Industry players can never ignore or avoid orders from regulators. In the capital market, the Securities and Exchange Board of India’s (SEBI) writ runs wide, and market participants follow its directives without fail.
There is only one segment of the market that tries to stand up to SEBI. This is the foreign custodians (FCs) of Foreign Portfolio Investors (FPIs).
FCs are custodians of cash and stock for FPIs. They keep custody of these assets on behalf of FPIs. FCs do not play any role in an FPI’s decision where to invest or how much to invest. FCs are part of foreign banks, and have to register with SEBI as a custodian for FPIs’ assets, and as clearing members with the clearing house of a stock exchange.
FCs enable FPIs to make a transaction in the capital markets in India. But because of their monopoly over FPIs and the importance of FPIs in Indian capital markets, they have gained some power. They dictate terms to market intermediaries in a manner that even FPIs do not or cannot do.
The first sign of it emerged in a news report that talked about FPIs threatening to stop trading in derivatives from December 3. While they are not quoted in the story, they threatened the regulators that FPIs will stop investing in Indian stock markets from December 1. Then they used Asia Securities Industry and Financial Markets Association, to represent their views to SEBI, asking it to defer the implementation of the peak margin norms by at least three months and reduce the penalty for not maintaining adequate margins, because of the new regulations on margins. This threat may have worked, and it exposes many other challenges in the system.
What were the new regulations, and why FCs opposed them
To understand this, we must see the first SEBI notification aimed at reducing risks on trades and its impact.
The regulator started with domestic clients and their brokers to prevent default in the derivative markets as with the markets creating new highs, and escalating risks. Therefore, a notification in June by SEBI told brokers that they cannot pool clients’ assets and pledge them onwards as margins for new trade.
This meant that brokers who used to earlier pool all their clients’ assets and lend them as a margin for trading purpose to clients for a fee could not do it anymore. Each client will have control over his assets and the use of any pledge will only be for their own use, and stock in account cannot be pooled by the broker or clearing member.
It stopped the misuse of clients’ assets by the brokers, but caused a lot of heartburn among brokers, custodians, and even high-frequency traders in the market. It also raised the cost of trading in derivatives as the cost of borrowing for margins went up.
There was a lot of protest against this move as it meant process changes in the system of borrowing and lending that brokers, custodians and banks had set up. It also meant that the entire chain of intermediaries had to rejig their processes to follow this notification by SEBI.
This change increased the cost of compliance for all intermediaries, reduced their profits and increased reporting requirement. But none of the domestic custodians or brokers involved said that they would not comply, nor did they threaten that large domestic investors are going to stop investing in the stock markets from September 1 — the date from which this notification was to become effective.
They negotiated hard with the regulator about the date from which it was to be implemented to prepare their systems and to manage the process without disruption.
This is in sharp contrast to the second notification by SEBI, which asked brokers and foreign custodians to ensure that they have upfront margin for every trade. Upfront margin is verified before brokers punch a trade.
Before this notification, brokers would punch in a trade with the FPI code, and it would go to the custodian/ clearing member, which would confirm to the exchange that there is enough margin to clear the trade and it would go through.
Sometimes the broker would punch in the trade over and above the margin, and the FC would reject the trade. The FPI would then ask the broker to reverse such trades. This would happen in derivatives because the margin requirement in derivatives is dynamic and cannot be known upfront. This led to a rise in risky non-margin trades that were squared off during the day itself.
Following this notification, clearing houses also levied a penalty on any trade during the day that did not have proper margins. This penalty could be recovered by the broker from the FPI, but it means a fundamental shift in the transparency of FPIs’ derivative trades.
SEBI’s notification meant that the entire process of confirmation, liability, and clearance was now with the broker before he punched in the trade, rather than after it.
Systemic change needed
This needed a systemic change, including transparency from FCs about the amount of total margin they held on behalf of FPIs. This meant that an FC has to open its system Application Program Interfaces (APIs) to several brokers. As FPIs deal with minimum 20-25 brokers, and, in some cases, with 100 brokers, FCs have to open their APIs to 100 large brokers in the Indian stock market, since all these brokers needed to see the margin upfront before they punch in the trade.
This means a system change, more transparency and even disclosure of FPI trades in the market. Foreign custodians have not been transparent with Indian intermediaries, and they have been reluctant about disclosing clients to even the Indian regulators.
SEBI wants the entire process to be more transparent, while foreign custodians do not want it to be.
Neither do they want to rejig their systems to meet India’s regulations. Hence, they threatened that FPIs cannot deal in derivatives if they enforce the new regulations -- a case of the tail wagging the dog, the walls deciding who will live in the house.
This is not the first time that foreign custodians have threatened Indian regulators or asked for relaxation. The issue of disclosure or transparency on FPIs, their usage of instruments like PN notes has been always been a contentious issue with the regulator over the last 15 years. It’s only in the last few years that due to the global anti-money laundering laws have foreign banks accepted stricter disclosures.
Because of the monopoly of four to five foreign custodians on the whole FPI inflow, they act as a cartel and can create hiccups in the market.
SEBI, exchanges and other institutions in the market are careful about dealing with them. They have been using this borrowed influence as a right.
Monopoly of Foreign Custodians
The monopoly of the FCs is a leading cause for lack of transparency and it happens because of the discriminatory policy of the US government under US SEC Rule 17 f-5 that prevents Indian custodians from getting FPI business.
Unfortunately, neither RBI nor SEBI has addressed this discrimination and monopoly be addressing the root cause. As a result, a crucial piece of Indian financial capital infrastructure is still controlled by foreign banks which continue to ignore regulations. RBI has to level the playing field between foreign banks and Indian custody service providers.