Peter Lynch while referring to margin trading said, “when you have a family, and a house, and the market is going down, and you’re on margin, it’s probably too much pressure for you to do the right research and the right kind of thinking to make good decisions.”
Over the past five years, especially since Covid-19 lockdown, as we have witnessed, Indian stock market is dominated by a herd of new class of investors. Since then, these investors have not seen any meaningful downside in the indices or witnessed a bear market. As the meme on social media goes “do you mean markets can even go down?”
Read More+
In India, margin trading (also known as “Pay Later” or “Buy Stock Pay Later” in commercial parlance) has seen a sharp rise due to increased participation from full-time traders. As per last available data, margin trading facility (“MTF”) book for the stock broking industry in India has surged to around ₹80,000 crore in October 2024, a significant jump from about ₹7,100 crore in February 2020.
Margin trading and trading in derivatives are considered as complementary to rolling settlement. Hence most securities market which follow rolling settlement provide for MTF. This makes the stock market more efficient resulting in smooth settlement.
MTF is an additional product offering for a stock broker (“stock broker” / “trading member”) to diversify its revenue segment. Margin is a loan from the stock broker to purchase a security. MTF is therefore an arrangement whereby investor uses borrowed funds from a stock broker to trade in securities which forms the collateral for the loan from the stock broker.
For instance, you have ₹10,000 in your trading account, and you want to buy a stock worth ₹20,000 per share. You can buy those shares through MTF by merely paying a percentage of the total amount. If the stock broker has decided 30% as the margin requirement, you will have to pay 30% of ₹20,000 and the stock broker lends you the balance amount (₹14,000), and charge interest on the margin amount. If the stock price rises on the same day, then the mark to market profit for the trader is ₹24,000 per shares, then the return on total investment is 20%. Similarly, if the stock price was to fall, the trader would incur mark to market loss. Thus, in this scenario, if a trader does not sell his shares before the prescribed time, then the stock broker would exercise his right to sell the said shares by squaring-off and liquidate the position to mitigate the loss. Interest cost grows as the duration increases. Stock broker is obliged to list out the situations/conditions in which the securities may be liquidated and include them in the terms & conditions in “Rights and Obligations Document”.
MTF allows traders to take up leveraged positions against margin requirement by providing securities or cash as collateral to the stock broker. It is also a useful tool for traders who indulge in “momentum” trading and “swing” trading, since a substantial portion of their funding requirement is taken care, and it enables them to trade smoothly without having to bother about any capital deficit while entering a trade. By leveraging capital, traders can borrow funds, take larger positions and boost their profit potential. Traders can amplify their gains without having to lock-in large amount of capital upfront.
MTF refers to buying of shares and securities by paying margin (securities/funds) by the investor and the balance amount is borrowed by the investor from the stock broker providing MTF facility. MTF can loosely be compared to a loan taken by the trader to trade in stock market say from a bank or NBFC. So instead of taking the loan from a bank or an NBFC, in MTF the loan is given by the stock broker where the trader has a stock broking account.
Stock brokers use various sources of funding to finance their margin funding facility. These include using their own funds, borrowing funds from scheduled commercial banks or NBFCs regulated by the RBI, and borrowing funds through the issuance of commercial papers (CPs) in the debt market or borrowings by way of unsecured long-term loans from their promoters and directors in terms of Companies Act, 2013. These borrowings by stock brokers is permitted in terms of the relevant provision of Securities Contracts (Regulation) Rules, 1957 i.e. not involving any “personal financial liability”. Borrowings via any other source is not permitted and TMs cannot use funds of their clients for providing the MTF for another client, even if it has been authorised by the client.
In terms of the existing MTF framework, SEBI and stock exchanges have prescribed eligibility requirements for a stock broker to be fulfilled to provide MTF to clients, only after obtaining prior approval of the stock exchange. There are various operational requirements prescribed for the stock broker providing MTF to the clients, such as:
SEBI has prescribed a robust framework for MTF with several controls. There are currently around 2,000 securities which are part of Group I securities which are acceptable as margin pledge for availing MTF. Acceptance of collaterals is based on risk-based objective approach to manage the efficiency of risk management and clearing & settlement. Positions taken by stock broker in cash/derivatives market are fully secured by adequate collaterals, hence their involvement in MTF as a lender does not affect the market integrity, without any risk to the clearing and settlement process.
While on the one hand, the MTF helps in increasing trade volumes, the interest earned by stock broker enables them to expand their client base through their distribution network, on the other hand, the funding provided by brokers gives convenience to the traders the ease to borrow and trade, essentially being a one-stop-shop.
MTF was traditionally considered a “bread and butter” product offered only by bank sponsored/promoted stock brokers (also because of the stringent norms as to how TMs can arrange funds for MTF). Off-late even non-bank promoted stock brokers and new-age discount stock brokers have jumped to the bandwagon of offering MTF to their clients. It was expected that because of various measures prescribed to curb the retail frenzy in derivatives trading; such as increase in STT on F&O and implementation of “true to label” charges[1] (fee structure), there is a likelihood that there may be decline in F&O segment volumes. Thus, it appears that, stock brokers may not have any other option but to increase the brokerages (some leading stock brokers have already increased their brokerages upwards) which they charge to clients (which hitherto in certain cases has even been a “zero-brokerage” model for trading), but also look for other business offerings such as MTF within the existing regulatory framework, which is stringent with very limited flexibility as discussed above.
As mentioned earlier, the primary reason for the increase in margin funding is also because of the outperformance of the market, particularly in small-cap and mid-cap stocks (SMID, as they are famously called), which has led to more individual traders taking a loan and buying shares to maximise their returns.
With the stock market considered overheated after the recent run-up, various market participants worry that equities could be more vulnerable to any sharp selloff. MTF works by giving a client full exposure to market, at an amount that’s only a fraction of their total position. Markets with higher volatility or larger positions may require higher margin requirement. Trading on margin thus amplifies both potential profits and losses. In other words, even though margin trades help traders expand their trading volumes, it can also inflate losses when the market is down by forcing the traders to offload shares.
MTF is a product typically associated with bull markets. Retail investors anticipating substantial market rally therefore generally assume leverage positions. Rise in MTF carries a risk that can materialise if market crashes leading to margin selling. Margin call happens when the MTF account falls below the maintenance margin. Margin call indicates that due to market conditions, the value of the securities in MTF account has decreased. However, if the price falls to zero, the TM will immediately sell the securities held as collateral to recover the debt instead of making a margin call. Margin call is typically avoided by experienced investors who constantly monitor their MTF account, and they sell the stocks in a timely manner which are falling and minimise their losses before the TM makes a margin call. MTF loan exposures are, however, fairly diversified across large universe of scrips with exposure to any single client at any point of time not permitted to exceed 10% of the member’s maximum allowable exposure calculated in prescribed manner. Moreover, the collateral margin on MTF exposures is actively monitored and these MTF are recallable on demand. In case of an inexperienced trader, who is aggressively trading, margin calls may be difficult to manage. If the transaction value is large, it will be challenging for him to have quicker access to large volume of funds to satisfy the margin calls. Hence, the situation may worsen even further in poor market conditions, when transaction value is high, if prices behave contrary to his expectations.
To quote Warren Buffet, although slightly in a different context, “Only when the tide goes out do you discover who’s been swimming naked”, meaning that when conditions are favourable, it’s hard to tell who’s successful and who’s just getting lucky. In a booming market, MTF trader may therefore generally be successful because a rising tide floats all boats. However, when times get tough, it becomes clear who hasn’t been managing their trades well. It is difficult to predict, when leverage can go against a trader.
It is said, for majority of retail investors, MTF can be a shorter route to lose money since it entices them to over-leverage or trade excessively and in the process may even get addicted to the adrenaline rush of high-risk trading.
Footnote
[1] SEBI circular dated 1 July 2024 (effective 1 October 2024). Prior to this circular, Market Infrastructure Institutions were receiving aggregate charges from members (stock brokers, depository participants, clearing members) on monthly basis, but members were recovering charges from the end clients on daily basis.
This article was originally published in Mondaq on 17 December 2024 Written by: Yogesh Chande, Partner. Click here for original article
Read Less-
Disclaimer
This is intended for general information purposes only. The views and opinions expressed in this article are those of the author/authors and does not necessarily reflect the views of the firm.
The Bar Council of India does not permit solicitation of work and advertising by legal practitioners and advocates. By accessing the Shardul Amarchand Mangaldas & Co. website (our website), the user acknowledges that:
Click here for important public notice from the Firm.