The shadow market for ‘proprietary’ stock trading is showing signs of unrest

“To be appointed a team lead, a trader must deposit Rs 1 crore or more of his own money. Against this, he can take a position of Rs 5 crore or more depending on the terms agreed with the main broker. The team lead then hires traders under him who have say, only Rs 10-20 lakh of capital, collect money from all of them, and pass it on to the broker. The broker will then release a certain quantum of funds and assign trading limits depending on their track record and experience,” said one trader, who was managing 10 traders below him.

Also read: IRDAI chief foresees major insurance industry transformation, urging more companies

As for the deposit to be given to the broking firm, it was routed through a privately held firm so that there was no paper trail linking the broker to the traders. This arrangement varied across firms, with some firms directly accepting deposits from traders through a vaguely worded agreement.

The illegal part here is that the traders are shown as employees/consultants on the proprietary broking firm’s payroll earning a fixed sum plus commission every month whereas actually, these traders are clients of the broking firm. If a broker declares itself as a proprietary trading firm to the stock exchanges, it cannot have clients. What is actually happening is that brokers offer their application programming interface (API) feed to these traders and allow them (traders) to run their algorithms on their (brokers’) trading platform.

By showing these traders as ‘employees’, the brokers are sidestepping two stock exchange regulations: one that stipulates trading terminals should be operated only by authorised employees of brokers, and second that brokers cannot finance the trades of their clients.

Trouble in paradise

The traders said that proprietary brokers have been under pressure of late because of inspections by the National Stock Exchange (NSE), and this had forced a change in the arrangement with the traders, leading to friction.

NSE regulations stipulate that the facility of placing orders on a proprietary account through trading terminals shall be extended only at one location as specified by brokers. In case any broker wants to use a proprietary account through trading terminals from more than one location, the broker has to submit an application to the exchange, giving reasons for the same. However, the employees operating the terminals need to be present at that location.

“Stock exchange regulations require that proprietary brokers’ employees should be working out of office but many of my team members have been working from home all along,” said the trader. “Also, regulations require that employees of the broker dealing in futures and options should have an NISM certification. Some of the traders under me prefer to do trades in the names of their parents or spouses. When I mentioned it to my team lead, he agreed to have the certificates ‘arranged’ for a payment of Rs 9,000,” said one of the two traders quoted above.

“I was told by my broker that the NSE inspected their premises and issued a warning, and that to avoid penalty, I and my team would have to rent a place and operate from that location so that it could be shown as a branch, or operate out of the broker’s office,” said the trader, adding that the broker was willing to foot the rent expense.

The NSE is also said to have written to over a dozen brokers last month, seeking know-your-customer (KYC) details and ledgers of their clients, ID of devices used to place the trade orders, IP addresses, according to a report in The Economic Times. The NSE declined to comment on the questionnaire sent by Moneycontrol.

Also read: RBI plans to test some more use cases in wholesale pilot of CBDCs, says RBI Governor

The arrangement

The trader said that the arrangements between prop firms and traders like him were diverse.

“At some broking firms, the leverage offered is low but they charge you interest only on the funds you utilise irrespective of how much funds have been transferred to your account. At other broking firms, the leverage offered is high but you will be charged interest on the entire amount you have been given, irrespective of how much has been utilised,” the trader said.

Derivatives market observers say the bickering between some traders and proprietary brokers could be isolated cases, triggered by the informal nature of the arrangement. However, they agreed that the arrangement was increasing the risk in the system through build up of leveraged positions.

“The trading limits (assigned to brokers) can be changed suddenly for many reasons—the broker may lose confidence in a trader because of a losing streak, or he may prefer one group of traders over another, market conditions may change, or it could be even because of personal issues,” said a veteran broker, adding “…sometimes it could be a dispute over profit calculation, and who owes whom how much money if one of the parties decides to end the arrangement abruptly.”

Both the traders said that the proprietary brokers ensured that the positions taken by the traders were hedged and trading limits were assigned in such a way that in a worst-case scenario, they (traders) do not lose more than the amount they have deposited with the broker.

Also read: NSEL Paired Contracts: Sebi cancels registration of Pulin Comtrade, MK Commodity Brokers

Win-win

The advantage of such an arrangement for the trader is that he will get a much higher leverage than is legally possible at a regular broking firm that does client trades. In simple terms, a trader who deposits Rs 1 crore with the proprietary broking firms can take positions of anywhere between Rs 5 crore and Rs 15 crore depending on the arrangement with the broker.

It is a profitable arrangement for a proprietary broking firm as it earns interest on the funds loaned to the traders (around 12 percent per annum) and a rebate from the NSE on exchange transaction tax once the turnover crosses a certain threshold. Besides, there are profit-sharing arrangements with traders as well.

Iceberg ahead

The second trader said that while the risk management systems have worked fine so far, they have not been tested under extreme market events. He also said that there was no standard risk management system because some of the traders were given higher limits based on their track record and ability to generate profits.

“The size of the proprietary book is getting bigger by the day, beyond a point things can get out of control. You could have a situation where some large traders may lose a big chunk of their capital, and other traders, which are part of the ring, may want their deposit back all at once,” the second trader said.

He said the steady increase in the number of traders being hired by proprietary brokers was resulting in a rise in the instances of ‘cancelled’ orders. Some traders who are part of the same circle have noticed that at times their trades were not going through.

“On expiry day, the same few contracts see a lot of action. So if one group of traders puts in a buy order and another group working for the same broker punches in sell orders simultaneously, the exchange will automatically cancel the trades,” said the trader.

That is because for the exchange, all the orders coming from a proprietary broker's server are for a single entity—the broker itself.

For the last many months, the market has been rife with talk about many lesser-known brokerages entering into arrangements with high-volume options traders who use algorithm-driven strategies. Moneycontrol had first written about it in May this year.

The share of proprietary trades on the NSE as a percentage of the overall derivatives turnover has rocketed from around 33.5 percent in January 2020 (just before the pandemic hit) to 59.5 percent in July 2023. On the BSE, the share of proprietary trade percentage of the overall derivatives turnover is around 75 percent (according to the SEBI annual report for FY23) but on a much smaller base. The BSE declined to comment on a questionnaire from Moneycontrol.