Karvy order: SEBI’s clean-up act may cause pain, but it is justified

| Updated on November 25, 2019

While margin funding deals help drum up short-term trading volumes, they’re inimical to the interests of long-term investors as they undermine trust and create systemic risks

SEBI’s ex-parte interim order against Karvy Stock Broking, barring it from accepting new clients and asking depositories not to execute select instructions from it, has created considerable uncertainty for over two lakh clients of the broking firm, while sending ripples of unease across the securities market. However, from a reading of its interim order, SEBI appears quite justified in its actions to clean up this murky area of stock trading in India.

The Karvy order was triggered by an NSE inspection finding several lapses on complying with regulatory requirements on separating clients’ accounts from its own. The NSE has alleged that the broker pledged securities belonging to clients and credited the proceeds to its own bank account. Off-market share transfers were made from demat accounts of clients who hadn’t made any recent trades. A key depository participant account was not disclosed and ₹1,096 crore was transferred from the broking firm to Karvy Realty. SEBI has found these transactions to be prima facie violating its stock-broking regulations, and thus issued an interim order to protect investors’ interests, even as a forensic audit probes the veracity of these findings. Karvy has been given 21 days to present its side of the case. It has insisted that it has complied with regulations and will be able to clear its name. While Karvy may have been singled out here, the disturbing truth is that co-mingling of clients’ securities and funds is not all that uncommon at Indian brokerages. The root of the problem lies in the margin funding facilities offered by broking firms, where short-term traders avail of generous leverage to transact in shares worth many times the sums lying in their accounts. Broking firms, instead of putting up their own capital, pledge the unpaid shares lying in such clients’ account to raise the leverage money, pocketing lucrative spreads. The Power of Attorney that investors sign while opening brokerage accounts actively facilitates such deals.

Noting that margin funding using client’s accounts was potentially market-disruptive, SEBI has been on an overdrive in the last 12 months to rein in this practice. In a series of circulars, it has set strict deadlines for winding up defaulting clients’ accounts and transferring pooled securities to clients. In June 2019, it expressly asked brokers to wind down margin funding using client’s shares and to carve out a specific ‘Client’s Unpaid Securities Account’ to avoid mingling. This diktat is said to have landed quite a few brokers in hot water and may well have adverse implications for market liquidity and trading volumes in the coming months. But this short-term pain is perhaps necessary for the securities market to emerge healthier in the long run. While margin funding deals help brokers and the exchanges drum up short-term trading volumes that bolster their profits, they’re inimical to the interests of long-term investors as they undermine trust and create systemic risks. In fact, SEBI needs to probe why the stock exchanges and depositories, as first-line regulators, allowed such dodgy practices to thrive under their very noses for so long.

Published on November 25, 2019

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