Vijay Kumar Gaba

The new margining norms proposed to be implemented from 1 August 2020, in respect of the equity market trades done on stock exchanges are a cause for worry for one simple reason, i.e., this highlights for the n^th time that the securities market regulation in India lacks a robust conceptual framework.

It is important to understand that regulation of securities market is like salt in a dish - any excess or less magnitude of regulation could make the dish unpalatable.

Any market participant would vouch for the fact that the regulators understanding of the risk management needs in the securities market is inadequate, as it relies more on adhoc methods rather than a strong conceptual framework. In the event of a crisis, comes out like a brave fire fighter and douses the fire with whatever tools it has. Unfortunately, there is little empirical evidence to highlight that SEBI has taken enough preventive measures to stop frequent occurrences of crisis in the market. We frequently witness the cases of blatant price manipulation, malpractices, and unethical conduct by corporates, intermediaries and large traders (called "operators" in the common market parlance). In past 28yrs of SEBI existence as statutory market regulator, there has been little diminution in the frequency or intensity of these instances.

The market participants will also vouch how much detrimental has been the SEBI's intervention in the matter of securities' classification for the purposes of categorization of mutual fund schemes. Ideally, the regulator should have flagged its concerns to the industry and self regulatory organization governing the industry, and let them evolve the optimum solution. Not relying upon the industry and imposing rules which made little sense caused tremendous pain to the industry and investors, and benefitted almost none.

One primary reason for this in my view is the lack of a robust conceptual framework for securities'' market regulation. For example, let us consider the instant case of revision in margining norms.

Minimizing the systemic risk is one of the paramount concerns of the securities' market regulation. Imposing prudent margining requirement for traders is one of most popular and effective method of managing the systemic risk. However, it defeats its purpose if margins become excessive or impractical. It is important to understand that margins are used to mitigate systemic risk of default on settlement obligation and not for the purposes like managing the trading volume etc.

There are two types of margins imposed in cash market, viz., (i) Value at Risk Margin (VaR) and (ii) Extreme Loss Margin (ELM). VaR is calculated based on historical volatility and trading pattern. This covers the normal expected adverse movement in the stock price in one day. ELM is used to cover exceptional volatility due to some extreme event. These margins should be adequate to cover 99.999% of cases of payment defaults.

When, an investor sells shares in the market, the default counterparty is the clearing corporation (e.g., NSCCL). Thus, the clearing corporation guarantees the settlement of all the trades executed on a recognized stock exchange. The moment trade is executed and securities are delivered to the clearing corporation as pre pay-in, the VaR for the seller  defaulting on its obligation becomes Nil. Since the counterparty is clearing corporation, the risk of counter party default for the seller is also Nil. Not allowing seller to use the sale proceeds for buying other securities is certainly no prudent risk management. This in fact creates doubts about the infallibility of clearing corporation itself, which in turn makes the whole argument of trade guarantee and secure settlement system suspicious.

There are also chances that some of the traders may move to grey market (dabba market in common market parlance) for trading, thus exposing themselves to larger risk of default.