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No room for Brokers on the ‘Float’ing Plank

Sandeep Parekh

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Co-authored with Raghuvamsi Meka (Senior Associate) and Parker Karia (Associate), Finsec Law Advisors

After the Karvy scam that rocked the broking industry a few years back, Securities and Exchange Board of India (SEBI) had come out with various circulars and guidelines to protect investors. The latest attempt in this endeavour is the proposal to block funds in investors’ bank accounts to undertake trades instead of funds being transferred to the trading accounts maintained with brokers. Presently, the clearing and settlement of transactions in securities involve multiple intermediaries and pool accounts before the funds and securities reach the intended recipients. For instance, an investor, before executing a trade, would have to transfer funds to the stock broker in his trading account, or would have to post collateral with the stockbroker. The stockbroker posts collateral with its clearing member, for both its as well as clients’ trades. The clearing member then posts collateral with the clearing corporation for their and their clients’ trades, and then carries out the settlement process with the clearing corporation.

A similar process exists for pay-outs released by the clearing corporation, till such time it reaches the beneficiary (recipient).Thus, the extant framework envisages either the transfer of funds to or the posting of collateral with the intermediary involved at each stage. Further,the funds and securities move through pool accounts, resulting in various clients’ funds and securities being clubbed together in a single account and then redistributed as per the individual orders (client-wise allocation). The regulator has observed that this framework has resulted in, and increases the probability of, misuse of funds or securities by the stockbroker.

In view of the above, pursuant to discussions with clearing corporations, National Payments Corporation of India, banks, and other stakeholders, Sebi has proposed a framework to introduce a facility of blocking funds for trading in secondary markets. Sebi has proposed that to trade on the market, investors can block funds in their bank account and there will be a direct settlement between the investor and the clearing corporation, thereby making the process seamless and more transparent. As a result of this, no funds are required to be transferred to the stock broker. This is similar to the ASBA (Application Supported by Blocked Amount) process employed for IPOs, in which the IPO application amount is blocked in an investor’s bank account and it is debited if shares are allotted to this investor.

For this mechanism, Sebi seeks to integrate the UPI mandateservice into the trading ecosystem, such that a single block allowing multiple debits can be created. Once a mandate is created, the funds will stay in the client’s account, but remain blocked in favour of the clearing corporation till the block expires or is released. The latter can debit money from the blocked amount only, thereby protecting the remaining funds in the account. The creation of the block would be considered the collateral, and would be available for settlement purposes as well.

This proposed framework is a positive step in ensuring greater investor protection and in mitigating any threats to the market due to any unscrupulous acts of brokers. This will enable clearing corporations to have visibility over ownership of funds without having to rely on reporting by intermediaries, while eliminating the risks associated with transferring the custody of funds and assets. Further, the funds and assets would no longer passthrough pool accounts, thereby avoiding any risks associated with co-mingling of clients’ funds and securities. This would also protect clients in case of defaults by brokers. Investors also stand to directly benefit from this one-of-its-kind proposal as the blocked amount in savings accounts can continue to generate interest.

However, it should be noted that Sebi is not keen on replacing the existing system completely. For the time being, it appears to want both modes of trading in the secondary market to run parallelly. If a client chooses the UPI block facility, till they opt out, they cannot go back to the previous method. All cash collaterals and the funds pay-in (receipt of funds post sale of securities) would be done through the UPI block only, as the direct settlement visibility available with the clearing corporation would be limited to the UPI block amounts. One of the reasons to proceed with a dual framework could be to ensure that the new system is tested for stability and consistency before making it the primary system to minimise any transaction failures which may be detrimental to investors’ interests.

While being significantly better for the investors, the proposed framework threatens stockbrokers’ earnings. First, the stockbrokers have an additional operational cost owing to the introduction of a new mechanism. Second, this proposal will put a dent into the brokers’ bottomline as they will not be able to use the funds and collateral lying with them to generate interest. Interestingly, Sebi has floated another consultation paper recently, seeking to further eliminate any surpluses that may be retained by the stockbroker or the clearing member by mandating the daily upstreaming of all investor funds from the stock broker to the clearing member to the clearing corporation. This would further impact the ‘float income’ that stock brokers and clearing members enjoy during the time for which the funds are in their custody. This move will probably hurt discount brokers more, who greatly relyon the interest income generated by this float/idle deposits. As a direct consequence to this proposal being implemented, we may also see an increase in the brokerage fees. Additionally, this method further poses questions in relation to collection of brokerage by stockbrokers, and gets further complicated in case differential brokerage rates are applied for different clients, or classes thereof.

Broadly, the proposed measures would more effectively safeguard investors’ money and provide them with timely information regarding their funds and securities. While the market structures and investors stand to gain in terms of reduced misuse of funds and increase in investor confidence, brokers will view this as a loss of a revenue stream. Overall, this would be an innovative step which will result in some creative destruction with existing business models, but would be very good if it succeeds.


This article was first published in the Financial Express: Link.