Equity markets across the world are interlinked through various channels. First and foremost, there are common investors.
For example, about 20 percent of the market-capitalisation of the Indian equity market are owned by foreign portfolio investors (FPIs). In terms of free-float market-capitalisation, this turns out to be more than 40 percent of the Indian equity market.
The impact on the portfolios of some of these investors due to the Archegos Capital debacle can affect the Indian equity market as well.
Second, sentiments of equity market investors across the world have a significant positive correlation. Any dampening of investor sentiment due to the (Archegos) episode would also impact the Indian markets to some extent.
Third, the epicenter of the ongoing problem is the equity derivatives market. India has one of the most thriving equity derivative markets in the world. This also has can have some implications for the Indian equity market.
That said, I do not expect the impact of the incident to be significant on the Indian market at least beyond the very short term.
3 Reason why the Impact Will Be Limited:
Firstly, we know that while factors like liquidity, investor sentiment, news flows, etc. exert a significant impact on the equity market in the short term, in the longer term, it is the economic, sector-specific, and company-specific fundamentals that drive the market.
Therefore, if the current episode results in disproportionate correction in the Indian equity market, which I think is unlikely, the market would bounce back relatively quickly.
Secondly, India has one of the most stringent risk management and margin requirement norms in the world for trading in equity derivatives.
Consequently, the spillover of the events that unfolded in the US, is unlikely to have a large impact on India.
Third, the underlying for the leveraged derivatives trade which unfolded last week does not include Indian equities.
Will India see a second Lehman-type moment?
The portfolio size, composition, and leverage of Archegos Capital still remained matters of guess. The total impact of the episode and also the damage on individual financial entities if not as yet totally known.
Consequently, impact analysis and implications of the same for India is difficult to work out at this juncture.
It is, however, likely that the overall damage can be large resulting in losses of some of the global banks up to the extent of $ 10-50 billion.
This is a very large number and capable of impacting the global equity market including the Indian market by a significant extent.
At the same time, the overall market capitalization of the global equity market is about $ 100 trillion. Most large global banks have significantly increased capitalization since the global financial crisis.
In view of all these, I do not expect the episode to turn out to be similar to what happened in 2008. So it is unlikely that India would see a Lehman-type moment.
Leveraging is a double edged sword:
Leveraged trade allows investors to build a position in the equity market beyond the money that the investor has on its own. If the investment call goes right, the return on the investor’s own money would be much larger done what the investor could generate by only investing their own fund. The opposite is true when the investment call goes wrong.
Since for leverage trade, the investor needs to maintain a certain margin with own resources, if the value of the traded portfolio goes below a certain threshold level, the broker can ask the investor to bring in fresh money, failing which the portfolio gets liquidated to cover the borrowed funds. This makes leverage trading a double-edged sword.
India has one of the world’s largest trading volumes in equity derivatives relative to the cash market. In terms of nominal value, 90-95% of equity trading volume in India gets generated in the futures and options market.
India offers one of the world’s largest number of single stock futures and options as also index futures and options. In some cases, the taxation and other levies favours the futures and options market versus the cash market.
Interestingly, in most matured financial markets, access to equity derivatives are effectively limited to institutional investors.
In contrast, in India, there are either complete or significant restrictions on domestic financial institutions such as mutual funds and insurance companies to take a position in the derivatives market.
On the contrary, retail participation in the derivatives market is very high in India as compared to the peers.
The Securities and Exchange Board of India (SEBI) has published a paper highlighting these issues. The SEBI has also overtime increase the margin requirement as a part of risk management strategy.
There are several types of margin requirements. Without going into technicalities, it suffices to say that when own fund of the investor falls below a certain threshold level, the margin call gets triggered.
The investor needs to bring in the fresh funds within a stipulated period failing which the broker sells the leveraged portfolio in the market to salvage the borrowed amount.
History repeats:
Margin calls generally get triggered during large market movements. While such calls for individual stocks are rather common, market-wide margin calls happen only during periods of large volatility.
Forced liquidation of the portfolio during periods of sharp market corrections results in further fall in the equity market. Similarly, during the periods of sharp upward movement of the market, short coverings result in a further rally.
Therefore, margin calls in India or for that matter in most markets generally result in the last leg of sharp market movement rather than giving direction to the market. In that sense, Archegos Capital episode is rather unique.
Indian markets on the 13th March 2020 witnessed Nifty50 hit a lower circuit and trade was halted thereafter for 45 minutes. The reason for the selloff was margin calls which were triggered by NBFCs having large LAS (loan against shares) books.
(The author is Co-Founder & Vice Chairman, Anand Rathi Group)
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