A welcome move to check misuse of client securities
Further, because of holding securities for different purposes in a single account, it was difficult for the regulator to monitor movement and usage of client securities.
The Securities and Exchange Board of India (Sebi) has been constantly enhancing its guidelines and circulars to protect the interest of investors. In this connection, the guidelines issued in June 2019 to strengthen its oversight relating to misappropriation/misuse of unpaid securities and securities-based collateral of clients, particularly those who have running accounts or margin trading accounts with their stock broker, is a welcome move.
In the past, a practice had emerged amongst certain brokers to hold a client’s securities for various purposes such as collateral securities, unpaid securities and running account authorisation (RAA). Such securities were held in a single demat account designated as client beneficiary account. The RAA on client securities resulted in brokers exercising control on all such securities at all points in time.
Further, because of holding securities for different purposes in a single account, it was difficult for the regulator to monitor movement and usage of client securities. Brokers carrying on this practice placed such securities as collateral with banks/NBFCs generally for raising funds to meet the respective client’s debit obligations. However, some cases of misuse also surfaced wherein certain brokers had used client’s securities for fulfilling securities shortages of other clients / proprietary trades or for raising funds for meeting debit requirements of other clients or for own account. This posed a risk to investors whose shares were being pledged, since, in case of a default by the broker in meeting his obligation towards the lender / clearing member, the pledge on the securities could get invoked and the securities could be liquidated without the client being at fault and without the client’s knowledge.
To overcome this issue, Sebi issued guidelines in June 2019 stating that client’s securities lying with the broker as collateral for availing of margin trading facility or as unpaid securities cannot be pledged to Banks/NBFCs for raising funds and that client’s securities already pledged should either be unpledged and returned to the clients upon fulfillment of pay-in obligation or disposed of after giving notice of five days to the client.
Further, no RAA is permitted for holding client securities and as per regulatory requirements, securities received in pay-out against which payment has been made by clients should be transferred to the demat account of the respective clients within one working day of the pay-out by the exchange. These measures will restrict usage of client securities for raising funds by the broker and accordingly avoid unpleasant surprises to clients arising out of sale of such securities because of a default by the broker or some other client.
Going forward, brokers will either fund clients out of their own funds (net worth or borrowed) or, where brokers cannot extend credit facility, clients will directly raise funds from another entity like a bank or NBFC.
Earlier, brokers were transferring securities purchased by the client (and received through the exchange’s payout into the pool account) directly to the collateral account. Now, Sebi has mandated that securities payout cannot be directly transferred from pool account to collateral demat account. It should be first transferred to the demat account of the respective clients and thereafter, the same may be transferred to the collateral account. This process has been created to ensure concurrence of the client to such collateral creation and to create an audit trail for the same. However, brokers have power of attorney on client demat account and they may still transfer client securities into the collateral account. Brokers are expected to adopt good practices for transfer of client securities based on client authorisation.
Also, as per the June 2019 circular, securities that have not been paid for in full by the clients (unpaid securities), should either be transferred to the demat account of the respective client upon fulfillment of client’s fund obligation or should be disposed of in the market by the broker within five trading days after the pay-out. This will ensure that any leveraged position in shares being maintained by clients beyond five days is created only in compliance with guidelines issued by Sebi for margin trading funding (MTF).
MTF guidelines stipulate adequate level of margins for various shares which in-turn ensures that customer’s positions are not required to be sold on account of small price movements which could further increase volatility in the markets. The margins also protect the interest of brokers by ensuring that they have sufficient cover against margin funding provided by them.
These measures are a commendable effort by the regulator to ensure protection of the interest of investors and will go a long way in developing a strong and robust capital market.
While implementing these measures may pose certain short-term challenges to certain brokers, these are welcome measures since they will provide a level playing field for market intermediaries with uniform practices and will result in immense value to investors by providing protection to their securities and a stable market in the longterm. Ensuring that client’s securities are not misused would result in a stronger and wider participation of investors in equity markets thereby going a long way in development of capital markets.
(The author is MD, ICICI Securities. Views expressed are personal.)