Haircut and Margin: What a Clearing Member Puts Up

Margin is money or securities placed with the clearing corporation while an obligation has not yet settled, and it returns to the member who placed it when that obligation goes. A haircut is the discount struck on collateral offered, so a parcel worth a stated amount is counted for less. The margin says how much must be there; the haircut says how much of what was offered counts.

The calculator opens on one obligation, followed from here to the end: 8,000 shares of Suvarna Commercial Bank Limited, an invented bank, at that bank's own reported Rs 105.00/- a share. The trade is worth Rs 8,40,000/-. At a margin of 18.00 per cent of the value of the trade it returns Rs 1,51,200/-. Collateral of Rs 2,10,000/- is lodged, a haircut of 28.00 per cent of the value of the collateral offered takes Rs 58,800/- off it, and Rs 1,51,200/- is what counts, so the counted value less the margin required is Rs 0/-. Divide that counted value back by the same 18.00 per cent and Rs 8,40,000/- comes back, the trade it is standing behind. The arithmetic proves itself rather than asserting it. A rate whose base has gone missing is a rate nobody can check, so every rate there arrived with its base attached.

Two orders met on Kaveri Stock Exchange Limited, an invented exchange. The clearing corporation that settles trades matched on Kaveri Stock Exchange Limited stepped in between them. From that instant the buyer faces the clearing corporation and the seller faces the clearing corporation, and the two sides no longer face each other at all. The substitution, the step called novationThe step in which one matched agreement is replaced by two, each against a party that was not in the original bargain. How it is done is worked separately., is covered separately and is taken as finished here. The clearing corporation has promised to deliver to whichever of the two is still there, and it has to hold something while it waits.

Two rates arrive together and they look so similar in a sentence that most people file them in the same drawer. The two rates do not belong in the same drawer. One settles how much has to be sitting there, and the other settles how much of what was handed over is allowed to count, and a member who cannot keep those two apart will never be able to say why it has been asked for more when nothing whatever about its position has changed.

What is margin, and whose money is it?

Margin is money, or securities, lodged with the clearing corporation while one of a member's obligations is still waiting to settle. The definition just given is the easy half. The hard half, and the half most readers get wrong on first meeting, is the second one: whose money it is once it has been placed.

The margin still belongs to the member who placed it. A clearing memberThe firm admitted to place obligations with a clearing corporation and answerable to it for them. Who may become one, and on what conditions, is settled separately. that lodges margin has not paid anybody. The member has not bought anything, it has not been charged anything, and nobody has earned anything. The margin sits where the clearing corporation can reach it, and when the obligation it was placed against goes away, it comes back. Margin leaves the member's control without leaving its ownership, and those are two entirely different events that happen to look alike from a bank statement.

The deposit a household leaves with a landlord before moving into a rented flat works the same way. The deposit is not rent. Nobody has spent it and nobody has earned it. The deposit sits with the landlord for as long as the arrangement runs, it is not available to the household for anything else during that time, and it comes back at the end unless something has gone wrong. A household asked whether it has paid the deposit will say yes; asked whether the money is gone, it will say no. Both answers are correct, and the gap between them is exactly the gap between money placed and money spent.

One consequence follows immediately. Because margin is not revenue, no institution holding it gets richer by asking for more of it. The clearing corporation that settles trades matched on Kaveri Stock Exchange Limited earns from other things entirely, and the margins it holds are not among them.

Why does margin exist at all?

Two facts about this arrangement are true at the same moment, and margin is what sits in the space between them.

The first is that the clearing corporation that settles trades matched on Kaveri Stock Exchange Limited became the counterpartyWhoever stands opposite a party in an agreement and has to deliver their half of it. Which entity ends up opposite whom is settled separately. to both sides. If the seller vanishes, the buyer still gets what was promised. The clearing corporation promised it. The clearing corporation's promise is not conditional on anybody else keeping theirs.

The second is that time passes between the match and the settlement. The length of that interval is covered separately. SEBI, at sebi.gov.in, decides it, and it changes. The interval matters for one reason only: it is not zero. During the interval, the price of Suvarna Commercial Bank Limited can move in either direction by any amount, and nobody has to do anything for that to happen.

Margin is what covers the price moving between the promise and the performance, and it exists only because both of those facts hold at once. Take either one away and it would not be needed. If the two sides still faced each other directly, a price move would be their problem to sort out between themselves. If settlement happened in the same instant as the match, there would be no interval for the price to move in. Neither of those is the world, so margin is placed.

So margin is not a precaution somebody added because they were nervous. Margin is the direct consequence of a promise made across an interval, and its size is a question about how far a price might move before the promise has to be kept.

What is a haircut, and what is it applied to?

A haircut is a discount applied to the value of collateral offered. Securities worth a stated amount are counted for less than that amount. The words that matter most in it are the ones naming what the discount lands on.

The discount lands on the collateral. Not on the obligation, not on the margin, not on anything the member owes. Nothing is taken away from anybody at all. A haircut is not a reduction in what has to be there, it is not a discount on the trade, and it is not a charge that anybody collects. The member still has every rupee of the parcel it lodged. A single thing changed: how much of what was handed over is permitted to count against the margin.

Work it on the parcel. The member offers securities worth Rs 2,10,000/-. A haircut is struck at 28.00 per cent of the value of the collateral offered, a setting chosen so the arithmetic has something to run on. Twenty eight per cent of Rs 2,10,000/- is Rs 58,800/-, and Rs 2,10,000/- less Rs 58,800/- is Rs 1,51,200/-. The parcel is worth Rs 2,10,000/-. The same parcel counts for Rs 1,51,200/-. Both statements are true at the same time and only the second one enters the comparison.

Why is collateral counted at less than it is worth?

The question answers itself the moment a different one is asked. When would this collateral ever actually be sold?

Not while the member is performing. A member that settles its obligations gets its collateral back untouched, and the parcel is never sold at all. The only circumstance in which anybody reaches for it is the one where the member who gave it has failed to do what it promised. Failure is a narrow circumstance, and it has a habit.

The habit is this. A member most often fails on a day when prices are moving hard against positions. On that same day, liquidityHow readily something can be sold without shifting its own price much. Liquidity is not a fixed property: the same holding can be easy to sell one week and hard the next. in the very securities lodged as collateral has very often thinned out and buyers have become scarce. So the parcel would be sold on the worst available day rather than on a quiet one. Collateral is therefore valued for the day it might have to be used rather than for the day it was given, and the haircut is the difference between those two days written as a discount.

The everyday version is a pawnbroker. An ornament handed over brings a loan of less than the ornament is worth today. The reason is not that the pawnbroker thinks the ornament is worth less today. The reason is that the only future in which the pawnbroker has to sell it is the future in which the borrower did not come back, and the pawnbroker has to be whole in that future rather than in the pleasant one. Every haircut anywhere is that same sentence in a different costume.

How do margin and haircut work together on one obligation?

Two rates and two amounts, and every one of the four has to be named with its base attached or the whole thing falls apart.

The margin rate answers how much has to be there, and the haircut answers how much of what was given counts, and those are two questions about two different things struck on two different bases. Swapping the bases even once makes both answers come out wrong together, which is the worst kind of error because it looks internally consistent. The calculator above therefore takes the two rates in separate fields: with one held still and the other moved, what happens is attributable to the one that moved.

The whole obligation, built up on the parcel followed throughout, so the working can be run again with a pen.

The last two rows carry the result everything below turns on. The parcel is worth Rs 58,800/- more than the margin it stands against, which reads like room to spare, and after the haircut it covers that margin to the rupee with nothing left over.

Where the numbers going into the panel are found

Where a figure is found matters as much as what is done with it. Not one of the four below is chosen by the member; each is read off a document.

What happens when the collateral no longer covers the margin?

Two numbers in that comparison move on their own, without anybody deciding anything. The value of the collateral moves because the securities in the parcel have prices. The value of the obligation moves because the security underlying the trade has a price too, and the margin is struck on it. So the comparison is not made once and filed; it is made again and again while the obligation stands.

The repeated comparison is the ordinary business of marking to marketRestating something at the price it would fetch now rather than at the price recorded when it was taken on. Restating a value that way is a measurement step, not a decision by anybody., which appears again in securities lending, where a lent security is compared with the collateral standing behind it over and over rather than at the start alone.

When the counted value falls below the margin, the difference is called for. Nothing has gone wrong when that happens, and the same arithmetic run on a different day simply gives a different answer. No rule was broken, nobody misbehaved, and the member was not careless. A price moved.

How often the comparison is made, and what follows when the difference is not provided, sit with SEBI, at sebi.gov.in. Both of them move, so the working figure is the one standing at that address on the day it is needed.

The ends of that line are worth reading. At a haircut of 11.00 per cent of the value of the collateral offered the parcel counts for Rs 1,86,900/-, a surplus of Rs 35,700/- over the margin of Rs 1,51,200/-. At 44.00 per cent it counts for Rs 1,17,600/-, a shortfall of Rs 33,600/-. Between them sits 28.00 per cent, where the two numbers are the same to the rupee. The crossing therefore sits in the middle of the range rather than tucked away at an edge.

Is a margin call a loss?

The quiet assumption is that it is, and the assumption is worth pulling out and looking at. Almost everything that goes wrong after a call goes wrong because of that assumption.

A call for more margin is a call for more of the member's own money to sit somewhere it cannot be used. Nobody has charged the member. Nothing has been deducted. The amount called for still belongs to the member, it is still on the member's side of the ledger, and it comes back when the obligation goes away. A call is not a charge and it is not a loss, and treating it as either one makes it impossible to plan for either one.

None of that means a call costs nothing. A call does cost something quite real. Money sitting as margin cannot be used for anything else while it sits there, and that is a genuine cost and a completely different one from a loss. The name for what is given up by tying money down that way is opportunity costWhat is given up by using something one way rather than another. The cost is real even when no payment changes hands: the thing forgone had a value too., and having the word stops the cost being written down as zero.

And there is a second cost that lands harder than the first. A call has to be met when it is made, so the difficulty in practice is rarely the amount and is usually the timing. Being asked for a further Rs 33,600/- is not difficult in itself for anybody carrying an obligation of Rs 8,40,000/-. Being asked for it on a morning when everything that might be sold to raise it is also moving the wrong way is a different problem entirely, and it is the problem that actually hurts people.

What does the same idea look like at the scale of the institution?

Everything above was one member and one parcel. Step back and the clearing corporation that settles trades matched on Kaveri Stock Exchange Limited is holding many such parcels at once. The corporation reports margins held of Rs 11,000 crore. Behind them sits a settlement guarantee fundResources pooled in reserve, so that when one participant fails the bill does not land on participants who had no part in it. The contributions to the fund, and the order in which it is drawn on, are settled separately. of Rs 2,750 crore. Divide Rs 11,000 crore by Rs 2,750 crore and the margins come to 4.00 times the fund.

The margins and the fund are doing two entirely different jobs, and neither of them belongs to the institution holding it in the way revenue would. The margins are members' money held against their own obligations, member by member, and each member's share goes back when its own obligations settle. The fund is there so that when one member fails, the bill does not land on the members who had no part in what went wrong. One pool is about a member and its own obligation; the other is about everybody else and that member's.

The sequence in which the resources of a member that has failed get drawn on is a real and carefully fixed one, and the sequence rather than the total is where the protection lives. Where it begins, where it goes next and what sits at each stage are all with SEBI, at sebi.gov.in, and all of them move. The reason an order has to be fixed in advance is worth one line: a rule decided while a failure is unfolding is a rule decided by whoever is loudest in the room.

How does a clearing member plan around a number that moves on its own?

Who sets the rates this calculator leaves open?

Four settings decide every figure above, and not one of them belongs to the clearing corporation on its own. An authority decides each one, each one gets revised, and each appears in the sheet below as a labelled line carrying an address and no figure.

The four rows are set out below. One of them, which securities and which instruments may be given as collateral at all, is a question about what may be pledgedGiven as security for an obligation without being sold, so it goes back when the obligation is met. What may be given this way is settled separately. and by whom.

Every rate in this calculator is a setting entered into it, and not one of them is a level anybody requires. A required level printed beside an instrument would not be merely out of date on the morning it changed, it would simply be false. A stale explanation is annoying. A stale number inside a calculator is worse: the output is trusted precisely because a machine produced it, and the wrong figure gets carried away without the rate that made it ever being seen.