The Karvy stockbroking scam, where collateral and funds held on behalf of clients was misused by the broker, has resulted in a slew of regulatory changes over the last two years aimed at ring-fencing client assets and ensuring that these are not misused. A recent SEBI discussion paper takes this effort forward by proposing a novel way to protect investors’ funds, by replicating the ASBA (application supported by blocked amount) process used in initial public offerings, in the secondary market.

The regulator is proposing that investors can trade in the secondary market with money blocked in their bank accounts. Further, this money will be transferred directly to the clearing corporation, bypassing the stockbroker, thus ushering in greater transparency and allowing investors to earn interest on the blocked amount. While there is no doubt that this will be beneficial to investors, the move could be disruptive for the broking industry, especially the smaller and low-cost brokerages.

There’s little doubt that the current system of trade settlement is complex, giving ample room for leakage of client funds. The investor has to deposit the collateral with the stockbroker before trading in secondary market. Once a trade is executed, the stockbroker uses a part of the deposit to settle the transaction with the clearing member, who in turn settles the trades with the clearing corporation. These multiple layers through which client money flows, results in some funds remaining with the brokers or clearing members which can be misused for settling their own proprietary trades, margin financing, and so on. SEBI’s proposal will ensure that the investors’ funds are not accessible to stockbrokers and clearing members, thus protecting them from frauds or defaults. The role of the stockbroker will be limited to ensuring that adequate collateral has been deposited. Many of the larger brokers, especially those promoted by banks, already facilitate 3-in-1 account to their clients including a demat, trading and bank account, and such blocking of clients’ funds is already taking place at the initial level. Such larger brokers will find the transition easy.

But this change will be difficult for the other brokers not linked to banks. Some of them may have to explore alternative business models to stay afloat. The unused client funds generate significant interest revenue, which is an important source of income for brokers, particularly low-cost online brokerages. Some of these brokers could shut shop and the reduced competition may actually lead to higher brokerages for investors. There could be a reduction in proprietary trading volume which can affect market liquidity. It may, therefore, be good to implement this change gradually. Secondary market ASBA can begin in the cash segment, where the volumes are lower and be implemented in the derivatives segment after a couple of years. Alternatively, the regulator could make it optional for brokerages to select this settlement method for a couple of years.