Two Gujarat-based, one Noida-based brokerages see huge losses; illegal deals with traders come back to bite

Brokerages and the brokerages' clients--who have also been made party to it with promise of higher returns--are being forced to absorb these losses.

Brokerages which have hired the services of big traders to manage their proprietary-account funds are running into huge losses, according to market insiders.

These traders have been unable to manage the change in market behaviour over the past ten months characterised by sudden price spikes and low volatility.

The brokerages' arrangement with these traders is illegal since the traders are not licensed to manage another's money. Therefore, the brokerages and the brokerages' clients —who have also been made a party to it with the promise of higher returns —are being forced to absorb these losses.

Sources told Moneycontrol that two Gujarat-headquartered brokerages and one Noida-based brokerage are the ones taking the deepest cuts.

Also read: MC Exclusive: Traders with shining strategies moonlight for multiple brokers, manage prop accounts

How it operates

"Brokerages usually enter into three kinds of agreements with these traders and all involve profit sharing," said an insider.

One is when the brokerage takes the larger chunk of the profit generated — around 80 percent — and the trader is given the remaining; in which case, the trader does not share the losses. Second is when the two enter into a 50-50 arrangement, in which profits and losses are shared equally. Third is when the broker takes a lesser percentage of the profit but the trader has to pay a heavy interest on the capital.

"A lot of these arrangements fall under the first two categories," said the insider.

Therefore, the lesser the profit generated by the trader, the lesser the money the brokerages make.

So how are the clients affected?

Another insider said that the brokerages also raise money for these arrangements by pledging their clients' securities with the clients' consent.

"If an investor has shares lying in your account, the brokerage will ask him/her, why are they letting the assets lie idle. Instead, the brokerage will suggest, why doesn’t the investor pledge it and raise capital for trading. Then, the brokerage will offer to manage the trading and put these traders on the job. When there is a loss and the client's securities are sold to meet the margin requirement, the client finds that the whole arrangement might have been illegal and that there is no legal redress," said the insider.

Stuck in the middle

A third group of people being affected by this are the smaller traders who 'borrow' access to the proprietary accounts for higher leverage.

Also read: Worth looking into and we are on it: SEBI chief on misuse of proprietary trading

The star traders also earn by parcelling out the prop capital allotted to them to smaller traders for a fee. That is, if they have Rs 5 crore to manage, they will loan this to five smaller traders for an interest of 6-12 percent, with the higher rates charged for smaller amounts. The star traders do this particularly when it becomes difficult to earn a profit from the market.

This is how the arrangement works. Smaller traders have to make an initial deposit to access this capital after which they are given access to the brokerage's proprietary account.

Smaller traders enter into this arrangement to get added 'leverage' of even up to 10x. That is, for a deposit of Rs 10 lakh, they will be allowed to take a market exposure of Rs 1 crore, which is multiple times the trade value they can take through their individual accounts.

Bhaskar (name changed) had transferred Rs 30 lakh to a company, which he thought was being given to one of the Gujarat-based brokerages mentioned earlier, for access to its proprietary account. This arrangement was mediated by a big trader who was aligned with the brokerage.

With the arrangement, Bhaskar was allowed to take trades by logging in to the brokerage's proprietary account. When Bhaskar started posting losses, he decided to pull out. When he asked for his remaining capital to be returned, the brokerage said that his deposit was transferred to the middle-man trader and not to the brokerage, and that the middle-man was let go.

Bhaskar is continuing to fight for his remaining capital of over Rs 25 lakh to be returned.