Notice: Function _load_textdomain_just_in_time was called incorrectly. Translation loading for the restrict-user-access domain was triggered too early. This is usually an indicator for some code in the plugin or theme running too early. Translations should be loaded at the init action or later. Please see Debugging in WordPress for more information. (This message was added in version 6.7.0.) in /home1/portfol1/public_html/wp/wp-includes/functions.php on line 6114
Deprecated: Class Jetpack_Geo_Location is deprecated since version 14.3 with no alternative available. in /home1/portfol1/public_html/wp/wp-includes/functions.php on line 6114
Deprecated: preg_split(): Passing null to parameter #3 ($limit) of type int is deprecated in /home1/portfol1/public_html/wp/wp-content/plugins/add-meta-tags/metadata/amt_basic.php on line 118 Opinion | Portfolio Yoga - Part 11
When it comes to Trust, there is only one quote that is evergreen and that of course comes from the Sage of Omaha
“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”
Warren Buffett
Debt funds in recent times have been in the news for all the wrong reasons. While the reason for investors choosing Debt funds were due to tax arbitrage, they have been in recent times been more surprised on the negative side than the positive.
One of the best performing funds in recent times has been from the Franklin Stable. The Franklin India Ultra Short Bond Fund – Super Institutional Plan recently had a one year return of 10% – something that was unmatched among its peers.
But like the Taleb quote of Turkey and 1001 days, the whole advantage offered by the fund came crashing down on 16th of January 2020.
Writing off the whole Vodafone exposure may seem prudent even though there is no default for it ensures that investors who are aware of the risks don’t scoot away with the return forcing the fund to sell other good quality assets which would raise the weight of the Vodafone exposure. But by preempting, it also avoids side-pocketing which means that those who have taken the hit don’t have exclusive benefits if Vodafone returns the money it has borrowed.
Since the incidents of defaults started impacting debt mutual funds started, I started to think about whether it made sense to even look at Alpha in funds. Based on my own risk profile, I decided to henceforth move funds more into Liquid of PPFAS or Quantum, the only two liquid funds that don’t have credit risks and at the same time moved a bit more of the assets into Equity.
Afterall, if I am to take risks of a nature that came with Equity funds, I better have the upside of Equity as well. The one year return for UTI Credit Risk fund for example is -15%. Losing 15% in Equity is acceptable, in Debt, it’s a death knell.
While my own debt investments are fairly diversified (10% approximately per fund), one fund that I gave the benefit of the doubt regardless of my view of the portfolio was the Franklin India Ultra Short Bond Fund – Super Institutional Plan. It was a leap of faith in the ability of the fund manager to extract himself from very sticky investments he loves to invest.
That leap of faith unfortunately has been shattered, not because he has taken a writeoff on the Vodafone but the way it has been taken. Vodafone for all its current misery isn’t dead, at least for now. The write off of the debt is based on the view that its unlikely to repay a cent.
My own belief in the fund came from their own past. In 2016, Franklin Funds were holding debt papers of Jindal Steel and Power Ltd. On 15 February 2016, Crisil downgraded JSPL’s debt rating to BB+/A4+, from BBB+/A3+. On 29th February 2016, the funds exited the whole investment with fund investors taking a 32.5% hair-cut. The buyer of the troubled bonds was none other than Franklin Templeton AMC.
Of course, even then there was a controversy whether fund investors should have taken a 25% haircut or 32.5% cut since the buyer and the seller were basically the same. But that was any day better than writing off the investment by 100%.
As an adviser, I had a clear view of most fund houses when it came to debt funds. One fund where I did not have was Franklin and that has been now set to rest. The King is Dead, Long Live the King
In today’s edition of Business Line, Aarati Krishnan tries to explore the gap between Large Cap and Small Cap and comes up with a few suggestions. While suggestions are valid, I think the reasons themselves lie elsewhere.
Let’s start with the chart plotting the relative movement of Nifty 50 (Large Cap), Nifty Mid Cap 100 and Nifty Small Cap 100 from 2018 for this dichotomy started then.
While Nifty 50 has generated an absolute positive return of 16%, in the same duration the Mid Cap lost 19% and the Small Cap 35%. Lets go a bit backward in time – 2013 August when this bull rally actually got started.
Suddenly the chart doesn’t appear so dichotomous. Nifty Midcap is the clear winner followed by Nifty 50 and Nifty Small Cap with more or less similar returns. Isn’t it amazing how the narrative can be changed by just changing the time frame we view.
Institutions are skeptical of buying small cap stocks for two reasons.
Liquidity: Mutual Funds, Hedge Funds and even Insurance funds are investing funds that one day needs to be returned back. For Mutual Funds, they need to be able to arrange for the liquidity on the same day as the request from the client flows in. This means that while they can risk being locked into low liquid stocks for a small part of the portfolio, for a large part, they are more comfortable with high liquid stocks that can be sold without having to crater the price.
Corporate Governance: Indian companies, even the large cap ones are the best examples of good corporate governance. The risk multiplies manifold when we look at small cap stocks. There are barely any adequate checks and balances which mean that the promoters more often than not are able to get away with decisions that could have a positive impact on their own pockets while having a negative impact on the company.
Indian Markets for all our chest thumping is fairly small. In the United States, any company with a market Capitalization of less than 1 Billion USD is considered a small cap and those below 300 Million USD, Microcap.
From Screener.in, I was able to get market capitalization data for 3800 Companies. Of these, just around 275 companies have a market cap greater than 1 Billion USD. Another 200+ would qualify as Small Cap and the rest, 3300+ companies are microcap.
It’s not so much of a surprise that most mutual funds are concentrated only in the top 300 stocks. Lower you go in market cap, Lower your ability to exit easily. Of the 3300+ companies with market cap of 2000 Crores or below, 2700+ companies have free foat (non-promoter) holding market cap of 100 Crores or below. Basically, much of the small cap universe is nano cap and one where you cannot enter and exit with even a basic capital of a few lakhs per day.
Another 270+ companies have free float market cap between 100 Crore and 250 Crore, 186 between 250 and 500 and 120 between 500 and 1000 Crores. Remember, we are talking just about the non promoter holding and often there are corporate houses that seem to hold a substantial quantity and ones that never seem to be liquidated. The real liquid shares which can be categorized as those held by Individuals with share capital upto Rs. 2 Lacs is very small.
Another big risk when it comes to small cap universe is the risk of delisting. Every year, a large number of small cap stocks are delisted to never make it back again. A company that gets delisted becomes a dead investment for the investor for he has no way to liquidate his investment even though the company in many cases are that continue to exist.
Investors are attracted to small cap stocks due to the supposed cheapness of the stock though most stocks are cheap for a reason. Very few small caps are able to break through and become midcaps and an even smaller number become large cap. Identifying them at a microcap stage is literally impossible for 99% of investors.
Today when small caps are down big time from their all time high, it appears to be cheaper but that is missing the forest for the trees. Most trees are down because there is very low probability they can survive let alone thrive. If you are a small investor, your best bet in small cap would be via a small cap mutual fund rather than actively investing unless you have the deep knowledge and experience that is required for such investing.
Agro Phos India came out with an IPO offering of 5,880,000 equity shares of face value of ₹10 aggregating up to ₹12.94 Crores. The issue price of the IPO is ₹19 to ₹22 Per Equity Share. Being a SME, this would be listed on the SME segment of the National Stock Exchange.
Stock was listed at a small premium and quickly went below the offer price but not by much where it remained for nearly a year. The stock started to ramp up in October of 2018. <SME Chart>
Agrophos Chart when it was trading in the SME Segment
As the chart above shows, the stock after another brief period of consolidation continued its upward rise till it got promoted to the main board in March of 2019. On the main board, it climbed a bit but not much till mid September when something really kicked off.
The stock started to climb vertically at a 45Degree angle. The surprising thing about this rise has been the delivery volumes. Between the 16th of September to 26th of December when it fell 20%, the stock had a delivery volume of 1.57 Crores.
Action post listing on the Main Board
The public shareholding as of 30th September is 92 Lakhs of which only 75 lakhs are in Demat Mode. Individual Shareholders actually hold just around 50 Lakhs. Basically the total delivered volume is 3 times what retail holds
Rare are occurrences where such huge delivery activity comes up even as the stock keeps moving higher every single day. General pump and dump has always been with very little stock being delivered. Wonder if I am missing something here
One of the key differences touted by PMS fund managers are the fact that they are long term oriented and willing to take higher risks by having a concentrated portfolio.Historically there have been examples of great fund managers coming off with huge returns when they bet and won big.
But history is written by the victors and we never know the number of investors who bought and held concentrated positions only to see large portions of their capital being wiped out. Survivor Bias is a key logical error one has to be aware of.
Rakesh Jhunjuwala is a man of many traits when it comes to the stock markets, but much of his fame comes from an investment he made way back in 2002 – an investment which today contributes to a third of his networth.
In the world of investing, its sexy to talk about big risks that paid off. Soros shorting the Pound is part of folklore history now, but it’s interesting to note that despite the fund being highly leveraged, they had a lot more positions other than the short on the pound. But it was not a risk that was foolish.
Steven Drobny in his interview with Scott Bessent in the book “Inside the House of Money” talks about that trade. The position was Gigantic, but that did not mean that Soros who asked Druckenmiller to go big risked the future of his firm on this one trade. Quoting from the book,
“With the pound, we realized that we could push the Bank of England up against the trading band where they had to buy an unlimited amount of pounds from us.The plan was to trade the fund’s profits and leverage up at the band’s boundary.The fund was up about 12 percent for the year at the time, so we levered the trade up to the point where if they pushed us back up against the other side of the trading band,we would lose the year’s P&L but not more.”
Inside the House of Money by Steven Drobny
In other words, the worst that could have happened if they went wrong was going back to square one for the year. But if right, they were likely to make a Billion which they did.
Once in a way, a big investor bets the farm and comes out as a winner with the biggest example being when Warren Buffett bet big on the stock, putting 40% of his partnership’s assets in American Express shares. But such instances are rare and even then one off.
Let’s go back to Rakesh and his stake in Titan. In around 2 quarters of 2002, he accumulated a 4% position in the company spending approximately 12 Crores. 12 Crores is a very large sum and betting that amount of money on a single stock may seem as recklessness but Rakesh hasn’t accumulated his wealth by being reckless.
In an interview Economic Times, he puts his networth in 2002 at around 250 Crores. 12 Crores when seen from that perspective was around 2.5% bet (in fact since he was levered, overall size of the bet would be even small). But that bet worked wonders to the extent that today constitutes approximately 40% of his networth.
Titan in 2002 wasn’t a dazzling stock. In fact, from 1995 when it started trading on the National Stock Exchange, it had gone down by more than 50% with another watch maker, Timex doing even worse by being down 77%. Nifty on the other hand was flat post the crash following the dot com burst.
Relative Performance Comparison between Nifty 50, Titan and Timex
The outcome of one stock dominating to such an extent in one’s portfolio isn’t a random occurrence either. Take the story of Anne Scheiber who is considered one of the great equity investors of the 20th century. Once again, wealth was not accumulated by a small number of concentrated positions but basically buying and holding a large number of stocks for lifetime.
While its guaranteed that quite a few stocks will be worthless, the overall portfolio can be a big gainer since the upside for stocks can be infinity versus just losing the capital if it goes bad. Recently there was this article about Voya Corporate Leaders Trust that hasn’t traded for 84 years and yet has beaten the S&P 500 over its lifetime.
More than 5 years back, I had written a post titled Throwing Spaghetti Against The Wall. My testing that over the long term, even a randomly chosen portfolio of stocks had a very high probability of beating the benchmark index.
Of course, this doesn’t mean that one should randomly invest into stocks. What it shows instead is what one remembers from one of the famous paragraphs from one of the greatest story ever told – Reminiscences of a Stock Operator.
In fact, if you were to think about it, the reason Coffee Can strategy works is simply because you are filtering for good quality stocks and then holding them for a decade. Not every stock will yield great returns, but the overall outcome is far better given that the selection is not random but consists of a well thought and tested strategy.
In 2016, after reading Saurabh Mukherjee’s book The Unusual Billionaires, I had invested in one such set of stocks for my brother.
It recently completed 3 years in which I haven’t done any trade. As on date, the portfolio is up 53% slightly beating the Nifty 100 which was the benchmark I am using. This despite the fact that 5 out of the 16 stocks that I have invested are in negative territory.
There was this interesting thread and one of the tweets applies when we look at investing in markets.
As investors, we are just side-car passengers. We are in a way at the mercy of the promoter and his idea. If it works out well, we claim credit for identifying it at an early stage while if it fails, it’s easy to blame the promoter for the various acts of omission and commission.
When I tested for my Momentum Strategy, the outcome was that the most optimal position size was around 25 stocks. But I have chosen 30 since it reduces the risk even further while allowing me to stay in stocks that have intra month dips without the need for panic.
Then again, my strategy is hole and sole based on the price of the stocks and nothing to do with fundamentals. But even when you know the company better than even the promoters, there is no telling what you may be missing and come back to bite. Should you take that Risk when your future is tied up with how well your investments will do over time?
While I can try and optimize it even further to gain those few extra bips, I have come to the conclusion that I can do better by just allocating right. A tactical Asset Allocation combined with a philosophy that works over time is good enough for me.
Investors take all kinds of Risks to earn a couple of percentage extra when even a small allocation to equity could have given them the same or even better return with much less headache. Then again, where is the thrill in it. Same is the story with Concentrated Portfolios.
I have in the past once written on Yes Bank with my view being to ignore Yes Bank as a stock to “Buy”. The price when I wrote the post was around 185, today it trades a touch below the 50 Rupee mark.
The world of finance operates based on Trust. Lose that trust once, its difficult if not impossible to regain it back. As Warren Buffet’ts once said;
It takes 20 years to build a reputation and five minutes to ruin it
Warren Buffett
Jignesh Shah started what was then known as Financial Technologies in 1988. Thanks to the debacle of National Spot Exchange, he was forced to quit his company in 2014. While the company renamed itself to 63 Moons, it hasn’t been able to shake off its past.
The stock couldn’t care less about the name as it still trades 97% below its all time high set in 2008. To give a context about the fall, anyone who bought and continues to hold the company shares anywhere from 2005 is still under water.
Stock Price Chart of 63 Moons (formerly Financial Technologies)
NBFC’s had a great run until IL&FS went bust. While IL&FS in itself was not seen as an ordinary NBFC, its sudden death created an environment of fear and panic and one which is yet to see its end. Weaker NBFC’s suddenly saw not only their cost of borrowing raise but many weren’t able to raise even at higher levels.
The 2008 financial crisis in the United States was of a similar nature with no company willing to trust another and lending freezing altogether. While Lehman had a lot of bad mortgage loans on its books, what killed it finally was their inability to raise the capital required even when they had substantial assets.
It was only after its death that the Federal Reserve decided to throw open its window to anyone wishing to avail of liquidity buying all kinds of mortgage bonds. The rest as they say is history.
Bank failures in India post the Nationalization phase have been very few and even those have been mostly limited to Co-operative Banks. The only scheduled bank that went down was Global Trust Bank.
In case of Global Trust Bank, RBI ensured that the banks customers were not impacted by going in for a shotgun marriage with Oriental Bank of Commerce.
Yes Bank has been facing issues for some time now. The very fact that RBI felt the need to appoint a Director on its board showcases the seriousness of the issue. But what is surprising is the lack of clarity when it comes to the future.
Yes Bank has booked losses of 2000+ Crores in the last 3 Quarters. This has meant that it now desperately needs to raise capital to shore up its capital. But what is interesting is the way the capital raise has been played about
In its board meeting dated Aug 30, 2019, the Board approved a resolution calling for the increase in the authorized capital of the company. This was not surprising given that the CEO, Ravneet Gill had way back in June was quoted as saying “The number one priority would be raising capital,”.
Yet nearly 6 months after that we are yet to see Yes raise any capital even as every other day rumours swirl about possible investors who are wishing to invest in the Bank. At the beginning of this month, Yes Bank claimed to have received firm commitments from investors amounting to around $2 Billion and one which was supposed to be approved in the board meeting of 10th December.
Yet, this was the outcome of the board meeting
The outcome of the meeting of the Board of Directors is as follows:
1. The Board is willing to favourably consider the offer of US$500 Million of Citax Holdings and Citax Investment Group and the final decision regarding allotment to follow in the next board meeting, subject to requisite regulatory approval(s).
2. The binding offer of US$1.2 Billion submitted by Erwin Singh Braich / SPGP Holdings continues to be under discussion.
The Bank shall continue to evaluate other potential investors to raise capital upto US$ 2 Billion
In other words, no new issue of shares were made even as the bank continues to try and scamper for new investors before it releases its quarterly results for the quarter ending December 2019.
Another bad loss making quarter could easily push the Capital Adequacy Ratio of the Bank below the RBI mandated 8%. The core capitalisation level for the Bank stood at 8.7% as on September 30, 2019.
The lack of clarity has meant a field day when it comes to rumours that swirl around their capital raising ability. Today for instance,
The constant flurry of news has meant that Volatility has shot up the roof with speculators having a field day.
30 Day Volatility of Yes Bank Shares
The inability to raise capital isn’t much of a surprise given how supposedly well run companies like DHFL collapsed like a pack of cards. No one knows how much of debt lent out by Yes is good and without a forensic audit by a neutral agency, its doubtful any major investor will be willing to risk capital or his name in an attempt to bottom fish.
In fact, Macquarie in a recent report wondered whether Nationalization of the bank loomed ahead and that question has been haunting me since I first wrote on Yes Bank. Unlike an NBFC, failure and collapse of a bank can cause unmitigated disaster when the overall environment is already weak.
Post the fall and freezing of depositors amounts at PNC Bank there is a fear that lurks around any bad news that could freeze up the depositors money with no end in sight. To me it’s surprising that RBI is keeping it quiet even as the media has a field day.
In 2008 when rumours were swirling around ICICI Bank, RBI had come out with a statement saying that ICICI had enough liquidity, and RBI was ready to make more cash available to the bank, should it run short.
Yes may not in that situation but as we have seen in the past, things can deteriorate pretty fast. As Andy Mukherjee wrote earlier this month,
Yes, India’s fifth-largest private-sector lender, can’t be left adrift much longer. But the RBI is so distracted fighting other fires that it would rather not have to think about Yes.
I sincerely wish that Yes Bank can raise capital before the end of this financial quarter for any weakness in numbers can set off a vicious cycle that isn’t easy to firefight.
Disclaimer: I have no personal positions in Yes Bank.
When one door closes, another opens is a famous saying. We Indians are famous for “jugaad” which loosely translates to finding a simple work-around or a solution that bends the rules.
SEBI has been tightening rules on who can manage money which has meant that enterprising entrepreneurs with not enough capital but interested in managing others funds have to find a way to overcome that limitation.
A few years back, you could manage a clients portfolio by becoming a SEBI registered Portfolio Manager if you had 50 Lakhs as Networth. The only limitation to what clients you could encourage was that he had to put in a minimum of 5 Lakhs.
The original limit was set in 1993 and was felt that over time the number had become too low. In 2012, SEBI enhanced the limits to 2 Crores and 25 Lakhs respectively. Recently, SEBI enhanced this once again to 5 Crores and 50 Lakhs.
The thing about Networth for a PMS is that this money basically sits in a Debt Fund / Fixed Deposit since it cannot be put to use or even invested in equity for any decline will affect your Networth.
The idea of having a higher networth is to scare away fly by night operators, but given how easy Banks can be duped, I wonder if networth is the right way to eliminate that risk. But SEBI is wise and they know what is best.
A limitation of PMS is that you cannot take leverage, in other words, the total nominal / gross exposure of a client cannot exceed the capital he has provided. So, if he has given 50 Lakhs and you wish to sell Nifty options, you can at best sell 4 lots since selling one more lot will exceed the limit.
You can take leverage if you are an Alternative Investment Fund, but to become such a fund you need to put in 5 Crores of your money and only entertain clients who can come up with a minimum of 1 Crore each.
But what if you wish to trade derivatives for clients and yet not register with SEBI as either a PMS or AIF? Theoretically its not possible, but recently I am seeing various websites openly offering a product where they shall generate returns for you on stocks that you give them as security.
Here is how this works – I have copied the matter from one website though the strategy is the same with 3 others I have seen.
Step 1: A Demat+Trading account is opened under your name, using your KYC documents. We act your broker who has the authority to executes trades in your account, with your permission.
Here is the interesting thing about the Step 1. As a broker, I can only execute trades that are requested by you. If orders are placed online, there is a log that contains the login information showing that the client himself placed the order (as also additional information to showcase from where it was placed) and if offline, most brokers today record the telephonic conversation since this is a requirement of SEBI.
Any permission the client gives to the broker to execute the trades himself is ultra vires. But, hey, who is checking anyways. Lets now go to Step 2
Step 2: Imagine a capital of 5 lac is brought to the table for investment purpose. We will park almost 80 % of this cash (4 Lac approx) into Blue chip equities.
You could have your already existing stock holding, Mutual Funds or even Fixed Deposits transferred to this Demat account of yours.
Take note of 2 Numbers, 5 Lakhs which is the Capital you are supposed to bring in and 4 Lakhs which is invested in Stocks. This means that there is 1 Lakh in Cash. Lets move to the next step
Step 3: The stock holdings and remaining cash is collateralized with the broker. This is a pledging process. Broker in-turn hands it over to Exchange.
Exchange (NSE/BSE) allows you to enter into derivatives trading with the allocated margin.
You must have heard about margin pledging when the Karvy scandal broke up. This is more or less the same. But there is a hiccup. Exchanges earlier used to have no limits on the split between Stock and Cash you provided for margin. But this changed a few years ago.
Exchanges stipulate that for overnight F&O positions, 50% of the margin needs to compulsorily come in cash and the remaining 50% can be in terms of collateral margin. If you don’t have enough cash, your account will be in debit balance and there will be an delayed payment (interest) charges charge of 0.05% per day applicable on the debit amount. So, if you take positions that requires a margin of Rs 1 lakh, you will need at least Rs 50,000 in cash irrespective of how much collateral margin you have. Assuming you don’t have this Rs 50,000, whatever you are short by will be the debit balance for the day, and delayed payment (interest) charges will be applicable for that amount. You can check this link to know more on how the delayed payment (interest) charges will be computed.
So, the client, that is you pay the broker an interest since you have provided 4 Lakhs as Stock and 1 Lakh as Cash vs 2.5 Lakhs. While this advisor asks for 20% Cash, another advisor asks for 30% Cash, both lower than what is regulated. Maybe they have a share in the interest charged, I don’t know. Let’s move on,
For the next step, I shall provide what another advisor’s presentation claims their approach is.
Money management helps us decide which strategy should have how much weightage of fund allocation and total fund to be deployed at any point of time in market.
Our risk is reduced as at any point in time we have multiple strategies running on a continuous basis, hence we are able to manage volatility while maximizing return and minimizing the risk. Diversified strategies helps permitted draw down to be adhered to strictly.
Our expertise lies in realizing and implementing which strategy has a better payoff possibility at that point of time in markets. We trade only in Nifty Options and hence completely eliminating news and event based volatilities of individual stocks.
Active dynamic management is deployed on all trades, tracking money flow tools on hourly basis, gives us fast indications about the change in trend dynamics of the markets.
Our Highly experienced teams tracks option premium charts and identifies trend reversal on them. Once money flow and charts indicate a trend reversal, unwinding of one strategy and loading another or booking loss on some positions plays an integral part of Exit strategy.
Option Strategies were coupled with the Money flow and technical analysis tools to reach at a product which had a potential to manage risk with a 7% drawdown.
In simple words, they shall use a strategy to sell options. While most claim to be Delta Neutral, the fact is that Delta Neutral doesn’t generate 18% returns (post all their expenses) which to me suggests that some if not all the time they expose themselves to market trends. In other words, they indulge in active trading / speculation.
Here is a performance chart showcasing a smoothness that even Debt funds don’t have these days. It’s as if like the old Hero Honda Ad, all you need to do is “Fill it, Shut it, Forget it”
The chart below starts in 2008 when Volatility went through the roof but not surprisngly this strategy had a great time even then.
Free draw of a line 😉
Trading on others accounts with or without their knowledge is as old as the hills. These days, most option experts who trade for others post screenshots which showcase the long list of clients they manage.
They are able to do this by getting themselves registered as an Authorized Person at SEBI with a broker of their choice. This allows them to deal on behalf of all their clients in a single platform without the need to open multiple windows or login individually to each client’s account.
Of course, all this is not legal, but its impressive as how openly its flouted with no fear of any repercussion. All these even as SEBI eliminates those who wish to go by the legal route by adding more hurdles and hence limiting choices for clients when it comes to investing.
My view – if you wish to preserve your capital stay away from such schemes. Its similar to a Russian roulette. All it takes is one bad day to wipe out not just the profits but also your entire savings.
Brokers have never been seen as Saints but the Karvy episode once again opens up an age old question, How trustworthy is your broker, especially when these days many of us have a major part of our networth in Stocks and Funds.
One interesting comment came from Nithin Kamath, CEO of Zerodha
Most brokerage houses are private entities save for a couple that are listed such as ICICI Securities, 5Paisa, Geojit, India Bulls among a few others. The vast majority are private entities that are unlisted and hence investors are clueless as to their financial strength. Then again in case of Karvy, I suspect that the financial strength is pretty good in the broking company while the problems themselves lay elsewhere.
From the time we have had stock brokers, they have had the unique ability to hold both the funds of clients and the securities which most of the time are multiple times their own networths. There is always the enticement to use the same for their end.
Back in the days of physical settlement, clients opted for the broker to retain the shares especially those bought for speculative reasons than carry them back to their house and return when the sale was done. Today, SEBI rules prohibit brokers from holding onto client securities for any length of period once the settlement is complete and the stocks have been funded, but as the Karvy episode has shown, that hasn’t stopped the mis-use from happening.
A Chain is As Strong As The Weakest Link and so is the case here as well. SEBI has tried to safeguard clients by framing strict rules as well as using technology to ensure that the client knows what is happening at his account. The weak point though is that the broker even today has access to both funds and securities of clients.
Clients make payment to the broker for securities bought and the stocks that are paid by him is delivered by NSE to the broker who then transfers to the client. Since most brokers also are Depository Participants and clients need to have accounts with them to function, this means that even when the stocks have been transferred to the respective client accounts, its still not totally safe for the broker always has access – legal and illegal.
One way to prevent misuse by brokers as well as reducing overall risks is to separate the function of broking from both collection of funds as well as delivery of securities. What we need are independent custodians who shall make the payments for securities bought by clients as well as be the depository participant who holds the shares bought by the client. This is currently done by Custodians for PMS clients and should be easy to accomplish at scale for others as well.
The way it will work is something like this. Anyone wishing to transact in the stock market opens up an account with a custodian. This account is then linked to the broker of his choice.
Every morning, the broker will sync with the custodian to know the amount and securities available with the client so as to grant him exposure for that day’s trades.
If a client buys securities, at the end of the day the broker sends a bill to the custodian who shall then make the payment not to the broker but to the exchange itself.
Securities purchased by the client will be delivered by the exchange to the Custodian who then transfers the same to the respective client account. The reverse works in case of Sale of Securities – the Custodian delivers them to the Exchange and receives the funds from the exchange itself. In other words, through the entire process the funds and securities are safe from the broker.
What this also accomplishes is the ability for a client to shift broker without having to open a new Demat account and shift securities. In other words, the trading account becomes easy to port.
By dividing the role, this will ensure that the broker’s earnings are dictated by only the brokerage he can charge to his clients and not be able to use / misuse clients funds or securities for his own benefit.
This is not a new proposal either as it seems SEBI has in the past discussed the same. While lobbying may have prevented this from being executed, the Karvy episode should hopefully swing the trend back in favor of such a move and one that shall ensure that clients funds and securities are never at risk.
If the government wishes that citizens move from savings in non financial assets to financial assets, its important to develop systems that can generate trust and one that cannot be easily misused by all and sundry.
