Explained: Why is Sebi’s ‘blocking funds’ proposal causing sleepless nights?

Under the new system proposed by Sebi, the client money stays in the custody of the client till settlement (Representative image)

The Securities and Exchange Board of India (Sebi) is proposing a game-changing reform in the secondary market.

It has put out a consultation paper on allowing investor money to flow directly from his/her bank account to the secondary market, instead of from an account maintained by their stock brokers.

A similar system is already in place for the IPO market, where a person can subscribe to an issue through the Application Supported by Blocked Account (ASBA) route. Here, the money is forwarded to complete the order only if the person is allotted shares; otherwise, the money is freed up.

Also read: SAT sets aside Sebi's disgorgement order against NSE

Why is this proposal momentous? While it protects investors’ money from being misused by intermediaries, including stockbrokers, it could mean higher brokerage fee and the end of many small brokerages.

Brokerages stand to lose a big revenue stream and smaller brokerages may have to cough up extra funds to retain customers.

Here's why.

In the stock market, there are delivery trades and intra-day trades. The first is when you want to hold on to the security and not sell it by the end of the day. In the second instance, you have to square off your positions the same day itself.

In delivery trades, you pay the broker in full, the money goes to the bank account of the broker, the order is sent to the exchanges and the clearing corporations (CCs), and the seller’s bank is credited on T+2 days. T+2 is the second day after the trade has been initiated.

In the second, you pay the broker only a part of the money needed, which is called margin money. Again, the order is forwarded to the exchanges and the CCs, and the settlement happens in T+2 days. But by T+2 days, you need to pay the entire amount to the broker to settle the trade.

That said, India has been transitioning to T+1 settlement for a while now and it will be completed by this January 26. Therefore, the money will stay in the broker's account only for one night.

As things stand, in both cases, when a client forwards money for a trade, it goes to the broker’s bank account, a.k.a., the pool account. It stays there for two nights—T0 and T1—before moving to the seller’s account on T2. It is these two days that are worrying for the market regulator.

The regulator is worried that the money can be diverted by the broker for other purposes, such as to cover the shortfall of funds for another client or to give it out as bank guarantees.

Therefore, Sebi has put out this consultation paper, which is suggesting a mechanism through which the money moves from the client account to the clearing corporations. That is, it does not make that stopover at the broker’s bank account.

According to a senior executive at a leading brokerage, pool accounts can contain up to Rs 500 crore-Rs 600 crore for bigger brokers, and they can earn a tidy sum in interest even when put in overnight liquid funds that can offer even 6 percent in returns.

Another risk that the market regulator sees is that, if the investor is to receive money and any of these intermediaries (broker or clearing member) goes bust, the investor is in danger of losing his/her money.

Under the proposed system, the client money stays in the custody of the client till settlement. Therefore, it is more secure. Secondly, the client continues to earn interest on the money till settlement day.

Thirdly, if a broker goes bust, non-defaulting investors can port out to another intermediary easily and without the hassle of getting their collateral from the insolvent broker. It helps the CCs, too.

Right now, the reporting of the order, which includes whether there is sufficient money with the client to complete the trade, is done by intermediaries.

The chain of flow of information is this: client to broker to clearing member (usually broker doubles as the clearing member) and finally to the clearing corporation. Under the proposed system, the CC will be able to directly check if the client’s bank account has sufficient funds. It does not have to rely on the reporting of the intermediaries.

Using his/her stockbroker’s app, the customer will initiate a request to block a certain amount in the bank. This request will be processed through a UPI app attached to the broker’s app, so the customer will need to approve the block-money request in the UPI App.

Once this is done, the CC’s bank will get a confirmation that the money has been blocked, and the bank will send a confirmation to the CC. The CC will verify the transaction details. If the verification fails, the CC will send a message to the investor’s bank, asking it to release the block. If the verification is cleared, the CC confirms whether the request has been accepted or rejected, to the intermediaries and the client-investor.

Also read: Ending money transfer to brokers will increase transaction costs

It will squeeze them from both ends. They will lose a stream of income and may have to absorb higher working-capital expenses.

The first is fairly obvious. If they can’t have the pool money, they can’t make that additional income by loaning it out.

The second will need a bit more explaining. So, we already know that clients who take intra-day trades do so by paying margin money. According to Sebi rules, clients are now required to pay 100 percent margin requirement upfront. That is, if the margin requirement is Rs 20 to take a trade worth Rs 100, the client has to pay Rs 20. That is, the client gets a loan of Rs 80 till the T+2 day.

But what smaller brokerages do to keep their head above these intensely competitive waters is that they offer to loan investors more than that Rs 80. Yes, they aren’t allowed to do that, but some do and they charge an interest for that extra amount they give clients.

Brokerages can do this because they have access to cheap money—the pool money. They are expected to return any excess funds back to the clients only on a quarterly basis.

Even under the new system, the clients will still expect to be given that extra loan (beyond the leverage that the margin system provides). But where will brokerages go for cheap funds if they don’t have the pool money? They will have to borrow and that raises their working-capital requirements.