Margin trading is a new concept in India. The Reserve Bank of India has allowed banks to finance margin trading in shares w.e.f September 18, 2001.
Marginal trading allows an investor to invest in excess of his financial capacity by providing only a part of the funds for the deal. The balance funding comes from banks in the firm of borrowing. Margin trading permits investors to buy shares by providing 40 per cent of the deal value as margin while borrowing 60 percent from banks. Banks provide finance to investors through stockbrokers for trading in actively traded scrips. Initially, 53 scrips forming part of NSE Nifty and BSE Sensex were identified for margin trading. Banks extend funding of margin trading within the overall existing ceiling or bank exposure to capital market.
The securities purchased by borrowing a portion of the deal from banks are used as collateral. Backed by the collateral and investor can buy assets which are greater in value than the value of the collateral. Hence, margin trading is a form of leveraged trading which leads to increase in the purchasing/selling power of the participants and helps them increase their earnings of the market price of securities move along expected lines.
The concept of margin trading issued as a means to infuse liquidity in the system. Banks, both private and public can invest 5 per cent of outstanding credit in equities with the leeway of fixing their own rates of interest. Today, banks are flush with funds and have immense potential to lend. However, they have to safeguard their loans and take risk containment measures.
Margin trading is a sort of deferral product. Investors generally use margins to own more without fully paying for them. However, margin trading creates a systematic risk that can lead to sharp volatility in the stock market.
The mechanism of Margin Trading: Suppose an investor has Rs 40,000 and he buys a share quoting at Rs 40. Under the present settlement system, he can buy a maximum of 1,000 shares with his own money. With margin trading, he can buy as many as 2,500 shares with Rs 1 lakh from his broker by paying Rs 40,000 as margin and by borrowing the balance Rs 60,000 from a bank through his broker. The broker pledges the 2,500 shares with the bank. The bank has a collateral of Rs 100,000 backing the loan of Rs 60,000.
Suppose the market price of the share moves up to Rs 50 and the investor sells the shares. Had the investor not taken the benefit of margin trading he would have realized only Rs 10,000 [1,000 shares x Rs 50 – 40] as profit. With margin trading, he gained Rs 25,000 [2,500 shares x [Rs 50 – 40)]. His net gain would be equal to gains from the sale of shares less interest on bank borrowings.
If the market price of the share falls below Rs 40 the bank will give a margin call under which the investor will have to furnish additional funds/securities to the broker to pass on to the bank.
Conclusion: margin trading offers banks a unique opportunity to park short term funds at a high rate of interest. Even small investors get an access to bank funds without being exploited by stockbrokers and other Financiers. Margin trading is the cleanest firm of leveraged buying of assets. It is a transport mechanism for channelizing funds into the stock markets. With margin trading the chances of scams are also reduced.
Banks will have to evolve adequate risk management systems for safeguarding loans given by them against collateral of securities. Moreover, reforms in the payment system are needed to bring about improvements in the infrastructure for funds transfer. Margin trading is an attractive mechanism which ensures a no default market with high levels of collateral and offers modest leverage to investors thereby increasing liquidity in the stock market.
In 31 stocks where derivatives trading is permitted margin trading is less compared with other stocks. This mechanism can infuse liquidity if SEBI issues operating guidelines for the same.