India’s stock broking industry is bracing itself for a major storm as a consequence of fall-out of SEBI’s November 22 order against Karvy Stock Broking (KSBL). Banks and financial institutions, who often guaranteed a broker's position limit with the stock exchanges or lend them money against shares for trading purpose, are threatening to pull out, sources in the know told Business Line.

This is after the NSDL, India’s largest depository participant, on Monday, transferred securities worth around ₹2,000 crore lying in Karvy’s demat account to nearly 83,000 clients, despite the fact that the brokerage had pledged them in favour of the lenders. Furious over SEBI’s decision to order such transfers in ‘blatant’ violation of their share pledging agreement, the lenders approached the Securities and Appellate Tribunal (SAT). The tribunal has stayed any more such transfers but banks see no easy way out to get back the shares that were already transferred out of Karvy’s account. Hence, they are contemplating to stop extending credit limit to brokers simply fearing that there would be no guarantee that shares pledged even by other brokers could belong to their clients leading to further legal hassle.

Already, client complaints are piling up with SEBI and stock exchanges against brokers for misuse of power of attorney and pledging of shares without consent of clients, the sources say.

“The situation will negatively impact (brokerage) industry with respect to availing of credit limit from banks,” said Rajesh Baheti, MD, Crosseas Capital.

“There is a cloud over banks now providing any short term fund limits to brokers against shares. Henceforth, brokers self certification has no value to banks. There are huge repercussions of SEBI’s order as brokers, who availed short term limits by pledging of shares, are being sounded off by banks,” said promoter of another Mumbai based brokerage. "Will regulators issue such a certificate of guarantee to the brokers?, he wondered.

Why brokers need bank financing?

Brokers need to put in a liquid assets like bank guarantees and cash with the clearing corporation of stock exchange for availing trading limits mainly in the derivative segment for themselves and their clients. Usually, brokers are known to give huge trading limits to their clients even on 10-20 per cent cash margin as they have huge bank guarantees to support them. These bank guarantees are in turn availed by pledging of shares and other assets with the banks. But after the Karvy episode and steps taken by SEBI to bring a closure to it have scared banks and they believe that their ‘charge on the assets and shares submitted by the brokers’ is not safe. It is what happened in Karvy, who had pledged client shares with banks and the lender simply could not sell them after SEBI’s order.

"Karvy case and the knee-jerk move by NSDL to transfer securities, even some of which could have been pledged, brings new challenges for brokers and lenders. It sets a precedent," said Deven Choksey, founder promoter, K.R.Choksey Investment Managers.

Reportedly, bank guarantees and limits worth around ₹7,000 to ₹9,000 crore are outstanding currently to just handful of top brokerage houses. This apart, there is huge loan that banks have given to high net worth individuals, retail clients and even company promoters against shares pledged by them. But there is fear that the recent SEBI order has set a precedent that shares lying in ones demat account may not necessarily mean that the same person or entity is the ultimate beneficiary of those shares, a legal expert dealing in SEBI related cases said.

Share pledging

Pledging of shares is a unique model in capital markets to avail finance. Under this system, the charge on the shares lying in a broker’s demat account is made in the favour of the lender. This means that even though the shares are in the demat account of the broker, the lender has a right to sell them at the click of a button. This is simply known as invoking of the pledge. But SEBI directed depositories NSDL and CDSL to not entertain any other request with regard to shares lying in Karvy’s account and return them to the clients of the broker if they had paid full money.

“Banks cannot check with each client of the broker to ascertain if the shares pledged by the brokers actually belonged to them. Lenders just depended on fact that shares were in Karvy’s account and regulations allow pledging of shares, based on which the finance was extended. SEBI’s move now shows that pledged shares were safe way to finance and banks are taking this into condieration,” said a financial consultant involved with arranging bank financing to brokers.

SEBI sets up clash with RBI

In the Karvy matter, SEBI's dictate to NSDL on transferring shares puts the capital market regulator in clash with banking regulator, experts say. The RBI has allowed banks and non-banking finance companies to do covered lending. Meaning, lend money against liquid assets. But since NSDL transferred shares in Karvy's demat account, which were pledged in favour of banks, to the Karvy's clients it has now left the banks with naked exposure to the broker.

"Lending against shares falls under RBI jurisdiction and equity brokerage under SEBI. The need is for both the regulators to arrive at a common ground. The need is to bring lending against shares on an exchange platform. Currently, it is in the shadows and done in a non-transparent manner. Otherwise, brokerage business will die with no funding," Choksey said.

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