Wednesday, December 16, 2015

Whether Collection of Margin on Derivative Trades is Mandatory?

[This post is contributed by Prachi Pandya, founding proprietress of Corporate Attorneys and Vanessa Fernandes, an intern at Corporate Attorneys]

Despite being termed as a weapon of mass destruction by Warren Buffet, derivatives are still an integral part of stock market trading. Whilst purchasing equity, one has to pay the entire value of the shares purchased within the settlement period of two days. Unlike equity, while dealing in derivatives, one has to pay only a minimum amount to purchase it. This minimum amount is prescribed by the stock exchange, which is called the ‘margin’.

Stockbrokers are required to collect margin from their constituents for the derivative instruments purchased by the latter. This margin money is then required to be paid by the stock broker to the relevant stock exchange. There are several types of margins payable by the investor depending upon the derivative product purchased.

The most important margin is the ‘Initial Margin’. Initial margin, which is prescribed by the stock exchange, is a minimum amount of money payable by the investor to the broker for the derivative instrument purchased by the investor.

Another important margin is ‘Mark to Market’ margin, which the broker is required to collect at the end of the trading day. Additionally, stock brokers themselves also have the option to collect additional margin over and above that prescribed by the stock exchange in order to cover themselves from any volatility occurring in the stock market.

The most common issue / question in disputes between the broker and its constituent involving derivative trades is “whether the collection of margin is mandatory?”

There are several cases wherein it is observed that when a constituent is dealing in derivatives, the broker does not collect the minimum margin or mark to market margin at the end of each trading day. Owing to this, the debit balance or the amount payable by the investor to the broker considerably swells up over a period of time. There are cases wherein the debit balance payable by the constituent swells up to crores of rupees.

The pertinent questions that need to be addressed are:

- Whether collection of margin is mandatory for a broker prior to placing trades in the derivative segment, for and on behalf of its constituent?

- Whether the broker has any discretion in deciding the amount of margin to be collected from its constituent?

The National Stock Exchange (NSE) and other stock exchanges have their own regulations which govern the issue of margin. For example, NSE’s Regulation (on Derivatives) 3.10 provides for “Margin Collection from the Constituents”. Regulation 3.10(a) inter alia states “The Trading Members must demand from its constituents the Margin Deposit which the member has to provide under these Trading Regulations in respect of the business done by the Members for such constituents.”

The said regulation further states “Trading member shall buy and / or sell derivative contracts on behalf of the constituents only on the receipt of margin of minimum such percentage as the Relevant Authority may decide from time to time ….. Trading Member. The Trading member may collect higher margins from constituents, as he deems fit.”

The words “must demand”, “which the member has to provide” and “buy and sell derivative contracts only on receipt of minimum margin” in the above quoted regulation makes it amply clear that the regulation mandates collection of margin by the broker prior to placing of trades in the derivative segment for its constituents. It can be safely said that collection of margin is a “condition precedent” to placing trades in the derivative segment of NSE.

What is discretionary is that a broker is free to collect margin over and above the margin amounts prescribed by the stock exchange. However, a broker cannot be said to be having discretion or leeway with regard to collecting the Initial Margin and Mark to Market margin prescribed by the stock exchange.

In fact SEBI and NSE (and other stock exchanges) have issued circulars which impose penalty on a broker for not collecting the prescribed margin.

The Regulations have further empowered and safeguarded the broker by providing that if the constituent fails to pay the prescribed margin demanded by the broker, the broker has the right to square off the constituent’s position. However, demand is a ‘condition precedent’ prior to broker exercising his right to square off.

Further, the Bombay High Court in the case of Bonanza Portfolio Ltd. v. Mrs. Roshanara Bhinder dated 16 April 2015 has held that the broker cannot square off open derivative positions without demanding additional margin. The said order further holds: “In my view the whole purpose of such bye-laws in the Multi Commodity Exchange of India Ltd. is to provide safeguard that there is mitigation of loss and thus makes is mandatory for the broker to square off the transactions immediately upon there being a shortfall which according to the broker had not been paid by the constituent inspite of demand.”

The High Court in its order in the case of Kritika Nagpal v. Geojit Financial Ltd. has held: “The nature of transaction and the business in question, if provides and gives sole discretion to the member even to square off and/ or sale of securities, without any reference and/ or prior notice to the client as stated, just cannot be permitted to proceed without considering the basic principle of power to exercise discretion and due notice and/ or intimation before taking such drastic steps.”

To sum up, collection of margin monies prescribed by the stock exchanges is mandatory. Brokers have the discretion to collect margin monies over and above prescribed by the stock exchanges. The brokers have to mandatorily make a demand upon its constituent for shortfall in margin monies on the outstanding derivative positions of its client. It is only upon failure to meet the margin call by the constituents that the brokers can square off the open position of its constituents.

- Prachi Pandya & Vanessa Fernandes

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