But amid all the backslapping, there was an underlying current of unease over a massive structural shift expected to happen soon, one that could potentially alter the way brokerages do business. Markets regulator Securities and Exchange Board of India (Sebi) does not want brokers handling investor money anymore.
If Sebi’s plans go ahead, brokers will only execute buy or sell trades and no money from an investor’s bank account will go into a broker’s account. This change is expected to hit the brokerages’ revenue, particularly interest income.
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“In the past two-odd years, brokers were allowed to grow their customer base, and we did not interfere. But now that the numbers have increased, it’s time we stepped in," said a regulatory official who did not wish to be identified as he is not authorized to speak to the media. “Why should brokers handle investor money? That it is not their job; they are supposed to execute trades and play a limited, advisory role."
Sebi’s plan to alter the way brokers conduct their business can be traced back to some bad apples. The market has witnessed no less than 30 broker defaults in a short span of about three years.
The biggest of them was Karvy Stock Broking Ltd, the poster boy of bad brokers. The firm, once one of India’s top five brokerages, rampantly misused clients’ securities by pledging them with banks for loans. These loans were then diverted to other group companies, mainly real estate firms.
Since 2019, when the scam came to light, Sebi has been working to end brokers’ access to investors’ securities and money. These measures were initiated by former Sebi chief Ajay Tyagi and are being taken forward by his successor and current chief Madhabi Puri Buch.
While limiting access to client securities has increased compliance costs, denial of access to clients’ money will hit brokers where it hurts: interest income. “Brokers generate interest income from the unused funds until it is sent back once every 30/90 days. So, there will be a revenue hit," explained Nithin Kamath, founder of Zerodha, a discount broking (zero brokerage) firm.
Sebi’s rationale
Most investors today are aware of the share allotment process in a public offer, wherein an amount equivalent to the value of an investor’s bid is blocked in his/her bank account. When the shares are allotted, the block is released and the money is debited. If they aren’t allotted or the IPO is withdrawn, the money is refunded to the bank account. This system is called Application Supported by Blocked Amount, or ASBA.
From 2016 onwards, Sebi made it mandatory for all retail investors to use ASBA while investing in an IPO. Now, the regulator wants to have a similar system in place for secondary market transactions or regular trading. In the regulator’s view, since this is already being done in the primary market, keeping investor funds safe in their own bank accounts, it can easily be replicated in the secondary market.
“(An) ASBA-like (process) for the secondary market is very much under discussion. But it is, as you can imagine, operationally complex and … the devil lies in the detail," Sebi chairperson Buch said on 30 September after a meeting of the regulator’s board. “We want to be absolutely sure that the process can happen seamlessly. So, it is still with the working group, with all the stakeholders. And they are making pretty good progress."
In the last two months, the regulator has indeed made a lot of progress in implementing the initiative. “There have been three rounds of discussions and Sebi is targeting the first phase of implementation in 2023," said the regulatory official quoted above. “There is a plan to keep it optional in the first phase and only for the cash market," he added, noting that it will be supported by ICICI Bank, HDFC Bank and Axis Bank. By optional, he means that investors who want to continue transferring their money to brokers can do so.
Excerpts of the first draft of what the regulations will look like have been reviewed by Mint. One of the key stakeholders in the entire process is the National Payments Corporation of India (NPCI), which developed the Unified Payments Interface (UPI). And UPI is expected to play a key part in the new system.
How it will work
Currently, when an investor wants to purchase shares in the secondary market, she/he transfers money to a broker’s account and the broker then initiates the trade. After deducting a commission and transaction charges, the broker transfers the money to a clearing house/exchange. Once the money is transferred, the securities are credited into the investor’s demat account. A clearing house is an entity that is associated with an exchange. It handles confirmation, settlement and delivery in a trading transaction. NSE Clearing and the BSE’s ICCL are clearing houses.
Under the new system, the investor will simply instruct the broker to execute the above trade. The broker will transmit that order to the clearing house, which, in turn, will block the money needed for the trade in the investor’s bank account via UPI. The order is then processed and the money will be debited through UPI when the securities are credited into the investor’s demat account. In the event the trade fails, the block on the funds will be lifted.
The clearing house will be able to block a maximum of ₹5 lakh in one instance in the investor’s account. There can be three such blocks in one day, totalling ₹15 lakh. Money will be debited from the blocked amount basis the securities bought. So, if someone buys ₹1 lakh worth of shares, then only ₹1 lakh will be debited from the blocked amount.
There are three clear benefits for investors in the new system. First, brokers will have no access to an investor’s money, so it prevents shady brokers, for instance, from defaulting and taking off with the money. Secondly, since the money remains in the investor’s account and not with the broker, interest will accrue to the investor and not the broker. Most of all, the system gives the investor more control and is thus expected to minimize broker-investor disputes.
“But this requires a huge process. The primary market process is one-time block and one-time debit. Technically, the use-case in the secondary market will be ‘one-time block and multiple debit’ — that’s the nature of the product," explained a second person with direct knowledge of the matter. “In the best-case scenario, if Sebi completes consultations and issues final guidelines by the first half of next year, NPCI will take at least six months to come up with the final product."
The first step in this direction was taken in the Reserve Bank of India’s (RBI) monetary policy on 8 December. “The capabilities in UPI can be enhanced to enable a customer to create a payment mandate against a merchant by blocking funds in his/her bank account for specific purposes which can be debited, whenever needed," said the RBI’s monetary policy statement. “This would be helpful for hotel bookings, purchase of securities in the secondary capital market as also purchase of government securities using the RBI’s Retail Direct scheme, e-commerce transactions etc. This will build a higher degree of trust in transactions as merchants will be assured of timely payments, while the funds remain in the customer’s account till actual delivery of goods or services."
“It has, therefore, been decided to introduce a “single-block-and-multiple debits" functionality in UPI, which will significantly enhance the ease of making payments in the e-commerce space and towards investments in securities. Separate instructions to NPCI will be issued shortly," the statement added.
The hurdles
Market participants expect the proposed multiple debit facility to pose a huge challenge. “A retail investor would typically apply for a maximum of two-three IPOs in a day. But in the secondary market, the number of transactions per investor could be 20 or 30 or 50; who knows? It would require banks and clearing corporations to work like a well-oiled machine," said an exchange official, declining to be named since the discussions are not yet in the public domain.
Many brokers have raised concerns over the trading limits in their discussions with the regulator. “The limit of ₹5 lakh per block and ₹15 lakh per day will impact the trading activity of many clients and the limits should be increased," said a broker privy to the discussions.
The exchange official quoted earlier disagrees. “This is meant only for retail investors. Savvy investors such as high-net-worth individuals (HNIs) and institutional investors will not be asked to go for ASBA. With these limits, at least 94% of the retail markets will be covered," the official said.
“If you want multiple ₹5 lakh transactions a day to be supported for the ASBA market, it is well within NPCI and banks to come together and decide those norms," said the second person cited earlier.
The second big issue is how brokerage will be collected. The draft does not envisage a scenario where clearing corporations can collect brokerage on behalf of brokers for executing the trades. “Clearing corporations deducting brokerage from clients on behalf of brokers may make the clearing houses a party to all commercial disputes between brokers and clients," said a third person aware of the regulator’s thinking.
Thirdly, it is not clear how margin requirements—the collateral investors need to maintain with broker/exchange to cover any losses—will fit into the new model. Every investor is given a trading exposure basis the margin kept with the broker.
Where it hurts
Earlier, clients’ unused funds were required to be transferred to investors’ accounts every quarter. This has now been changed to 30 days.
Even so, this cash is available on the books as cash and bank balances. And those balances are not small by any measure. Zerodha’s cash balance as of March 2021 was ₹13,175 crore. IIFL Securities earned an interest income of ₹1,794 crore as of March 2022. Motilal Oswal’s balance sheet shows it earned interest to the tune of ₹478 crore. To be clear, the broker’s cash balance does not only comprise of client funds, but a substantial portion is investor money.
“Assuming that more informed investors make up 50% of the investor base and opt for the blocking mechanism, that would hit the profitability and revenue of brokers. They would need to rely on brokerage fees, which have anyway shrunk quite a lot in the past couple of years. For cash transactions, discount brokers do not charge a fee," said the broker cited earlier. “If their income does not keep up with expenses, brokers will have to shut shop or look for other revenue streams," he added.
It is not as though the regulator is against the broking community; it simply wants to make investing in equity markets a safe experience for investors, said the regulatory official cited earlier in the story.
According to Ashwani Bhatia, wholetime member, Sebi, the regulator has formed a separate working group for brokers so that they can air their grievances directly. But it is not clear how much the regulator will be able to reassure the broking community. Given how their avenues to earn revenue have narrowed in recent years, and how the new proposals will shrink what’s left further, some of them may feel they are at land’s end. And not in a good way.
Arti Singh contributed to this story.
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