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SEBI's new circular on bank guarantees will brew a host of funding troubles for small brokers

Small brokers are in for a tough time as they will have to grapple not only with working capital issues but will also have to funnel in their own funds, in case they were using clients' funds for prop or arbitrage trading

April 27, 2023 / 03:30 PM IST
Small brokers in a tough spot

SEBI makes the going tougher for small brokers

Market regulator Securities and Exchange Board of India's (SEBI) latest circular barring the deployment of clients' funds by stockbrokers to create bank guarantees for themselves is set to birth a host of funding challenges, especially for smaller brokers who until recently relied on clients' funds to meet their capital needs, say industry observers.

"For large brokers like 5paisa it (the circular) will not impact as we are well capitalised and even today we are able to manage working capital requirements through our own capital. Our networth is almost 50% of client funds which is much more than what Sebi prescribed," Prakarsh Gagdani, CEO, 5Paisa, an online brokerage house, said in a tweet.

However, he also cautioned that the new circular will have an impact on small brokers who rely largely on client funds as "100 percent working capital requirement should be done either from internal accruals or external borrowings".

Brokerage rates to go up?

Gagdani also indicated that brokerage rates, on the whole, will see a rise given the rising regulatory compliance burdens.

"Having said that regulatory changes have increased the cost of doing business. Profit margins have taken a beating. This will have an impact on the brokerage rates for customers. There were many cost components that a broker used to absorb and not pass on to clients. That will go off and basic rates will go upwards." he tweeted.

Venu Madhav, COO of Zerodha, one of India's biggest online brokerage, told Moneycontrol that with the recent circular, the need for brokers to infuse their own capital into the business will also witness an increase. "This is because, unlike before, brokers cannot use the non-funded portion of the BG (bank guarantees) to legitimately fund certain client transactions like instant credit against the sale of securities, margins against unapproved securities, etc.," Madhav said.

Capital crunch fears

Tejas Khoday, co-founder and CEO of FYERS, a broking-tech platform, pointed out that the move could affect clients as well.

"If a broker is creating BGs out of client funds and using the limits assigned by the banks with the clearing corporation for funding client positions either in cash (margin trading facility), peak margins, or RR (risk reduction) mode, it may impact their clients as they will be unable to do so going forward," Khoday said.

"New SEBI regulations require brokers to maintain segment-wise segregation on a client level, and failure to abide by this will attract heavy penalties. Other than that, it may reduce the income that such brokers were able to generate through the use of BGs which generally provide 2x exposure on the funds pledged with the banks. It could create a working capital crunch, too. Penalties on proprietary and client fund segregation could potentially add to this crunch," Khoday elaborated.

Shrey Jain, founder and CEO of SAS Online, a deep discount broker that boasts over 50,000 clients and a daily turnover of Rs 1 lakh crore, indicated that for brokers engaged in proprietary or arbitrage trading, the cost of capital before the circular was released was close to zero, which will not be the case now.

"For the brokers, since BGs on client funds would have to be wound down, the requirement of brokers' own capital in the business will go up. Currently, the cost of capital for such brokerage firms doing arbitrage/prop trading was close to nil but now they would be required to deploy their own funds which come at a cost, or in some cases brokers may have to reduce their prop book size due to limited funds," Jain said.

"SEBI’s decision to prohibit brokers from using client funds to create new BGs will certainly impact the working capital requirements of the brokers and they will be required to infuse more funds to procure BGs from banks. It will put more pressure on small brokers who are already finding it tough to compete in the current scenario," said Sandeep Jain, MD of Trans Scan Private Limited, a financial services company, and chairman of the Eastern India Regional Council of the Association of National Exchange Members of India.

Kaushal Shroff