Wily traders, brokers take ‘prop’ route to dodge SEBI margin rules, evade GST, I-T

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No matter how stringent the rules or how many of them, there will always be workarounds.  This is true for nearly every industry and the stock market is no exception.

A section of stock brokers are helping their high volume clients sidestep the new SEBI rule on peak margins, and in the process avoid GST and Income Tax as well, Moneycontrol learns from multiple sources in the market. This is being done by client trades being passed off as ‘proprietary’ trades-prop trades as they are called in market parlance- meaning trades done by the broker in his own book and not for the client.

This practice has been around for a while, but a combination of tighter margin requirements over time and a booming market has led to a sharp rise in such arrangements of late, market participants say. Data from the SEBI annual reports bears this out. On the BSE, the share of proprietary trades as a percentage of annual cash market turnover has risen from 22.1 percent in FY19 to 33.9 percent in FY22. On the NSE, this number has increased from 22.7 percent to 27.5 percent during the same period. In the F&O segment of NSE, the share of proprietary turnover showed a declining trend between FY19 and FY21, but rose 4.5 percentage points in FY22.

In FY23 so far, gross daily turnover of proprietary F&O trades has consistently been higher than that of client trades (retail + HNIs). Till last year, proprietary trades were just about the same as client trades or even lower.

Modus operandi

When an order is put through a trading terminal, it has to be marked as either as a proprietary trade or a client trade. If the trade is on behalf of a client, the broker needs to collect margins from the client. If the broker tags the trade as being proprietary, the margin requirement will be adjusted from the broker’s funds already deposited with the stock exchange as part of networth compliance. Say, a broker has Rs 10 crore deposited with the exchange, he can use Rs 8.5 crore of that as margin towards proprietary trades.

In short, a client trade falsely shown as a proprietary one helps the client save on margin costs. Under the latest SEBI rules, brokers have to collect 100% of the margin, upfront from the clients.

If the trades are shown to be proprietary, the margins are indirectly being funded by the broker. If the client wants a higher exposure, the broker will deposit additional funds with the exchange. This kind of broker funding of margins is not possible otherwise.

Also, there is no brokerage applicable on proprietary trades. This means, there won’t be any GST applicable either, since GST is a percentage of brokerage. Or for that matter any government levies based on the brokerage charged. None of it comes free though, the broker will charge for that in cash. This means a revenue loss for the government.

Sources say that brokers are exploiting an ambiguity in stock exchange regulations that does not limit the number of trading terminals/user-ids they can avail of. Brokers avail connections in excess of what they would otherwise require, and then share the user-id and passwords with their preferred clients, allowing them to put in trades. This is in violation of stock exchange rules which stipulate that the trading terminals are required to be under the direct control of the trading member and be managed either by an authorized employee or by an approved authorised person of the trading member.

Take your pick

There are different kinds of arrangements between brokers and the traders who use the trading terminals illegally, said a trader who is familiar with such operations.

“If the client does not do too many transactions, he can relay his trades to the broker through a call or message. The broker will then enter the trades as proprietary,” said the trader, who did not want to be named.

“Some clients do big volumes but still don’t want to do those trades by themselves, so the broker will arrange a dedicated terminal and a dealer to punch those trades. There is a different charge for this kind of transaction. Lastly, there are high volume traders who will want to do the trades themselves. They will be provided user id and password by the broker. The profit/loss is settled in cash. The broker also charges a commission in addition to the share of revenues,” the trader said.

What about risk management?

“The broker sets positions limits on the terminals based on the track record of the traders he is giving access to,” said the trader.

What if the trader refuses to pay up after running a loss?

“That too happens, but is rare. Like the grey market or cricket betting, this arrangement too works on trust and has been working well so far. If a trader defaults with one broker, he will not be entertained by another broker in that ring,” the trader said.

What about tax liability for the broker? Wouldn’t it be a problem if his clients make a lot of money?

“All the transactions are settled in cash ultimately. If the broker has to pay tax on behalf of the client, that too will be taken into consideration while dividing the profits. Besides, the broker offers this service to multiple traders. Not all of them money; some lose money as well. At the net level, the broker’s tax liability may not come to much,” said the trader.

What the rules say

The BSE declined to comment on a questionnaire from Moneycontrol on the rules the number of terminals that can be allotted to trading members.

In its response, the NSE said:

“Members may apply for connectivity or user ids as per their business requirements. The Exchange provides the facility of placing orders on “proprietary-account” through trading terminals. Facility is extended only at one location of the members as specified / required by the members. Members requiring the facility of 'proprietary-account' through trading terminals from more than one location and / or CTCL are required to obtain requisite approval from the Exchange.”

(With data inputs from Ravindra Sonawane)