Karvy | Sebi: Sebi rules on share separation leave brokers shaken

Mumbai: The stock broking industry is undergoing an unprecedented shakeup. The trigger is the capital market regulator’s seemingly innocuous set of rules on separation of client shares from broker accounts, a move aimed at preventing misuse of investors’ stocks and money.

But the step is having unexpected ramifications, including a slew of defaults — the most recent being Karvy Stock Broking — and an increase in the cost of business that has made it unviable for many small firms to continue. At least five more smaller broking firms are said to be under Sebi’s scrutiny for wrongful use of client accounts, said a person familiar with the matter.

Sebi said in a June circular that brokers must segregate the securities and funds of clients. The directive followed complaints alleging mishandling of clients’ securities and money by errant broking firms. Brokers pledged client shares to raise money from banks and finance firms that was diverted to other businesses such as real estate, as in the case of Karvy.

In other cases, broking firms used the shares to make up for any shortage in margins of other clients or for their proprietary books.

Industry executives said broking firms that have pledged client securities and diverted them out of the business are the ones facing default issues.

“It is about how the broker has used the funds by pledging unpaid shares,” said Vinay Agrawal, CEO of Angel Broking. “If the broker diverted it elsewhere, he will pay the price. Those brokers who have not misused the funds will be safe.”

With the latest rules plugging various loopholes that brokers exploited to misuse client securities, many firms are gasping for air with funds drying up. The regulator has asked brokers to start separate client unpaid securities accounts (CUSA), which will hold shares of clients who have not paid for the purchases. Such shares cannot be held for more than seven trading days, after which they have to be sold if the client does not bring in money. Sebi also directed brokers to start client margin trading securities accounts (CMTSA) for shares brought through margin funding. This is to ensure that the shares received as collateral are used only for the client’s trades.

These steps have struck at the heart of a business model that many brokers survived on for years. For instance, an investor would buy shares worth Rs 5 lakh, four-fifths of it through the broker’s margin facilities. The shares purchased through margin funding would be treated as ‘unpaid’ shares, which were held in the broker’s account. Brokers would raise money by pledging these ‘unpaid’ shares. Now, with Sebi asking brokers to create two separate accounts — CUSA and CMTSA — the possibility of brokers raising funds by pledging unpaid shares has dimmed.

MIDCAP, SMALLCAP SELLOFF

Sebi also asked brokers to remove pledges and return shares to clients if they cleared dues. Else, these shares had to be sold. Brokers said the selloff in several mid- and smallcap shares in August and September was on account of brokers disposing of these pledged shares after clients refused to buy them.

The frauds at Karvy Stock Broking and BRH Wealth Kreators (formerly BMA Wealth Creators), among others, have been triggered by mishandling of clients’ shares and funds, which were unearthed during audits by the NSE.

In the case of Karvy, which has been barred from taking on fresh clients and executing trades of existing ones, shares of a few customers were routed to its real estate business. Brokers said the slowdown in real estate may have hindered Karvy’s ability to recover the money and repay clients.

Firms that used this arrangement to augment their marginfunding capabilities will have to scale down businesses, making it unviable for many.

“The cost of running the business will go up after these regulatory steps, which will increase the net worth requirement for brokers,” said Nithin Kamath, founder of online broker Zerodha. “Many small brokers who ran businesses solely on such models are facing an existential crisis and will have to look at the possibility of consolidation.”

The CEO of another brokerage said many firms will have to scale up their net worth by 50-70 per cent if they want to maintain the same business size. The executive said he had received almost 50 offers from small regional brokerages looking to sell their businesses.