Are you a broker or broke? Compliance and tech will decide

The Securities and Exchange Board of India (SEBI) has been progressively tightening regulations involving equity investments and the broking business. The capital markets regulator has amped up disclosure requirements and fortified margin rules—and it has had good reason to do so.

The fallout is that the cost of capital for brokerages has gone up sharply. The latest in SEBI’s efforts to improve safety for equity investors was another hike in margin requirements.

Starting May 2, traders need to bring in 50 percent of their margins towards futures and options in cash. This is bound to increase the cost of funding for brokers. Further, brokers cannot use the cash of one client to meet the margin requirement of another.

The banking regulator has asked banks to refrain from lending to traders for intra-day liquidity requirements, according to an Economic Times report on May 23. The cost of capital and getting funding is becoming onerous, according to Pandit.

He lays the blame on the regulator for taking compliance too far at times and the stifling penalties in case of deviations, although he is quick to add that compliance is necessary.

“I am not against compliance. It is required as it instils more trust in the system. But do not come after us with a fine-tooth comb and view every transgression as triggered by mala fide intentions,” he said.

Small brokers rely on the flexibility they can offer their clients, which at times, may entail pushing regulatory boundaries.

“If there is no evidence of financial gain to the broker or the client from a slight deviation, they should not be punished. But that does not happen now. Even a slight delay in disclosures automatically attracts a penalty,” said Pandit.

Tech-tonic shifts

In a technology-driven world, regulatory compliance involves upgrading tech platforms at various levels, from backend systems to frontend software. The fixed and recurring costs incurred on such upgrades are stifling to small broking desks. A Mumbai-based broker’s recurring costs almost doubled due to regulatory changes.

“Previously, my software cost included a one-time initial Rs 3 lakh and a yearly maintenance cost of Rs 50,000. Now, due to new additions in compliance, which even the software developer has to update, the developers ask for a lump sum of Rs 50,000-70,000 for every update,” the broker said.

Though compliance is necessary, its impact can be mitigated by scale. This is where small brokers fall woefully short and large, tech-enabled broking houses including startups such as Zerodha have an edge.

“The brokerage industry remains skewed towards larger entities. For instance, top 20 players account for over 80 percent of active clients and also a high share of industry revenue,” said Samriddhi Chowdhary, vice president and co-group head for structured finance ratings at ICRA Ltd. Chowdhary said lack of scale intensifies the negative effects of increasing compliance.

The increasing cost of complying with stringent rules has affected even the profitability of large broking houses. SEBI’s latest rules on margin requirements led to a decline of 5-7 percent of the customer base, said a top executive of a large broking house.

“Trading volume impact is 7-10 percent because of the latest changes,” he said, asking not to be identified. “A few other mid-sized brokerages have seen 20-25 percent volume loss.”

The Mumbai-based small broker mentioned earlier said that profit has fallen by at least 20 percent. Penalties for delays in disclosures or non-disclosures to the stock exchanges further dent profitability.

Faced with steep costs amid reluctant funding sources, small brokers have little choice but to close shop or join big firms.
“Perhaps there is a need for a category of light compliance, which could help smaller brokers. Margins and disclosures are justified and the cost for investors has gone down, thanks to technology,” said Ajay Bagga, an independent market consultant.

Shape up or ship out
The rise of discount brokers such as Zerodha, which are armed with new-age tech, has made the going even tougher for small brokers like Pandit. Zerodha pioneered the discount broking system and its success is credited to its superior tech platforms.

In discount broking, the investor pays an upfront brokerage to get the advantage of a low brokerage fee. Other innovations in the capital market include fractional investment, which allows investors to allocate small amounts in expensive securities, and smallcase, which is a bunch of stocks that reflect an idea or theme. Bagga pointed out that these are ultimately investor-friendly and should be encouraged.

But for Pandit, this means doubling up on his efforts to get more clients and make existing ones stick with him.
No wonder the number of brokers surrendering their stock exchange membership has gone up even amid the growing interest of retail investors in the equity markets.

Many other small brokers have partnered with big broking houses for technology support. The broking house executive quoted above told Moneycontrol that many small brokers are willing to tie up with it.

“We provide technological support, give them access to our API and we charge accordingly. This is a win-win situation. Otherwise, many have decided to surrender as compliance has made business unviable for them,” he said.
The upshot is that broking is going through a consolidation phase.

“We expect these challenges to continue over the near term, given the increase in regulatory oversight, higher compliance requirements, and costs for implementing the processes which could act as a deterrent for small brokerage entities. We expect the trend of consolidation in the industry to continue,” said Chowdhary.

Customised service

While the regulator has been friendly towards technologically superior and large players, small brokers insist that tech cannot replace customised service.

“Our traditional broking business, unlike these guys, is built more on relationships than systems. We may charge higher brokerage, but the services we offer our clients justifies it. Now, compliance and penalties are painting us as the bad guys,” Pandit said.

These challenges for small brokers come at a time of unprecedented growth in equity market participation. Indeed, Indians have never been more enamoured with equity investments, as demonstrated by the rise in the number of accounts opened to hold shares in dematerialised (demat) or digital form, a requisite for investing in the stock market.

Throw in the opportunity to invest in the country’s largest life insurer whose policies are lying in almost every household and the desire to enter the stock market has only increased. But this has translated into big business for only a few large players armed with tech.

There are 4,835 registered equity brokers as of today. Both tech and compliance will determine how many of these survive in a volatile capital market.