The NSE's margining system would have helped avert a crisis, but in some cases it would have pressured prices down.
Mumbai: One of the reasons given for the market crash is the margin calls made by stock exchanges.
According to statements made by the finance minister, some of the selling in markets could have been on account of margin pressure faced by some brokers on their propriety accounts.
Unable to cough up additional margins, it was either brokers themselves who squared off positions or stock exchanges who did the needful on their behalf.
This is how the margining system works. Stock exchanges like the National Stock Exchange (NSE) collect margins from broker members to cover the price risk in outstanding positions.
The initial margin collected is based on the 'value at risk' principle. 'Value at risk,' or VaR, margins cover the largest loss that can be encountered on a position on 99% of the days.
Apart from this, the NSE also collects an 'extreme loss margin', to cover losses in situations that go beyond those envisaged in the 99% value at risk estimates used in the VaR margin.
Consider a buy position in stock XYZ worth Rs 1,00,000, which entails a VaR margin of 20% (Rs 20,000) and an extreme loss margin of 5% (Rs 5,000).
In extreme cases, like on Monday, when the markets fell sharply, it's highly likely that these margins would soon be depleted. On Monday, for instance, many stocks fell by 20% in just about two hours of trading.
Assuming XYZ was one of them, the loss on this position would be Rs 20,000, which would have wiped out the entire VaR margin paid. Left with only Rs 5,000 as margin money and considering that the markets had another three hours plus of trading to go, the stock exchange would then ask brokers to cough up additional margin money.
This is known as mark-to-market margin. In case brokers do not pay the additional margin required, they would have to close out the position.
In other words, they would have to sell shares of XYZ, because the margin available with stock exchanges for that position is inadequate.
It also needs to be noted that initial margins have been raised lately, which could have exacerbated the pressure owing to margin calls.
Margins being charged currently are higher for most stocks, compared with Friday's levels. For about 800 stocks, the margin has been increased from 74% to 85%.
Margin calls and compulsory closing out of positions can sometimes force shares prices down further because they involve selling in a falling market.
This could well have happened over last week and on Monday. But it would have happened only in cases where brokers did not produce the margins required.
It needs to be noted here that most brokers have banking accounts with banks that are designated as clearing banks of stock exchanges.
This facilitates real-time transfer of money between the broker's bank account and the account the exchange has with the clearing corporation. If brokers have access to funds, paying up additional margin calls is not a problem.
The mark-to-market margin demanded by an exchange from a broker will depend on the total of all the losses made by the broker's clients and the loss made on his/her own propriety account.
Losses cannot be offset by profits made by some clients.
As far as the course of action at the client level goes, it depends entirely on the arrangement between the broker and the client. Brokers normally pay-up on behalf of the clients and then demand an immediate payment at the end of the day's session.
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