We have come a long way since the pre-1990 era when the manner in which investor funds were handled for stock market trades was shrouded in mystery. With trading, clearing and settlement moving online, investors now have a fairly good idea about where their funds are going and how they are being utilised. But there are always regulatory gaps and loopholes waiting to be discovered by those looking for them.

The spotlight turned on these gaps in November 2019 when the Karvy Stock Broking scandal broke out. The amorphous way in which the assets of different clients and the brokerage’s own funds were being held and managed came to the fore in this scandal. The broking firm had misused the power of attorney given by clients to pledge securities held on their behalf to raise money. A flurry of circulars and guidelines from SEBI followed this scandal, tightening the rules for managing client assets.

The recent statement by the SEBI Chairperson onr introduction of an ASBA-like (Application Supported by Blocked Amount) system, in secondary market needs to be seen against this background. While regulations in India have kept pace with other markets in most aspects, the rules on protecting client assets fall short of global standards. It is good that the regulator is taking steps to address this now.

Principles and rules

Safeguarding the securities and funds entrusted by a client to the intermediary, either for trading or as collateral, is key to establishing the credibility of a stock market ecosystem. The International Organisation of Securities Commissions (IOSCO) had consulted with market regulators globally and published a report in 2014 containing eight principles outlining the manner in which intermediaries should handle client assets and the way regulatory supervision should be established.

A review of the adoption of the principles was conducted in 2017 in which 36 countries including India had participated. Based on self-assessment, India had met the requirement relating to intermediary records, statement of accounts, disclosure regarding protection, regulator’s oversight of compliance and information on foreign jurisdiction.

But India was found short in Principle 3, which reads, “an intermediary should maintain appropriate arrangements to safeguard the clients’ rights in client assets and minimise the risk of loss and misuse”. This principle had seen the least adoption, with just 24 out of 36 jurisdictions taking up measures on this. It is therefore not surprising that the Indian regulator is now moving forward in this area.

That said, it is not as if rules have not been in existence in India, but their enforcement had been lax. Regulation 17 of the SEBI Act and the circular issued on November 18, 1993 specify that “the money/securities deposited by the client should be kept in a separate account distinct from the firm’s own account or account of any other clients.” The circular issued in 2008 specifies that brokers should have adequate systems and procedures in place to ensure that client collateral is not misused and should also maintain records to ensure proper audit trail of use of client collaterals.

Despite these rules, there was rampant misuse of client funds and securities prior to 2019.

Ground reality

The situation on the ground is however better after the regulatory tightening over the last three years.

Currently, client funds are reasonably well segregated from the brokers’ own funds. The process is seamless for brokerages floated by banking groups. In these brokerages, the client funds are held in the client bank account and moved to the trading account only at the time of order execution. In other words, an ASBA-like system for cash and derivatives trading in equity is already in place here.

In case of other brokers, client funds and broker’s funds are held in two different accounts. Within the omnibus client account, there is clear segregation of individual client accounts, mapped to the client ledger.

The problem, however, arises when a broker decides to misuse the power of attorney given by the client to transfer the client’s funds to any other client’s or to the broker’s account. These could be extremely short-term transfers reversed within a day or two, but are still in violation of client protection rules. If SEBI implements ASBA for the secondary market, this issue will be addressed.

How will it work

India’s pioneering ASBA framework in primary market has been immensely successful. It allows clients money to stay in the bank account and earn interest in the period between subscription and allotment. Not only does it benefit investors, it has made the IPO subscription and allotment process much simpler.

As explained above, an ASBA-like system is already being used by bank-led brokers. Implementing it for other brokers will require alterations to the trading software and systems, but may not be impossible to enforce. Clients will benefit greatly since the unutilised trading funds can earn interest in the bank accounts.

Therefore, in principle, this is a great idea. But the reality is that the funds in the trading accounts of clients provide a float for a large number of market intermediaries. Moving the funds away from the intermediaries’ reach will affect the way they are currently conducting business. A significant disruption is likely in the broking industry with larger brokers, especially bank led ones, gaining a larger market share.

Trading volumes on the stock market are likely to contract. Proprietary trading by market intermediaries, on their own books, accounts for 27 per cent of cash market volumes and around 50 per cent of equity derivative volumes. These volumes could contract going ahead, as the funds handled by brokers reduces.

Brokers, hardpressed for funds may be unable to provide facility for leveraged trading to clients, impacting volumes further. It could be the way forward, but the consequences should be thought through and implementation done in a non-disruptive manner.