Explaining the Indian stock market's fall

Business Standard carries a report on how margin requirements contributed to the steep fall in the Indian stock market earlier this week:

According to stock brokers, the real pain in markets started with the over-zealousness on the part of stock exchanges in collecting margin money after the 700 points fall on January 18 and another 14,00 points fall on January 21.

The trading terminals of nearly 90 per cent stock brokers were shut on Tuesday when the markets hit the lower circuit of 10 per cent within a few minutes of opening bell, as the National Stock Exchange doubled the margin money overnight.

"The exchanges wanted stock brokers to pay additional margin money immediately. How can we do this when our clients' cheques take at least two days to clear?" asked a Bombay-based broker who deposited an overdue margin of about Rs 1,000 crore (Rs 10 billion) with the exchanges on Wednesday.

A payment crisis was already looming in the aftermath of the Reliance [Get Quote] Power IPO.

The call for more margin money, from stock exchanges, had a domino effect on the markets.

How far is this explanation valid? Well, increased margin requirements for brokers at a time of falling markets are always a reason for the sharpness of market declines. But, it is not as if the problem will go away if the cheque settlement system is improved.

That's because many of the investors who get into payment difficulties are those who have borrowed in order to speculate in the market. They borrow for day-trading, for IPOs and for any other investment in the stock market. They will have to sell their shares any way in order to meet margin calls. Whether the shares are sold by the brokers on whom margin demands are made or by the investors makes no difference- there will be huge sales and there will be overshooting in the market.

Theoretically, banks can provide finance to investors but they will be wary of lending when markets are in a state of free wall. As the BS report mentions elsewhere, there has to be some proportionality between margin payments made by investors and their brokers- the less stringent the margin requirement, the greater are the chances of a decline in the stock market escalating into a crash.