The central bank’s new rules restricting funding to proprietary or prop traders from 1 April could stop the practice among some brokers who carry out trades on behalf of clients on their books in return for a fee, often skirting margin rules.
Certain brokers, playing in a grey area of regulation, were providing additional leverage in the futures and options (F&O) segment to their clients, according to three industry sources.
“While brokers are not permitted to offer leverage or funding beyond exchange limits to clients, in these arrangements, trades were routed through the broker’s proprietary desk. Since the positions were taken in the broker’s own name [done via the broker's prop book], the usual leverage restrictions applicable to client accounts did not apply,” said one of the three persons.
“If the client trades under the prop book’s name, it is termed as the broker trading using his own money. So, there is no question of how much leverage is given by the broker to the client for F&O,” said the second person.
A proprietary book refers to an individual's own capital that is used for trading. In this case, the individual will be the broker.
Providing funding to clients using prop books is a way of earning money for some brokers who were not able to capture retail clients, added the second person. This way the brokers earn money through interest they get by lending. There is also a profit sharing between the client and the broker, which is the additional income.
An era of tighter financing
The Reserve Bank of India (RBI) via a circular dated 13 February effectively stopped funding to prop traders. The circular said that from 1 April, banks must provide bank guarantees to prop traders only against 100% collateral, of which half should be in cash margin and the rest in cash equivalents such as government bonds, sovereign gold bonds, and listed securities. Earlier, this number was 50%. This simply means, if any one has to give 100% collateral, he has the money to buy the asset completely.
This will, in turn, limit funding to proprietary traders and make it costlier to carry out these activities in grey area as it leaves them with less money to be used by their clients.
“Since such structures often relied, directly or indirectly, on bank credit lines or guarantees, the (new) higher collateral requirement increases the cost of maintaining these exposures and makes the model less viable,” said Winnie Akhoury Shekhar, partner at CMS INDUSLAW.
The new rules should lead to tighter risk management in the derivatives ecosystem, Akhoury added.
Emails sent to RBI and markets regulator, Securities Exchange Board of India, or Sebi, remained unanswered.
A practice in the grey ending
Proprietary traders have an overall market share of 50.5% in equity options turnover and 32.8% in equity futures turnover, in January, as per National Stock Exchange’s (NSE) market pulse report.
Brokers are not allowed to provide funding or additional leverage for F&O trades beyond exchange-mandated margins which sets the minimum margin requirement for a stock or an index.
Say, for example, if one has to buy a derivative contract of ₹10,000 total value where the margin is 20%. The trader will collect a ₹2,000 deposit from the broker. If the margin increases or falls depending on the market, the trader will be asked to collect more margin money.
But often, clients using the broker's prop book would bring in just ₹200, take a leverage of ₹1,800 from the broker in return for a fee, and trade in the prop book’s name. If this was to be done in the correct sense of regulation, the client would have to put down ₹2,000.
Sebi regulations prescribe 100% upfront margin for F&O to be collected from the client. "Sebi discouraged broker-funded margins to reduce excessive speculation, prevent misuse of client funds, and limit systemic risk arising from high leverage in derivatives trading. The objective was to ensure trades are backed by actual client funds and improve market stability rather than "fragile leverage" that could evaporate during high market volatility,” said Diviay Chadha, partner, Singhania & Co.