Over the last two decades, the capital market has been witnessing an interesting paradox. Investors are fast disappearing even when policymakers are introducing more and more investor protection steps. This, when the transaction cost in primary as well as secondary markets fell drastically. We are fast approaching a situation when we will not have small investors to protect!

The transaction cost in general and commission rates in particular have been declining to touch very low levels. The commission rate for delivery transaction has come down from 150 basis points in general to as low as 20 bps. In the initial public offering (IPO) market, the rates came down from 250 bps to 25 bps in the past two decades.

Getting into detail

Going by the normal theory of competition, brokers should have been shocked by the way the business has been disappearing, when brokerage is falling. This runs counter to the conventional wisdom that high commission rate is a major reason discouraging investors from investing.

But there is a notable difference. While brokers were generally charging 150 basis points as commission, there was a jobbing difference of around 5 per cent, which pushed the total transaction cost to above 6.5 per cent.

Interestingly, the investment horizon in the past was much longer than what it is today and investors rarely thought of investing in equities for a period of less than a year. Unless the market moved up by more than 13 per cent (adding the two legs of 6.5 per cent) they would not make a profit. Hence, the investment horizon was always longer.

When transaction costs and commission rates collapsed, the investment horizon for the present day investor narrowed to a few days if not few hours.

Who’s at fault?

Brokerage firms and the remaining lot of sub-brokers, perhaps, are to be blamed for this sorry state of affairs of converting investors into traders in the market. The broker’s service has shrunk to mere transaction execution rather than advisory on investment.

A collateral damage of the faster application of technology in Indian markets has been the shortening of investment horizon that typically converted the conventional conservative investor into a trader in the markets.

When commission rates fell and markets became technology-driven, a lot of sub-brokers fled broking as the fee structure was not conducive to their survival. At today’s rates, a small investor who trades in, say, 100 shares of a company with a value of ₹100 pays a commission of ₹20 to the broker.

At this rate, assuming a small investor does four trades a month, the broker earns ₹80 from him. A broker or an employee of a broking firm today needs a minimum of ₹40,000 per month to survive in the business. In this case, the broker will need at least 500 active clients to trade in a month to break even.

To have 500 active clients per month who trade at least a minimum of four times a month, the broker/employee must service at least 5,000 clients. The assumption is that only 10 per cent clients will be active in any given month, which is a marketwide experience.

Given this calculation, it is beyond imagination to expect the community of brokers and sub-brokers who were servicing the small retail investor to come back to the market.

As they vanished

Over a period of time when the business became unviable, sub-brokers closed shop extensively, which includes the thousands of members of regional exchanges. In their place, a new breed of large, nationwide brokerage firms, branches, franchisees, sub-brokers appeared, who used employees to service investors.

If we assume that the monthly minimum average cost is ₹40,000 for an employee in a branch office of a brokerage firm, it is not difficult to see the improbability of such an employee servicing 5,000 clients on an average.

Hence, it is not realistic to assume that brokerage firms can service small investors with the current commission structure, and so is the case with sub-brokers. No wonder, brokers are wooing large traders who can generate higher volumes and pay higher brokerage amount, even if the applicable rate is low.

The collateral damage of intense competition and application of technology in capital market has been the near absence of service for large investors, leave alone the smaller ones. When markets and the policymakers celebrated falling transactions costs, nobody thought markets were driving towards a wall.

Today, due to the absence of service, new investors are not looking at equities as being an inherently risky investment. When the instrument is risky in nature, more time is needed to make an investor understand the intricacies of what he is up to, which needs time from the broker and the attendant costs.

We have generally failed to understand this reality at a time when markets are ‘exported’ to FIIs and, consequently, are guided more by global trends than its unique fundamentals.

The most serious hit is taken by the primary market as brokers and sub-brokers have virtually stopped selling IPOs to potential investors. IPOs need time with an investor and that time of a professional has its value. If he is not compensated for his efforts, he will not service the investor.

Helpless situation

Today, the country looks forward to a vibrant capital market to supply capital to our corporate sector, but we are in a helpless situation as far as the IPO market is concerned due to the absence of investors. When the secondary market becomes hot, the primary market is likely to become active.

We should not, however, mistake this for new investor interest, as it will only be the same secondary market trader who wants to make a quick buck when the primary market is ripe.

Unfortunately, all policymakers are advised by Ivy League experts who work for global investment banks and brokers. They compare what the US market is today with India’s fledgling capital market.

We need to learn from history and must know that even the legendary Merrill who founded the great institution, Merrill Lynch, went door to door, visiting houses of investors, and that is how the market in the US was built after the great depression.

Today, brokers do not service small investors and may never service them in the future, unless the commission rates justify the service. Otherwise broking will remain as a mere transaction execution service and will be taken over by the machine soon.

We need to bring the neighborhood sub-broker back into business to service the small investor and perhaps to save our capital market.

The writer is the managing director of Geojit BNP Paribas

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