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SEBI’S ban on stock brokers using clients' funds to obtain bank guarantees

Finsec Law Advisors

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Through a recent circular issued by SEBI on April 25,SEBI has prohibited stock brokers (SBs)and clearing members (CMs) from using clients’ funds to obtain bank guarantees (BGs) for availing trading limits. Beginning May 1, 2023, no new BGs shall be allowed to be created using clients’ funds, and SBs and CMs have been directed to wind up existing BGs created out of clients’ funds by September 30, 2023.

RBI, as mentioned in its Master Circular on Guarantees and Co-acceptances dated November 9, 2021, allows banks to issue guarantees on behalf of share and stock brokers, in favour of the stock exchanges (SEs) and this is done in lieu of security deposits. The banks are also allowed to issue guarantees in lieu of margin requirements in accordance with stock exchange laws. The RBI, however, advised the banks to obtain a minimum margin of 50%while issuing such guarantees and maintain an additional minimum cash margin of25% with respect to such guarantees. The banks are also advised to observe safeguards that include exposure ceilings. Once issued, these BGs are then submitted to clearing corporations (CCs)which then determine the trading limits of the SBs.

Previously, it has been observed that brokers have been using their clients’ funds to procure BGs twice the amount of the fixed deposits they had placed with the bank. This exposes the clients’ funds to a market risk since there is often a stark disparity between the actual net worth of the broker and the BGs that are utilized. Thus, SEBI has issued the present circular to safeguard investors from being exposed to such risks and also prevent brokers from misusing client’s money.

To ensure proper compliance with the circular, CCs and SEs have been directed to monitor the winding down of the existing BGs. SEBI has also mandated for periodic reporting mechanisms to be put in place by the SEs for SBs and CMs, and from June 1, the CCs and the SEs shall submit a report to SEBI fortnightly. Further, the SBs and CMs are required to provide the SEs and CCs with a certificate issued by its statutory auditor by October 16, 2023, confirming the implementation of the circular. The SEs and CCs can also verify compliance and formulate adequate mechanism to address cases of non-compliance.

The market regulator, however, has stated that the above prohibition shall not be applicable to proprietary funds of SBs and CMs in any segment. It will also not be applicable to the proprietary funds that are deposited by the brokers, as client, with the CM.

The above ban is expected to have an immediate impact on the working capital requirements for brokers, especially for small brokers. While the practice will pave way for a more transparent market, SBs shall no longer be able to use the BG’s non-funded portion to fund client transactions like instant credit against sale of securities. The prohibition will now require brokers to infuse more capital of their own into the business to procure BGs.