A close examination of these defaults suggests that less regulation was not the problem and more regulation is not the solution
Three of the most widely reported defaults in the Indian financial market in 2019 have a common faultline running through them: the quality of collateral underlying financial transactions.
At the end of 2018, most people believed that shadow banks were at the heart of the Indian financial crisis, and that the policymakers had their work of “fixing the NBFC crisis” cut out for them in 2019. However, the trajectory of crises is rarely as linear as they have a way of triggering dormant problems at the most inopportune of times.
Two big financial defaults in 2019 involved brokers and the exchange. The third involved the securitised loan portfolio of DHFL (Dewan Housing Finance Corporation Ltd), the beleaguered shadow bank. In the first two cases, India saw a settlement failure on exchanges. In all three, sophisticated contract enforcement mechanisms such as central clearing and escrow bank accounts failed, and the contracting parties sought court intervention to enforce their claims.
Calls for more stringent regulation of financial market intermediaries, in particular brokers, seem like a natural response to these incidents. However, a closer examination of these defaults indicates that less regulation was not the problem and more regulation is not the solution.
Three litigated defaults in 2019
In December 2018, institutional investors were staring at an imminent default on option contracts purchased by them from Allied Financial Services on the NSE. When the options expired in June 2019, it turned out that Allied Financial had unauthorisedly used its client's securities as margin collateral with its broker for the option contracts sold by it.
For the uninitiated reader, every trade executed on an exchange is backed by margin collateral, provided by both the parties to the trade, which can be liquidated if a party to the executed trade refuses to honour its commitment at the time of settlement.
This is a neat self-enforcing mechanism that ensures the sanctity of contracts executed on an exchange. When the options sold by Allied Financial expired, its margin collateral could not be liquidated. Without going into the specific chronology of events, it suffices to say the matter did the rounds of the Supreme Court, the Securities Appellate tribunal and SEBI (Securities and Exchange Board of India) itself. The failure to settle obligations on contracts executed on an exchange is the near equivalent of a Black Swan event in the ecosystem of securities markets exchanges.
Even as market participants rationalised the settlement failure in the Allied Financial case as a one-time event, Karvy Securities, a major Indian brokerage, was reported to have defrauded its clients by unauthorisedly raising funds by offering clients' securities as collateral to its lenders. The modus operandi was to use the power of attorney, often obtained by brokers from their clients as “standard paperwork” to pledge their clients' securities as collateral for the bank loan. This incident, too, nearly translated into a settlement failure, and banks which had lent to Karvy on the basis of the collateral, unsuccessfully approached the Securities Appellate Tribunal (SAT) to effectively enforce their security.
The third default, also resulting in court litigation, involved the secured bond holders of DHFL, the troubled NBFC (non-banking financial company). The bond holders had a floating charge on the receivables of the loan portfolio. When the NBFC defaulted, it turned out that the loan portfolio offered as security for the bonds had been securitized or sold to a bunch of banks. Simply put, the security had gone missing exactly when the bondholders needed it.
The mutual funds which had invested in these bonds sued DHFL and the bond trustee in the Bombay High Court. For a brief period, the court prohibited any pay-outs to any of the creditors, including the holders of the securitized instruments of DHFL. While the stay order prohibiting payouts issued by the Bombay High Court was subsequently lifted, court intervention that jeopardises the enforcement of securitization contracts can be irreversibly damaging for an economy that is desperately looking to set up a market for stressed assets.
The role of regulation
In 2020, it might be tempting to respond to these defaults by enacting a series of stringent regulations such as restricting trading practices, mandating higher ratings for institutional investment in securities or forcing standardised contracts between brokers and their clients. However, doing so might be costly, ineffective and indeed undermine years of efforts invested in making the securities markets accessible to the average Indian household. In fact, in the three cases of defaults described in this article, light regulation was never the problem, to begin with.
A common feature across the three defaults is the non-availability of collateral when the default occurred. In the Allied Financial case, the margin collateral could not be liquidated as it did not belong to Allied Financial. In the Karvy case, the banks could not liquidate the securities provided as collateral, as these securities beneficially belonged to Karvy's clients. In the DHFL case, the bondholders could not access their security, namely, the underlying loan portfolio and its receivables, as it had been securitised away.
The first two defaults were a result of the violation of the Volcker rule -- named after the famed Paul Volcker who incidentally expired in 2019 -- a critical rule in the financial services market. The rule requires custodians of client funds such as brokers to ring-fence these assets from their own assets. This has been the rule applicable to brokers in India for a long time. In fact, in June 2019, a circular issued by SEBI prescribed the manner in which this separation is to be operationalised. This measure reportedly triggered the Karvy default and is likely to adversely affect several small brokers who have hitherto functioned on the boundaries of a neat and a not-so-neat separation of assets.
Even as the enforcement of this rule requiring the separation of assets is strengthened, there is no gainsaying that these defaults are symptoms of a weak collateral management and information system in India. A calibrated intervention in response to these defaults must, therefore, seek to improve the quality of information that is available to lenders and exchanges with respect to the collateral deposited with them.
In the case of Karvy, the practice of brokers obtaining widely worded powers of attorney from their clients as standard paperwork was known for a long time, and SEBI had repeatedly advised against this practice. A power of attorney is effectively a contract between a principal (investor) and its agent (broker).
Attempting to address a Karvy-like default by regulating the terms of contracts between brokers and their clients would be a costly and disproportionate response to the Karvy crisis. Some classes of investors, particularly those who trade frequently, might be comfortable executing widely worded powers of attorney to their brokers for the sake of efficiency.
A one-size-fits-all approach of standardizing broker-client contractual relationships would increase the transaction costs for the entire system without necessarily safeguarding consumers from their securities being misused by brokers. A nuanced response would involve addressing this problem by requiring lenders to improve the diligence standards applied by them while lending to brokers against the collateral.
That the secured bondholders of DHFL could not access the collateral underlying their 'secured' bonds as it had been securitized away, reinforces a longstanding pain point in financial regulation. That is, whether disclosures in issuance documents are effective at all. During the arguments in the court, it became clear that DHFL's bond issuance document explicitly allowed DHFL to securitise its loan portfolio in the ordinary course of its business. The standard toolkit of regulatory intervention in the form of mandating more disclosures is, therefore, not the solution to this problem.
What might be a pre-emptive solution, one might ask to ensure that the collateral underlying financial transactions is available, adequate and enforceable when it is needed the most? Part of this is linked to better information structure such as the warning system introduced by SEBI in 2018 that allows for early detection of the likelihood of diversion of client assets by brokers.
The other part pertains to monitoring by financial intermediaries. For instance, the job of the bond trustee in the DHFL case to constantly monitor the quality of collateral relative to the value of the outstanding debt cannot be understated. Perhaps, this should be one of the primary selection criteria in the appointment of trustees to bond issuances.
Finally, in 2020, financial market intermediaries would do well to adopt self-regulatory standards of conduct in their dealings with consumers. It is in their interest to do so to pre-emptively reduce the costs that potential stringent regulation can bring with it.
Karvy and DHFL are household names in India. The defaults of 2019 will undoubtedly do lasting damage to the trust the Indian households have, over generations, come to develop in the Indian financial market. To ensure that these defaults do not push their savings back into gold and real estate, the financial services sector must get its act together to address the trust deficit resulting from conduct that was, until now, accepted as “common market practices” and “regular business models” in financial intermediation.Bhargavi Zaveri works with the finance research group at IGIDR. Views are personal.