In the stock markets, when one person makes money, there is always a counterparty who loses the same amount of money. This is a rule that holds true for every trade that gets executed in a stock exchange. The stock exchange simply recovers the money from the person who has made a loss and gives it to the person who has earned the profits.

Now you must be wondering how the exchange manages the risk that someone may simply not pay up the loss amount, thereby hurting the person who made the profit. I will try to answer this question in a simple way so that your doubt gets cleared.

The stock exchange is essentially a marketplace which brings the buyers and sellers together. It acts as a mediator between them and charges a fee from them for every trade that they execute.

The most important point that you must remember here is that every trade that is done in the market belongs to the buyers and the sellers only. The exchange never executes even a single trade on its own.

Essentially every buyer in the market has a bullish view and the seller is bearish. Hence when the market goes up the buyer makes a profit, and the seller makes a loss. On the other hand, when the market falls the seller makes a profit and buyer makes a loss.

Margins

To secure the trades that get executed in the market, the exchange asks for deposits from both the buyers and sellers. This deposit is known as the ‘Margin’. The amount of margin that will be charged will depend on the risk involved in the trade. Stock exchanges across the world use a software called Standard Portfolio Analysis Of Risk (SPAN) to calculate this margin. Once the margin amount is calculated they go ahead and collect it from the buyers and the sellers.

Let us understand this with an example.

Assume that there is a stock whose price is Rs. 10,000 and the lot size is 100. Therefore, the contract value becomes Rs. (10,000 x 100) = Rs. 10 lacs.

If the margin for this contract is 20% then it means that the buyers and sellers both will have to pay Rs. (10 Lacs x 20%) = Rs. 2 Lacs before they execute the trade.

The exchange will collect Rs. 2 Lacs from the buyer as well as the seller and retain this entire amount of Rs. 4 lacs with itself. After this, the trade is executed.
On the next day, say the market starts moving up and the buyer makes a notional profit of Rs. 20,000. The exchange will recover Rs. 20,000 from the seller (who is making a loss) and credit it to the account of the buyer. This is called the Mark to Market Profit and Loss Adjustment.

Say, on the next day the market falls, and the seller makes a profit of Rs. 10,000. The exchange will now recover Rs. 10,000 from the deposit given by the buyer and give it to the seller.

This mark to market adjustment happens every day and the exchange will always ensure that the margin requirement of 20% is made by both the buyer and the seller.

Under no circumstances will the exchange let the loss go beyond the amount of deposit collected, i.e., Rs. 2 Lacs. In fact, as soon as the losses start, the exchange will ask the party to deposit the loss amount with it by making a margin call.

This risk management mechanism followed by the exchanges is very robust and it ensures that the exchange can manage its risks properly even when the markets make sharp moves.

This is the reason why we consider the Indian stock markets to be structurally very secure and both the buyers and sellers can trade in it with complete peace of mind.