The Hindu Business Line : SEBI directive on mandatory internal audit of stock-brokers

Last month, SEBI issued a circular to he various stock exchanges requiring mandatory internal audit for their stock-brokers / clearing members on a half-yearly basis.

The scope of the said audit includes the existence, scope and efficiency of the internal control system, compliance with the provisions of the SEBI Act, 1992, Securities Contracts (Regulation) Act, 1956, SEBI (Stock Brokers and Sub-Brokers) Regulations, 1992, circulars issued by SEBI, agreements, know-your-customer requirements, by-laws of the exchanges, and data security and insurance in respect of the operations of stock brokers / clearing members. The first such audit period will be from October 1, 2008 to March 31, 2009.

Following the SEBI circular, it is expected that the respective stock exchanges will come out with detailed guidelines in this regard. On the audit front, it is expected that the Institute of Chartered Accountants of India (ICAI) will also come up with guidance notes for its members for the conduct of audit.

This requirement has drawn mixed response because of the increased cost of compliance for the stock-broking community, which is facing a profit squeeze given the subdued capital market conditions and declining volumes.

On the other hand, the requirement provides an opportunity for strengthening controls and to reduce risks under volatile market conditions.

Recent Capital Market Reforms

During the last few years, there have been substantial regulatory, structural, institutional and operational changes in the securities industry.

These have been brought in with the objective of improving market efficiency, enhancing transparency, preventing unfair trade practices and bringing the Indian market up to the international standards. Some of the significant changes are listed below.

Screen-Based Trading in place of physical trading, which has enabled trading to be carried out from various regions.

Reduction in Trading and Settlement cycle from T+14 to virtually T+2 / T+1day cycle in a progressive manner.

Trading in derivatives, options, futures, etc.

Demutualisation of securities and virtual discontinuance of trading in physical form.

Development of Risk Management System in Stock Exchanges like constant monitoring of exposure and turnover, indemnity insurance, on-line monitoring and automatic disablement, virtual surveillance, introduction of circuit breakers etc.

Globalisation of markets with highly sophisticated and matured players like FIIs, Mutual Funds, HNIs etc entering India and high inter-connect between Global stock exchanges and Indian stock exchanges.

Changing Landscape for Stock-brokers

The recent capital market reforms and globalisation of the economy have opened up various business avenues as well as increased the exposure to certain risks for the stock-broking community arising from:

Substantial increase in geographies operations

Considerable increase in scale of operations

Polarisation of stock exchanges, with the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) together accounting for over 99.98 per cent of the national turnover of trades.

Increased use of IT

Change in the type and scale of investors, with the emergence of a new class of investors in mutual fund houses (MFs), venture capital funds, private equity players, portfolio managers, etc.

Increased transparency and media

Increased reporting requirements and greater responsibility on the various functionaries.

Increased volatility in the markets following greater and quicker information flow, and the integration of Indian capital market with global capital markets

Internal Audit

Instead of considering the SEBI directive for internal audit as a compliance requirement, it should be used as a tool to strengthen internal controls and improve risk management. The areas that are of the utmost importance wherein the internal audit can add value are:

Client acceptance and anti-money laundering compliances

Client exposure and margin policy aspects

Sub-brokers and franchisee exposure and adequacy of margins

Treasury management

IT systems’ review and IT security aspects

Business continuity and disaster management

Designing budgetary control system with profit and cost centres

Revenue audit based on contractual arrangements with client and revenue sharing agreement with the franchisees/sub brokers

Manpower cost review including performance based incentives

Review of operating costs, including infrastructure and IT

Compliance with applicable regulations, such as those of SEBI, stock exchange regulations, Securities Transaction Tax, Service Tax, Income Tax, and Companies Act (in case of corporate entities).

Efficient implementation of this directive can go a long way in improving the internal controls, risk management and operational efficiency for the stock broking community which can far outweigh the compliance costs.

(The author is a Chartered Accountant and founder of RSM Astute Group.)

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