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Who pulled the trigger on Black Monday?

N Mahalakshmi in Mumbai | May 24, 2004

Monday, May 17, 2003, was a historic day for the stock markets. The Sensex recorded its largest-ever intra-day fall, declining 842 points at one point during the day.

Subsequently, the market regained much of its loss, but the pros feel that it will remain weak for a while. Based on Friday's close, the market has lost nearly 40 per cent of what it gained over the last one year.

The dramatic fall on Monday has once again shaken the confidence of investors who were just about showing some faith in equities after a prolonged hiatus.

The question is: was the dramatic collapse necessary or could the exchange authorities have done something about it? On the plus side, it's clear that the system held up fairly well.

There was no payments crisis or default, underlining the strength of the risk management system. Kudos for Sebi and stock exchanges for that.

However, there is a feeling that a part of the fall may have been triggered by the same risk management measures. Before we explain how, here is the anatomy of the market fall on Monday.

According to brokers, a lot of hedge funds and foreign institutions turned bearish after the Left made its anti-privatisation views clear.

Fearing that the Left parties would play spoilers if they joined the new government, many institutions began dumping stocks. The upshot: the markets fell 330 points on Friday. FIIs sold Rs 504 crore (Rs 5.04 billion) worth of securities, but the selling wasn't over.

There were a number of pending orders which could not be executed on Friday.

"There was selling pressure built into the markets on Monday morning as many of the outstanding positions were not squared off on Friday. After a 200-300-point fall, investors normally like to hold on to their positions, expecting to square off the position once the market recovers a bit," says Navneet Bansal, derivatives trader, Kotak Securities.

Meanwhile, the stock exchanges slapped an additional margin on some specific derivative positions given the higher perceived risk after seeing the manner in which they fell on Friday.

Brokers had to make good mark-to-market losses, meet the higher SPAN margin requirements and pay certain discretionary margin on specific client positions on top of that. A number of brokers could not meet their margin calls and, hence, the exchanges had disabled their terminals.

When the market opened on Monday morning, some brokers with large outstanding positions as well as some banks and stock exchanges pressed the sell button. Within minutes the market lost 500 points.

While institutional brokers are understood to have been selling on behalf of hedge funds which are known to be extremely fast on their feet, the National Stock Exchange was simultaneously squaring off positions, particularly in the F&O segment, on behalf of brokers whose terminals were disabled.

Another set of sellers was banks and finance companies which had indulged in margin lending. While banks sell securities to avoid taking on the market risk in the event clients are unable to bring in additional margins in the prescribed time, the exchanges are also free to unwind brokers' positions once their terminals are disconnected for want of margins.

Most brokers believe that in the first few minutes after the opening bell, the NSE was on the selling side.

The NSE, however, dismisses popular belief that it sold heavily on Monday: "The only orders that the clearing corporation entered were those that were requested by members to be entered on their behalf. Very few disabled members in the derivatives segment, who were desirous of closing out their open positions in order to reduce their capital utilisation, requested the clearing corporation to place orders on their behalf," the exchange clarified.

Even the requests received for squaring off in the derivatives segment were only from seven members during the entire day and the value of such orders placed by the clearing corporation was negligible and extremely insignificant at 0.2 per cent of the value traded during the day.

Reliable sources confirm that about 70-odd members lost connectivity at various points during the day and the exchanges collected margins to the tune of Rs 350 crore (Rs 3.50 billion). NSE officials did not confirm this.

Whoever the sellers were, market experts say most of the selling in the first few minutes of trading on Monday were market orders - or orders to sell at best available market prices.

In the absence of many buyers, market orders dragged down prices in no time. The imbalance in the market was reflected in the futures prices of most prominent shares which quoted at very steep discounts to spot prices.

"The fact that futures contracts were trading at abnormal discounts to cash market prices only indicated that there were people selling without looking at prices," says Navneet Bansal.

That kind of selling can come only from someone who sells dispassionately - exchanges, banks or hedge funds, which normally follow a policy of sell at whatever cost if the view is negative.

But with the NSE denying it was doing much selling, that leaves only banks and hedge funds as villains. Some market experts say this could also have been precipitated by programme trades as stop-losses get triggered automatically when the market hits consecutive lows.

Also, some sources say a Nifty basket worth $100 million was also sold. On Monday again there was basket sale of $50 million. NSE sources could not confirm this.

Sebi whole-time director T M Nagarajan said the regulator is yet to get details of such trades, if any. Both the NSE and Sebi are tight-lipped about who sold on Monday.

While no one can be blamed for selling, the root of the problem may lie in the way the margining system works. NSE has been charging discretionary ad-hoc margins based on specific client positions in the derivatives segment for some time now.

Market participants say the additional margins on client positions slapped by the exchange was hiked drastically and that caught them unawares.

NSE senior officials deny imposing any additional margins. But brokers insist that they were instructed by fax to collect substantially higher margins from clients for specific positions.

After the 600-point fall during the week, market participants were already stretched for cash and the additional ad hoc margins imposed by the exchange on some positions may have only compounded the problem.

If margins were completely rule-based (currently, a part of it rule-based and the stock exchanges have the discretion to impose ad hoc margins and additional volatility margin based on market conditions) and not determined at the discretion of the regulating bodies, the brokers could have prepared themselves, seeing the rise in volatility through the week.

Rule-based margins seek to attack problems in real time as they arise and prepare market participants better for such situations.

An earlier article published in The Smart Investor, J R Varma, professor at the Indian Institute of Management, Ahmedabad, and former executive director of Sebi, argued that discretionary margins are both unnecessary and undesirable -- unnecessary, because simple rules based on recent volatility do a very good job of modifying margins as market conditions change; undesirable, because discretionary regulations are often highly destabilising and could pose a threat to market integrity.

Varma said: "The more important case against discretionary margins is that while they may start out as attempts to reduce risk, they invariably end up being attempts by margin setters to push the margin in a particular direction."

"In the short run, they do often succeed, and the result is a successful market manipulation. The margin setter may think that they have only been regulating the market, and they might not even realise that they have been indulging in market manipulation. There may indeed be no corruption or fraud, but the fact is that this manipulation also creates a false market, distorts price discovery and leads to wrong resource allocation signals to the rest of the economy. Discretionary margins are, therefore, a threat to market integrity and should be avoided as far as possible," Varma added.

Varma is on a summer vacation and could not be contacted for further comments related to the recent fall.

What really precipitated the avalanche of haste selling on May 17 was the forcible unwinding of positions due to brokers' inability to pay the margins demanded by NSE even as buyers were few and far between.

Market participants argue that the arbitrary nature of the margining system often catches them unguarded. Even while the exchange has to be complimented for avoiding a more serious payment crisis, rule-based margins may have put brokers in a better position to manage their trades, say brokers.

Having said that, the relatively high volatility prevalent in the Indian markets itself is a great cause of worry. India may not lead the list of most volatile markets, but it is far more fickle than many of its peers. Blame it on the lack of depth of the markets.

One reason for the Monday market fall was the lack of buying support even at ridiculously low levels. Stocks fell on thin volumes before the market hit the circuit-filter (twice during Monday).

In the first 20 minutes of morning trade, when the Sensex fell 10 per cent, volumes on the BSE cash segment added up to only Rs 350 crore.

Says T M Nagarajan, "The depth of the market is not at the desired level. In any case, if there are extraordinary situations like what prevailed on Monday, it is impossible to create buying interest to arrest a fall in the market."

But the regulator says volatility is not really bad per se. "The regulator's role is not to curb volatility really. In fact, we would not like to interfere with the price discovery process. We would be concerned only if there is a possibility of market manipulation by some of the participants," he added.

Seconds a senior NSE official, "The role of the regulator and the exchanges is to ensure that the markets function efficiently and are safe during volatile situations. There are several other parameters that determine the efficiency of stock markets - for instance, the bid-ask spreads, the impact cost and order depth. On some of these counts the National Stock Exchanges proves more efficient than even leading American stock exchanges like Nasdaq."

In essence, it is not necessarily the role of the regulator to curb volatility.

However, for investors at Indian bourses, it is definitely a cause of concern if a significant part of your gains accumulated over years evaporates in one day.

The whole idea of having a derivatives segment was to shift the speculative element away from the cash market. Futures and options were introduced to give investors an alternative way to hedge their positions.

But the big players in the derivatives segment today are not mutual funds trying to hedge their risks. Nor are they retail investors covering their risky positions.

"Overall, a very small proportion of the total derivatives volume is on account of demand for hedging existing cash market positions," says Bansal. The derivatives market is dominated by the futures segment where naked positions are mostly taken by retail investors and HNIs.

Some experts say that the high amount of leverage available in the market has only made a number of retail investors trade on the futures side instead of going through the hassles of delivery trades.

They feel that developing an alternative to futures trading by way of a proper securities lending and borrowing is essential for greater stability in the market.

The hard reality, however, is that in an ascending market there is buying from all quarters. But in a descending market only truly long-term investors like pension funds can play the role of stabilisers.

In the absence of such institutions, the markets will be vulnerable to such crashes. Equities in that sense will continue to be unsafe.

The only option for individual investors is to develop alternate strategies to cope with the volatility in stock markets and book profits continuously to limit losses when such unforeseen events happen.



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