The Reserve Bank of India has finally woken up to the problem of ‘unofficial margin trading’ in the stock market, by calling for more disclosures from NBFCs which give loans against shares.
In 2011, 2012, and 2013, shares prices of many midcap stocks collapsed in a sudden tidal wave of selling as financiers dumped pledged shares when the borrowers—operators and promoters–were unable to meet margin commitments.
In a circular issued today, the RBI said that henceforth NBFCs cannot lend more than 50 percent of the value of shares pledged. Also, NBFCs can accept only Group 1 securities as collateral. Group 1 securities are defined are defined by Sebi as those with an impact cost of 1 or less, which means the share price does not move more than 1 percent up or down when a block of those shares worth Rs 5 lakh are bought or sold.
In addition, NBFCs with an asset size of Rs 100 crore and above will have to disclose to stock exchanges about the shares pledged with them.
“Irrespective of the manner and purpose for which money is lent against shares, default by borrowers can and has in the past lead to offloading of shares in the market by the NBFCs thereby creating avoidable volatility in the market,” the RBI said in the circular.
“Certain other associated areas of concern relate to absence of adequate prior information to the stock exchanges on the shares held as pledge by NBFCs, probable overheating of the market, over-exposure by NBFCs to certain stocks and overleveraging of borrowers,” the circular added.
The new RBI guidelines could make life tough for many stock market operators and promoters who manipulate stock prices using borrowed money.
By seeking more disclosures, the RBI effectively has put an end to the ‘unofficial margin trading’ that has been a major source of volatility in mid-cap stocks.
In margin financing, an investor puts up part of the money required to buy a stock, while the lender puts up the rest of the money
Sebi has clear rules for margin financing of by stock brokers, and also the shares they can lend against. Brokers can finance only 50 percent of the transaction value, and the position has to be disclosed on the stock exchange Web site.
So far, there were no clear guidelines on margin financing by NBFCs, which would at times lend up to 70 percent of the transaction value.
Also, there are no restrictions on the stocks that can be funded and the positions need not to be disclosed on the stock exchange Web site, since NBFCs are regulated by the RBI and not by Sebi.
Not surprising then that margin financing by broking firms never took off in a big way. Brokerages have managed to work their way around it and provide margin funding to clients who required it, on more attractive terms.
Most broking firms have their own NBFC arm or have tie-ups with NBFCs. The client opens an account with the broking firm and signs up with the NBFC affiliated to the brokerage. In addition, the client opens a bank account as well as a demat account, and gives the Power of Attorney for both accounts to the NBFC. Typically, the client puts 30 percent into the bank account and the balance is funded by the NBFC for purchase of shares. The shares go into demat account on which the NBFC has the Power of Attorney.
This arrangement ensures that the NBFC can sell the shares if the price falls below a certain level and the client is unable to meet the margin call. The PoA on the bank account means the NBFC can take their share of funds once the proceeds from the sale of shares are credited to the bank account.
Surprisingly, it has taken the RBI so long to issue the guidelines, despite it being an open secret that stock brokers were building leveraged positions through the NBFC route, so that they could avoid making disclosures to the stock exchanges.
In fact, a Sebi order on a high profile stock market investor in August 2006 clearly said that the investor and his associates were violating RBI guidelines on NBFC lending to capital markets. But Sebi said it could not take any action as it was for the RBI to look into the violation.