Is margin trading facility adding to the pressure in smallcap and midcap stocks?

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The sell-off in the small- and mid-caps over the past month has left portfolios across the country reeling from losses, with a portion of the drawdown contributed by the margin trading facility (MTF).

Over the past month, the Nifty Midcap 100 and Nifty Smallcap 100 have fallen up to nine percent, erasing crores in wealth. Companies with seemingly strong fundamentals have seen their stocks stage a double-digit fall, while other shares have gained significantly.

The MTF book, which touched a high of Rs 1.6 lakh crore, has fallen to Rs 1.51 lakh in October as investors cut leveraged positions and reduce exposure. "Over the past three or four days, we have also seen margin funding-related pressure and the liquidation of positions in stocks," said Chandan Taparia, Head of Technical & Derivatives Research, Motilal Oswal.

MTF allows investors to buy shares by paying only a portion of the purchase price upfront, while the broker funds the balance. The investor will then have to pay interest on the borrowed amount, and the shares serve as the collateral for the borrowing.

When the market rises, the shares do well. However, in a falling market, the share price falling reduces the collateral backing the loan. If the investor's margin falls below the required level, the broker can ask for additional funds. However, if an investor cannot meet it, then the broker can liquidate their position to recover the loan.

"If you look at the past couple of quarters, large caps weren’t performing particularly well, but mid caps and small caps were doing well. People began taking leveraged positions in these stocks," Taparia added.

"Now, the market isn’t finding buying interest, and there is no follow-through buying. Supply is emerging at higher levels, and mid-cap and small-cap stocks are also seeing liquidations."

The MTF book is largely concentrated in small-caps, which make up 46% of the total amount financed, compared with 29% for large-caps. Small-caps also have lower trading volumes and market depth compared to large-caps.

As a result, when investors rush to exit these stocks, modest sell-orders can cause sharp price fluctuations, leading to further sales and additional price declining, which can lead to additional margin calls.

Mehul Koradia, Chief Strategy Officer, Mirae Asset Sharekhan added that the brokerage has been collecting additional margins as per the mark-to-market movements in stock prices. "We have been constantly collecting additional margins in accordance with exchange rules."

However, Koradia stated that the brokerage is more conservative and its MTF book has a lower-risk tilt. "Around 60% of our book is concentrated in low-risk stocks. Around 25-30% is in medium-risk stocks, while high-risk stocks account for around 10%," he said. Further, Mirae Asset Sharekhan asks clients to pay an additional buffer so as to "not approach customers everyday."

MTF growth could slow

The immediate outlook for MTF is closely tied to the average investor's confidence in the markets. If the market remains sideways or declines over the next few months, most brokerages don't expect the retail MTF book to grow.

“People are losing short-term faith in the market. They see that it will take time to get back to normal,” said Koradia. Investors also need to maintain their existing positions and meet mark-to-market margin requirements, which ultimately leaves less room for them to take on fresh leverage.