that was the case or other explanations were more relevant, discretionary or ad hoc action on margins is not a good way to run markets; there should be clear rules on the basis of generally accepted principles so that market participants are not caught unprepared for sudden action. An adaptive system of margins involves charging low margins for the normal sleepy days, and driving up margins when higher volatility shows up or can be expected. When market risk goes up, participants are forced to put up more capital to support their positions. This is an unhappy but essential feature of a sensible margin system, for times of stress require stronger safety nets. The alternative is to charge high margins all the time""which wastes capital. As long as margin changes are mostly rule-driven, market participants have correct expectations about what margins will be charged, and under what circumstances. | |
| The events of May 2006 were easier to handle, compared with May 2004. In May 2004, the volatility flared up suddenly, in a context of low margins, soon after the election outcomes became known and Left leaders began sounding off. In contrast, in May 2006, volatility rose in a more gradual way, and many market participants had already sensed higher risk. This situation was therefore easier to manage. The rules of the equity market were able to successfully increase margins in lockstep with the rise in volatility. But what is to be done when volatility rules? |
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| Some believe that just as increasing margins "cools the market" and therefore pushes down prices, reducing margins tends to help "prop up the market"""and this might explain Sebi's decision to drop margins late last month when there was a wave of selling. However, higher margins can hurt both buyers and sellers, though not equally in the middle of a bull run. The more subtle relationship is one where higher margins make it difficult to hold positions, thus reducing market liquidity. Some believe that the system of margins induces a spiral of selling where a person is forced to make good his losses, and simultaneously submit bigger deposits, and thus collapse into distress selling""and there is evidence of some of this having happened in recent days. So, this is certainly a possibility in certain market conditions. However, it is also good to remember that for each speculator who has lost money, there is an equal and opposite speculator who has made money""though in a situation of generally falling share prices, most market participants lose. |
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| Margin systems in India are not perfect, but their basic logic is sound. It is important for the market to understand how the regulator sees the issue, so that unexpected steps do not lead to unwanted outcomes. |
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