Why lower leverages, no BO/CO, during higher volatility?
Let us take the example of Monday, March 9, 2020. Crude oil futures on MCX opened down 30%. On Friday evening, the margin required to hold Crude Oil was 15%. So the clients who were long Crude futures had twice the losses of the margin required on Monday morning. The losses made have to be paid to the clearing corporations (exchanges) by the brokerage firm irrespective of the client having the required funds. Yes, brokerage firms might recover money from clients using legal means, but it could potentially take time and if brokerage firms aren’t well-capitalized, that means all other customers’ funds lying with the broker are at risk. Very similar to what has happened with Yes Bank — some large clients not returning the borrowed money has put the money of everyone else at risk.
While the 30% fall in Crude was a black swan event of sorts, with high leverages, even smaller moves in the market can push brokerage firms to take risks which can be detrimental not just for the business but also for all customers trading with them. For example, imagine the leverage for trading Reliance intraday is 20 times, or 5% of the position is asked as margin on normal days. If the client loses more than 5% intraday, the broker’s own capital is at risk. No sensible broker can continue allowing trading Reliance with 20 times (5%), or 10 times (10%) or 5 times (20%) or even 3 times (33%) in volatile markets like now when the intraday stock price can move as much. This is the reason why we reduce leverages significantly and also block products like BO/CO which are designed to give higher leverages due to mandatory stoploss. Also as per our risk management policy, leverages can be changed dynamically during the trading day based on volatility, and it is very tough to inform in advance before changing this.
I’d like to take this opportunity to also let you know that having a stoploss in the system doesn’t guarantee execution at the stoploss price. Say a stock moves from 100 to 90 instantly, and assume you had a stoploss at 95. When the stock drops, the stoploss gets triggered at 95, if you have a limit selling at say 95 itself, it becomes a pending order as the price is now at 90. If you have a market stoploss, it will get executed at 90 as that is the market price, losing much more than losing at 95. So yeah, while under normal market conditions these stoplosses work to limit loss, they do not necessarily guarantee the max loss in volatile times like now. Adding to this, BO/CO products add a lot more load on our Order Management Systems (OMS), as each order is potentially now multiple with Stoploss and Exits which have to be all tracked together by our Risk Management System (RMS). This is the reason why we don’t offer BO/CO even with reduced leverages when we expect high activity and volatility. Adding more servers or capacity does not scale BO/CO as they are complex financial products that are tough to offer when there is extreme volatility in the markets. Such products can potentially hurt the experience for the customers who don’t use BO/CO and also increase the risk for the business.
You will always find brokers who compromise on risk for gaining business, but as you’ve known for a decade now, at Zerodha, we have always followed a conservative and healthy approach. With the events (defaulting brokers, banks, NBFCs) over the last couple years, we have seen what can happen to financial services firms who compromise on risk continuously in the long run.
I’d want to use this opportunity to reiterate that we are and always have been a zero-debt business. We are extremely conservative in terms of risk management. We are also very well capitalized — our own funds are normally more than 25% of client margins.
These volatile markets are tough even for the most seasoned traders. It is important to reduce bet sizes & trade with as little as possible. The lesser the money on the line, the lesser the risk you take, and the lesser the fear you are likely to experience.
Here is a relevant Innerworth post: https://zerodha.com/varsity/chapter/fear-of-a-sudden-turn-of-events/