The last few days have been abuzz with news of Axis Mutual Fund and the alleged front-running case. While no irregularity should go unpunished, we must strive to also improve the systems to reduce the chances of repeat of such incidences. It is in this regard that the incident must also be seen from another perspective.
One news report said the following: “Sources said the dealer/ fund manager punched in trades on behalf of the MF at values that were way higher than the market and received kickbacks from brokers.”
If the above is true, the respective fund manager / dealer must be punished, but at the same time, the involved brokers also must be caught and penalised in the same manner. Both parties are equally guilty.
Having said that, some key questions that probably have not been considered so far are: “Why are stock brokers needed by institutional investors like mutual funds that are highly regulated? Why can’t they be given direct access to the stock exchanges and allowed to trade without any involvement of a broker?”
The role of stock brokers
In the earlier days, we had open-outcry based trading system, where brokers’ men would gather and the transactions would take place. The brokers also acted as moneylenders, funding the positions of their clients (known as margin funding). To facilitate the functioning of the stock markets and also as a risk management system, the brokers were critical. In order to add value to their clients, brokerages also provide valuable research reports.
However, times have changed and we have moved to a different era. Mutual funds are large regulated entities. They do not need funding from brokers, as these investors do not invest borrowed funds. MFs are required to undertake delivery-based transactions. In such a case, risk management is already taken care of.
Now comes the value addition in the form of research reports that the broking houses provide. While large fund houses have in-house research capabilities, they can also afford to buy research reports from independent agencies. The availability of research reports cannot justify the need for stock brokers.
The last and a very important role that the brokers serve is related to the settlement of trades. In case of mutual funds, this function is undertaken by regulated custodians, who can directly settle the trades with the clearing house or clearing corporation.
So, why do mutual funds need the services of brokers?
Direct market access
The mutual fund houses may be provided direct market access (DMA) i.e., they be allowed to trade directly through the stock exchange platform. The trades may then be settled between the custodian and the clearing house / corporation. (Note: While DMA is currently available for mutual funds, it is still through a stock broker. It is ironical that it is still called DMA).
Allowing the mutual fund houses to transact directly with the stock exchanges would ensure:• Anonymity of the investor: While the investor identity is not revealed at the stock exchange level, the brokers know on whose behalf they have put the transaction. So, there is no anonymity there.
• Plugging of potential leakage of information: This reduces the potential leakage of information about the trades carried out by the fund house as there is one less link in the chain.
An additional benefit of this may come in the form of reduced transaction costs, making mutual fund investments cheaper. Currently, mutual funds can pay a maximum of 12 bps (the actual brokerage charges payable could be lower) on their transactions in the cash segment of the market. If the scheme turnover is 100 percent (this is just an example and actual turnover ratios would differ), the scheme would incur a minimum of 24 bps on the AUM (turnover ratio is calculated by taking the lower of buy or sell transactions). This could be a huge saving for the fund investors.
Providing liquidity in illiquid stocks
It is also argued that the stock brokers provide liquidity in illiquid stocks allowing a fund to offload the position at low impact costs. While there is logic in this argument, can there be an alternative to making it compulsory for mutual funds to use the services of a stock broker? Well, a lot has been discussed about creating a market-making structure, which exists in many securities markets across the world. Such a structure may have its own flaws, but it needs to be re-evaluated in light of this note.Disclaimer: This note is not prepared to suggest that brokerage houses are in the wrong, but it is about asking several questions regarding the risks and rewards of the current arrangement.