Stock brokers in India are an ingenious lot. Throw any rule at them, and they will find a workaround, as the Securities and Exchange Board of India (SEBI) and the stock exchanges have learned over the years. And not just that, there have been instances when brokers have been able to profit from some of the regulations. But the latest proposal from SEBI to allow investors to directly transfer funds from their bank accounts to clearing corporations for cash market trades poses the most serious challenge till date to the business model of stock broking firms. Like the Application Supported by Blocked Amount (ASBA) facility for IPOs, SEBI has proposed that money will leave a client’s account only when the trade is to be settled. This marginalises the broker’s role considerably and reduces their hold on their clients.
The proposal aimed at eliminating the possibility of clients' funds being misused will, at the same time, deprive brokers of a steady stream of income.
At first glance, discount brokers—who just provide a platform to trade and charge low commissions—stand to lose the most. That is because they had been making up for ultra-low or zero broking charges with the interest earned from the short-term funds lying in the accounts of their clients, most of them active traders. Full-service brokers, which besides a broking platform also provide research, and charge higher commission will feel the pinch too, though to a lesser extent. Bank-owned broking firms will be the least affected, as they will still have access to the funds.
Also, the move is clearly beneficial for clients as they will be able to earn some extra interest on funds as long as it stays in their bank accounts, besides the added safety. So brokers can’t publicly oppose the proposal either. The question is: will broking firms be able to navigate this rule without a serious dent to their bottomlines? A look at the history of compliance by stock brokers is a clear indicator of their ability to spot a loophole in almost any regulation.
In the 80s and early 90s, when retail investors were just getting a taste of the stock market, there was no concept of having to deposit margin money with brokers while buying shares. In fact, brokers would first make the payment to the clearing house, and collect money from their clients much later, even weeks. Of course, brokerage rates used to be a princely 2 percent back then.
That changed sometime in the mid-90s after SEBI was set up to regulate the stock market. But while brokers were required to collect funds from their clients ahead of pay-in, few brokers did that, and continued to extend credit to clients, in order to retain business in a fiercely competitive market. Margin regulations at that time were treated as suggestions more than anything else.
That changed following the dot com meltdown of 2000-01. Scores of clients defaulted on payments, in turn leaving quite a few brokers bankrupt. Margin rules were tightened after that, but never enforced. When the market started rallying again from April 2003 onwards, bitter experiences of the previous crash were forgotten. Brokers continued to offer favourable terms to clients, in violation of norms.
In the 2004 Budget, the UPA government introduced the Securities Transaction Tax, which brokers and traders opposed fiercely. To placate them, the government allowed a tax rebate on STT paid up to a certain amount. But some smart brokers figured a way to profit from this. The excess STT on which no rebate could be claimed, was dubiously transferred to the accounts of high networth individuals (HNIs), helping them lower their tax liability. (The rebate was later scrapped)
As the bull market raged, brokers again goaded clients into taking up excessive positions. As a precaution, margin collection in cash and collateral (shares) was better than the previous time, but it was mostly clients who came to grief when the market crashed in early 2008. Since there were no clear rules for segregating the monies and shares of individual clients, brokers used funds and shares of smaller clients to bail out the premium ones. Some brokers had even parked clients’ shares with the exchanges as margin deposit, passing it off as their own. When the exchange liquidated brokers’ positions for overshooting trading limits, the clients lost their shares and were told by the brokers that the exchange was to blame.
Margin rules were further tightened to ensure that brokers did not extend easy credit to clients. Brokers sidestepped the new rule by setting up non-banking finance companies (NBFCs). SEBI rules did not allow brokers to fund more than 50 percent of their clients' trades under an arrangement known as margin financing. Plus, these trades had to be disclosed to the stock exchanges. But since NBFCs were regulated by the Reserve Bank of India (RBI) and not SEBI, a parallel and invisible market for margin financing quickly emerged. Through a power of attorney arrangement, the NBFCs would finance almost 75-80 percent of the value of the trade. And the trades did not have to be disclosed to the stock exchange either.
This would go on till 2014 when the RBI finally stepped in, and set limits to how much NBFCs could fund stock market transactions. Margin requirements continued to be tightened to the point where clients have to put up 100 percent before initiating the trade. And brokers couldn’t finance it; the money had to come from the client’s account. Here again, some brokers have managed to find an out, by extending loans in the guise of Loan Against Property (LAP) through their NBFC arms. In addition, many brokers are also said to be helping clients sidestep margin requirements by putting the traders through the broker’s proprietary account, and later settling the profit/loss in cash.
For all these ‘innovative’ techniques, traditional broking firms have been under pressure from discount brokerages, who have managed to grow their revenues and market share considerably over the last few years. To keep up, some traditional brokerages have also been offering discount broking service.
“The move (if it becomes rule) will lead to a de-rating of broking (firms) stocks,” said a veteran BSE broker turned investor. “It is not just about the loss of interest income; brokers will no longer own their clients as far as pure broking services go.”
Already, shares of stock broking firms like Angel One, ICICI Securities, SMC Global, Motilal Oswal Securities, and IIFL Securities are way off their highs seen in 2022.
Discount broking firms earn hefty interest income because they cater largely to active traders who always have some funds in their accounts at any given point in time.
“An interesting battle lies ahead,” said a market observer, “discount brokers have a tough choice of keeping commissions unchanged and taking a hit on revenues, or raising commissions to offset the revenue loss, but risk losing customers to rivals. For traditional brokerages with a vast army of relationship managers (RMs), there has always been an element of personal touch. The challenge for them will be to try and capitalise on those relationships by cross selling products so as to retain their loyalty, and make up for the loss in float income.”
