The stock market regulator has finally plugged a gap in its oversight that allowed brokers to pledge their clients’ stocks to borrow money for themselves. Brokerages allow investors to buy securities using margin facilities provided to them by stock exchanges—a facility to settle the difference of separate buy and sell trades in a single stock at the end of a specified period. The stocks bought thus are kept in a pool account and either transferred to the client’s account when payment is received, or sold if the broker is so instructed. Despite repeated reminders by the Securities and Exchange Board of India (Sebi) on keeping the securities of clients apart from their own, it was not uncommon for brokers to pledge shares held in their pooled accounts to raise money. Finally, Sebi intervened in June with a set of rules asking brokerages to set up specific accounts for their clients’ unpaid and bought-on-margin securities. Brokerages had till August to set up these accounts and park shares in them. Stock exchanges, clearing corporations and security depositories are required to report any delinquency.
As long as money was flowing into the pooled accounts of brokers from their clients, nobody had any reason to complain, however objectionable the idea of pledging somebody else’s shares to borrow money. But once a guillotine was applied, some brokers that had dipped heavily into their clients’ securities to either play the market on their own, or divert borrowed money to other ventures, were bound to come up short. Karvy Stock Broking is allegedly finding it difficult to redeem pledged shares for return to clients or for sale. The brokerage has said it needs some more time to set things in order as Sebi barred it last week from accepting new clients and from trading stocks on the bourses. Reports suggest Karvy may not be an isolated case, although its ₹2,000 crore default vis-à-vis its clients is startling enough. The market regulator has been receiving similar complaints of some brokerages delaying payments to clients, and is reported to be considering a further tightening of rules to deny these firms the facility to hold stocks or settle trades on behalf of clients.
That could be an overkill. Brokerages, and by extension stock markets, feed off trading volumes, and margin trading is a universally acceptable means of amplification. An insistence on watertight compartments for client and broker stocks would curb the use of extra large margins. This, by itself, will add to the cost of doing business and could lead to a shakeout in the brokerage business. Moving collateral and clearing of trades to a separate set of custodians could affect brokerages that derive a chunk of their income from settlement services provided to large institutional clients. Sebi has been flagging the issue of segregating client and proprietary trades from as far back as 1993—with higher frequency since 2016—and its latest rules require depositories to keep watch of brokerages. As long as this is effective, Sebi’s stated objective of averting systemic market risk from excessive margin trading will be served. The regulator could wait and see how these rules are enforced, and how market players adjust to the new regime, before it turns to stronger measures like designating a new set of custodians for trade settlement services.