RBI lands a gut punch on prop traders

**SPEAKER_1** (0:01)
Hello, folks, you're tuned in Finshots Daily. In today's episode, we explain why prop traders are worried about the RBI's latest capital market exposure rules for banks.
But before we begin, here's a quick note from Team Ditto. This weekend, we're hosting a free two-day insurance masterclass that helps you build real financial security by understanding health and life insurance the right way. Well, the masterclass is completely free, and you can head to the link in the description to register while your seats last. Okay, let's start with the story.
Off late, the RBI has become something of a villain for the stock market. That's because starting this month, the central bank has effectively pulled back how much leverage proprietary trading firms can use while trading in the capital markets. Now, we know what you're thinking. The RBI regulates banks, and it's the SEBI that regulates capital markets. So how is the RBI suddenly influencing what happens on the last street? We'll get to that. But first, some context. A prop trading firm or desk is simply a firm that trades using its own money. So unlike stock brokers who execute trades for clients or mutual funds, which invest other people's savings, prop desks put their own capital as well as borrowed money at risks to earn profits. They trade everything from stocks to futures and options, either manually or through high frequency and algorithmic trading, where computers, programs and not humans execute trades. But to trade, exchanges typically ask participants to maintain sufficient money margin. Think of it as a security deposit. If a trade goes wrong and you make losses, the exchange can recover those losses from the margin. As an example, let's imagine you're a prop trader with one lakh rupees. The exchange tells you to keep aside 20% as margin. Now, we're ignoring leverage trades here for simplicity. That means 20,000 rupees gets locked up with the exchange, leaving you with only 80,000 rupees to actually trade. That's not a great situation, especially if your business depends on deploying as much capital as possible. But thankfully, margins don't always have to be cash. Exchanges also accept government securities and even bank guarantees. And that's where banks come in. Instead of parking 20,000 rupees with the exchange, a prop trader could approach a bank and ask for a BG. That's bank guarantees. In simple terms, the bank tells the exchange, if this trader fails to pay, we'll pay instead. Of course, the bank doesn't do it for free. It charges a fee, which is usually much smaller than the amount of capital the trader would have had to lock up. The bank also protects itself by typically checking whether the trader has a strong enough financial profile to avoid defaulting in the first place, apart from asking them to provide collateral, such as securities, deposits or cash, where there are half the guarantee amount. So if the trader defaults, the bank can sell that collateral to recover part of its money. This essentially means that instead of locking away 20,000 rupees, the trader pays a relatively small fee, ledges some collateral, and gets to use almost the entire 1 lakh rupees for trading. In the real world, that translated into prop traders being able to operate with roughly 1.7 times the capital they actually had. And this system worked fairly well for years. To put that in perspective, according to a Care Edge ratings report, banks' exposure to the capital markets accounted for less than 3% of their total advances in FI 25
As a share of their net worth, it was only around 7% to 13%.
Even defaults in this segment was extremely low. Another interesting thing is, if you look at Sebi's analysis of equity derivatives trading between FI 22 and 24, prop traders actually earned the highest profits of around 33,000 crore rupees on the NSE. That's even more than foreign portfolio investors and like individual traders, 91% of whom lost money in F&O. But think about what were to happen if a bunch of prop trading firms suffered massive losses and failed to meet their margin calls.
Banks would then have to honor the guarantees they issued and pay the exchanges on behalf of those traders. Sure, they could recover part of that money by selling the collateral, but the rest would come from banks' own funds, money that would otherwise be used for lending or other banking operations. If such failures become widespread, it could eventually threaten the banking system and indirectly depositors like UNB. Now, that's certainly an extreme scenario, but regulators don't seem to be waiting for worst-case scenarios anymore. And that may be exactly what prompted the RBI to tighten the screws.
A few months ago, it directed that banks issuing guarantees to proper trading firms must now do so against 100% collateral, with at least half of it being cash or cash equivalents such as fixed deposits.