Note of Dissent to The Report of the Group
to Review the Carry Forward System
By Dr. R. H. Patil

The main report has spelt out at various places the differing views held by me on some of the important recommendations made by the majority group. Since the logic underlying my differences with the recommendations of the majority have not been fully brought out at relevant places it would be appropriate that this is explained properly. In what follows I have made an attempt to explain my position briefly.

Twin Track Trading System


The logic of the twin track system is based on the fact that the risks associated with the transactions that have to be necessarily closed out within one week are materially different from the transactions which can be carried forward indefinitely. While the main report has argued that the daily margins should be unified and that the same daily margins should be applicable to both the segments, this argument has not taken into account the underlying risks between the two different types of transactions. Daily margins are just one instrument for controlling risk. As the carry forward system deals with transactions which need not be closed out for an indefinite period, the total exposure of a member can rise to a point which may pose serious danger to the system whenever there are sharp price fluctuations and surges in trading volumes.

In this context it should be noted that almost all the brokerage entities in India are heavily undercapitalised. Since their capacity to absorb shocks emanating from the system in unusual periods are severely limited any proposal to abolish the segregation of or the dividing wall between the two trading systems appears to be fraught with considerable risks. While computerisation of the trading system has enhanced the ability of the exchange authorities to regulate the system, it should at the same time, be noted that the ability of a trading member to build exposure vis-…-vis the rest of the market in a very short period of time has increased manifold because of the ease of trading on the computer and the substantially increased liquidity on the screen at any point of time during the trading day.

Another major reason why the two segments are different is that the price discovery process in each segment is different. The carry forward trading system is highly dominated by the speculative element while the weekly trading segment is dominated relatively by investor interests. Just as great importance is being given to the need to separate out the cash transactions from the futures transactions in the yet to be approved derivative segment, exactly the same principles of transparency and risk containment would call for the same separation between the cash market transactions and the carry forward transactions.

Registration of Vyaj Badla Financiers


The main report suggests that the Vyaj Badla financier is merely a client of the broker and therefore need not be separately registered with the clearing house. While this view perhaps appears to be practical in the case of small financiers, it would not be proper to take this view for large financiers. The reason is that the vyaj badla financier is also akin to a lender/borrower of securities under the SEBI approved scheme for lending and borrowing of securities.

When such lenders/borrowers of securities have to get registered and route their transactions through SEBI registered intermediaries like custodians, clearing houses/corporations, etc., there is no reason why vyaj badla financiers also should not be asked to deal through clearing house/corporation so as to lend transparency to such transactions. The main report has recommended removal of the limit of Rs. 10 crore on vyaj badla. When large amounts will start flowing into this activity it is desirable that these amounts flow from sources which can be clearly identified.

In the case of securities lending/borrowing scheme as approved by SEBI it is required that the securities have to be lent through an intermediary like clearing house/corporation and custodians. This condition has been stipulated to get over the problem of income tax and capital gains taxes as lending and borrowing transactions should not be treated as selling and borrowing of securities. All transactions done under the carry forward system are identical to lending and borrowing of securities. In view of this it would be appropriate that all the vyaj badla financiers are registered with the clearing house and all their transactions are routed through the clearing house so as to get over the problem of income tax / capital gains tax.

Need for Up-front Margins


The main report has argued in favour of reduction of daily margins from the earlier 15% to 10% on the ground that the margins should be based on the maximum price change within a single day and not whether the transaction is for delivery or carry forward. While this argument is correct in so far as mark to margin is concerned it may be noted that the current weekly trading system itself has three types of daily margins. These are mark to market margin, gross exposure margin and net exposure margin with the latter two types of margins being on a graded basis. It is important to note that the mark to market margin only covers the risk of the maximum price change within a single day. It presumes that the principal transaction is not at risk and the margin is actually received on the same day in question.

The main report has summarily dismissed the proposal for up front margin as not being "practical in the absence of electronic funds transfer facilities"(page 7). It has not been fully appreciated that it is mainly because of the absence of electronic transfer of funds that it is necessary to have up front margins. Under the current arrangements the notice by the exchange to pay mark to market margin is given to the members earliest at the end of the trading day say T. The member is expected to deposit the instrument to pay margin to the exchange or the clearing corporation on T+1 day.

If the member is in a position to deposit the instrument in the early banking hours the cheque gets credited in the account of the exchange/clearing corporation at the end of the day. If the margin cheque is deposited later on T+1 day the amount gets credited in the account of the exchange or the clearing corporation earliest on T+2 day. In the meanwhile it is possible that the prices could have moved adversely thereby increasing risk to the trading and the settlement system.

Thus, because of the absence of the electronic funds transfer facilities the system would run large risks as members may not be able to bring the margins in time. The stock exchanges keen to introduce MCFS should have the required software to calculate the mark to market margin and communicate to all their members on the same day. Unless they are able to do this risks to the settlements systems will be very high. Several stock exchanges planning to expand its trading network to a large number of cities which are far away from their present areas of operations. When this happens the problem of delayed funds transfer would get further accentuated whenever the members especially from distant cities will not be in a position to pay margins in time.

The problems arising from the weaknesses of our banking system in the funds transfer area should not be underestimated. It is primarily for this reason that NSE has been strictly adopting the system of up front margin deposits for its weekly cash market despite its ability to inform all the members at the end of each trading day the various margins they are expected to pay. This has been possible because of its excellent captive satellite based communication network and the margin software developed by it.

Trading limits to members should, therefore, be granted on the basis of the up front margin deposits they keep with the exchange(including those with the clearing corporation/house). An up front margin deposit of Rs 50 lakh should normally entitle an exposure limit of Rs 5 crore. Before considering removal of various trading limits on members' combined exposure to the market in both the cash and the carry forward segments a system of upfront margin should be in place. Members keen to have larger trading limits should be asked to deposit proportionately larger amounts with the exchange.

In this context it should be noted that the current capital adequacy requirements adopted by different exchanges are not stringent enough to protect market integrity especially under volatile conditions. The current capital adequacy requirements do not link capital adequacy with market exposure limits as is done internationally. The current capital deposit requirements only stipulate minimum amount of deposit that the members are required to keep with the exchange. They are currently exchange specific and within any exchange they do not make any distinction between members with large or small trading exposures.

If the internationally adopted definition of capital adequacy is accepted the amount deposited by members with the exchanges in India may not be said to be determined by capital adequacy criteria Based on the current deposit requirements the maximum permissible exposure that a member could possibly have jointly in the cash and the carry forward segments would be Rs 100 lakh if the principle of 10% up front margin is to be stipulated. For example, currently NSE grants an exposure limit of 7 times the amount of up front deposit. Thus the up front deposit insisted by NSE even for the weekly cash market is about 15%. Based on the performance record of members NSE is considering further lowering of this exposure limit to members who are not prompt in paying their margins to the exchange in time.

Given the large amplitude of price fluctuations of individual securities in India a tight margin system should be maintained. Further, with banks needing much longer time for funds transfer from the accounts of brokers to the account of the exchange there is a pressing need for collecting up front margin deposits especially for the carry forward trading segment which is heavily influenced by speculative activity.

All the major steps taken by SEBI especially during the recent past have been to strengthen the surveillance and margining mechanism. Because of these market friendly steps it has been possible to prevent market disruption despite periodic sudden surges in trading volumes or volatile market conditions. During these volatile periods there have been some broker failures but the market integrity continues to be maintained. Before considering relaxation of any of the current margin or other requirements which have all been put in place for protecting the market integrity it may be worthwhile to carefully examine impact of these relaxations on the health of the market.

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