Protecting Client Funds and Securities from Unscrupulous Brokers
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.
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