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One circular to rule them all: Circular on System Audit of Stock Brokers

Finsec Law Advisors

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SEBI passed a circular on Annual System Audit of Stock Brokers / Trading Members on 6 November 2013 ('Circular'), which seems to be modelled on the SEBI circular dated 29 November 2011 on Annual System Audit Framework for exchanges and depositories.

The system audit framework for stock brokers is required to be conducted with differing periodicities. Those stock brokers who use Computer-to-Computer Link ('CTCL') or Intermediate Messaging Layer ('IML') / Internet Based Trading ('IBT') / Direct Market Access ('DMA') / Securities Trading using Wireless Technology ('STWT') / Smart Order Routing ('SOR') and have a presence in more than 10 locations or more than 50 terminals and those stock brokers who are depository participants or are involved in offering any other financial services have to conduct an annual system audit Stock brokers who use Algorithmic Trading orprovide their clients with the facility of Algorithmic Trading are required to conduct a  half-yearly audit. All other stock brokers have to conduct a system audit once in every two years.

The Circular provides for a system audit framework for stock brokers / trading members of stock exchanges including the system audit process, auditor selection norms and terms of reference. Stock brokers have been categorized into the following different categories: (a) Type I Brokers - those stock brokers who trade through exchange provided terminals such as NSE's NEAT, BSE's BOLT, MCX-SX's TWS, etc.; (b) Type II Brokers - those stock brokers who trade through API based trading terminals like [CTCL or IML] or IBT/DMA/STWT or SOR facility and who may also be Type I Brokers; and (c) Type III Brokers – those stock brokers who use Algorithmic Trading facility to trade and who may also be Type II Brokers. Separate terms of reference have been provided for all the three categories of stock brokers.

The Circular requires the stock exchanges to keep track of findings of system audits of all brokers on a quarterly basis and ensure that all major audit findings especially with respect to critical areas have been rectified /complied with in a time bound manner and also obligates stock exchanges to report all major non-compliances / observations of system auditors, broker wise, on a quarterly basis to SEBI.

Hitherto, the system audit framework was prescribed by the stock exchanges through their bye-laws and it varied from exchange to exchange. This Circular provides a uniform framework to be followed by all stock exchanges for system audit for stock brokers. However, it may result in an increase in the cost of compliance for stock brokers, who are already reeling under falling revenues because of low retail participation and high compliance costs.