Here's how Karvy Stock Broking "almost" dodged regulatory lens

With India's financial services sector reeling under numerous cases of defaults, the latest episode involving Karvy Stock Broking has spooked the trading community and raised question marks over the practices followed by brokerages.

In what now appears as timely regulatory intervention, markets regulator SEBI's circular dated June 20, which came into effect from October 1, has acted as a mechanism to promptly identify instances where brokers are misusing funds and securities in their clients’ accounts. According to the circular, brokerages have to settle the accounts of clients on a quarterly basis, failing which clients can complain to the regulator. Before the implementation of the circular, there were instances of brokers like Unicorn, Kasa Finvest and Amrapali allegedly misusing client funds.

SEBI got wind of the goings on at Karvy in mid-October when the brokerage used clients funds for proprietary trading.  The regulator then carried out a reconciliation exercise of the client accounts.

"More than 21,000 alerts of wrongdoings were generated (at Karvy). At that time, the company had pledged investors’ money worth Rs 2,800 crore, affecting more than 1,23,000 investors," a source told Moneycontrol.

SEBI then immediately alerted NSE to keep a tab on the brokerage.

Despite being given time by SEBI, Karvy has been able to release only Rs 600 crore out of Rs 2,800 crore of client shares that it had pledged, according to the source.

Another source said that timely action by SEBI has limited the damage to some extent.

"As of now, almost 90,000 clients have been affected due to this fiasco. However, on the other side, around Rs 2000 crore is still in the company which they have pledged with banks. Banks and NBFCs should be aware that collateral belongs to whom. Banks say they are authorised to sell collateral. But these shares actually belong to the clients and not the broker," a source said.

A market expert on the condition of anonymity told Moneycontrol that banks and NBFCs should do due diligence before sanctioning loans against shares and in the case of Karvy, they did not verify the ownership of the shares.

According to the SEBI circular of June 2019, Trading Member and/or Clearing Member are required to transfer the clients securities received in payout to clients demat account within one working day. In case the client does not pay for such securities received in payout, then the TM/CM shall be entitled to retain those securities up to five trading days after payout.

Further, if the client fails to meet its funds pay-in obligation within five trading days from payout day, the TM/CM shall liquidate the securities in the market to recover its dues. Under no circumstances, the securities of the clients received in payout can be retained by the TM/CM beyond five trading days and/or can be used for any other purpose.