While SEBI Sleeps

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. 

From Zerodha’s Margin FAQ;

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.

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.