The Hindu Business Line : Margin is a leverage that cuts both ways

Henry David Thoreau writes, "A broad margin of leisure is as beautiful in a man's life as in a book." Ah, what a luxury, that is, in times as turbulent as recent weeks! Also, margin doesn't seem to have the romantic appeal Thoreau would have us visualise, especially after margin trading and calls have been repeatedly branded the villain of the biggest crash witnessed by Sensex on Monday.

What is margin? It is what allows investors to buy securities by borrowing money from a broker, explains Financial Glossary on Bloomberg.com. Thus, margin, as a credit mechanism, gives the market volume. When activity is hyper, regulators can tweak margin requirements, as a valve to tighten available liquidity.

In 2000, when the US witnessed `record-breaking boom,' the Federal Reserve Board (which is the equivalent of the Reserve Bank of India) `remained silent about the speculative level of the market, neither commenting that the market is too high nor using its powers over margin requirements to dampen the markets,' noted Robert Shiller in The Wall Street Journal on April 10 that year.

"Between 1934 and 1974, the Fed changed this margin requirement 22 times, often with explicit statements that its aim was to restrain `speculation' in the stock market. But for 26 years the Fed has kept the margin requirement constant, at 50 per cent," wrote Shiller.

Closer home, we too have the 50 per cent margin requirement, as stipulated by SEBI (Securities and Exchange Board of India). However, when we did a quick survey of brokerages, to know the way the margin markets operate in India, we found hints of instances where funding was even up to 70 per cent. Evidence of inevitable exuberance, that was, given the way markets were sizzling not long ago.

Ominously, a page titled `The Crash of 1929' on www.btinternet.com chronicles that what made the market popular during those days was margin. Peter Fortune, writing on www.bos.frb.org, remembers that in The Great Crash: 1929, John Kenneth Galbraith placed margin loans front and centre as the reason for the depth of the market plunge that preceded the Great Depression.

"Indeed, margin loans, now only 1 to 2 per cent of the market value of common stocks, often accounted for more than 10 per cent of the New York Stock Exchange's market value during the 1920s (some estimates range as high as 20 per cent or more)," adds Fortune. Wonder if we have any numbers here.

On why the US central bank abruptly abandoned its active margin-requirement policy in 1974, Shiller postulates that an important factor was "the influence of efficient-markets theory, the idea that markets always work extremely well." It is debatable whether our markets are efficient.

For the avid, there is `Discussion paper on Margin Trading and Securities Lending', on http://web.sebi.gov.in. Since margin trading can be done on both the sides (i.e., buy and sell), it helps increase demand for and supply of securities and funds in the market, which in turn contributes towards better liquidity and smooth price formation of securities, argues the paper. "Further, with contracting settlement cycles, it becomes important to provide for this facility of supporting buy and sell sides of trades for smooth settlement and reduce the fail trades."

Gains of the client (that is, the investor who has borrowed) are amplified by margin funding, if the markets move favourably.

On the other hand, losses too are amplified, were the shares to move counter to investor's expectations. "The lender has also a motivation. He earns interest on the funds at a rate higher than the bank rate," notes the paper.

Our mini-survey showed that interest ranges between 15 and 18 per cent. "In case the lender happens to be the broker, which is often the case, he also earns higher brokerage on higher volumes of trades, that too, without any additional risk," states the discussion paper.

It explains, in detail, `mechanism of margin trading.' In a typical agreement between the client and the broker, two types of margins are spoken off, viz. initial and maintenance. Initial margin, or margin as often referred to, is the portion of purchase value which the client deposits with lender of funds before the actual purchase.

"After the agreement, the client opens a margin account and deposits initial margin amount, based on which the lender executes purchase order on behalf of the client. The securities so purchased are kept as collateral with the lender."

What is maintenance margin? It is the amount of equity that the client has to maintain in addition to the initial margin. "Equity is nothing but the net value of portfolio, that is, the value of portfolio less the margin debt. This equity should be a certain percentage of the market value of securities. This percentage is called maintenance margin."

A serious situation emerges when equity is less than the maintenance margin. "The client is called upon to bring in the shortfall," and that call is the dreaded margin call.

Dreaded, because if the margin call isn't met, "the lender can sell the collateral, partially or fully, to increase the equity."

To those still recovering from margin fever, Lord Tennyson's thought may seem relevant: "All experience is an arch wherethrough gleams that untravelled world whose margin fades for ever and for ever when I move."

Hope the lessons that lie on the frayed margins don't likewise fade.

ZeroBase@TheHindu.co.in

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