Clients' idle money to slip out of brokerages' hands

Currently, brokers use idle money in clients’ trading A/Cs to lend to others at interest.

The capital markets regulator feels this arrangement makes for systemic risks.
MUMBAI: A cheap and easy source of funding for retail brokerages is set to dry up soon. Brokerages will not be allowed to use the money of clients to finance other trades from July 1, possibly triggering a sell-off in small-cap and penny stocks at that time. The move is aimed at preventing brokers from misusing client funds, a concern that prompted the Securities and Exchange Board of India to push for tighter rules.

Currently, broking firms use money that lies idle in clients’ trading accounts to lend to others at interest. Some of them use it for proprietary trades. For brokerages, it is a free source of funding as firms do not pay any interest to clients, many of whom do not withdraw their money after every trade.

The capital markets regulator feels this arrangement makes for systemic risks.

Sebi has been seeking stricter norms in the past few months but brokers have managed to delay such a move. But with the regulator yet to indicate that the new rules will be deferred any further, broking firms are now resigned to its implementation. “It will have major implications for brokers because the new rules limit their cash flow,” said the chief executive of a Mumbai-based retail broking firm.

Top executives said the move will impact most broking firms, especially the smaller ones that rely heavily on this arrangement to run business. Most of the larger established brokers also fund clients through their non-banking finance companies (NBFCs). But if a broker funds a client through the NBFC, the client has to bring in an upfront margin. Also, there are restrictions in the stocks a client can invest in through the funded money. However, if the broker is funding clients without going through the NBFCs, it does not need to comply with these rules.


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Brokers said a lot of buying in small-cap and penny stocks in the past year has been funded by brokerages, which in turn used clients’ idle money. Many of these stocks would not be eligible for funding by NBFCs. With the new rules set to be implemented in July, brokers expect a sell-off in many stocks in these categories in June.

“Its implementation will lead to the artificial volumes disappearing because brokers will not be able to fund clients so easily,” said Rahul Rege, business head, Emkay Global Financial Services.

“This would be a bold step by the regulator to clean up the system.” Various small brokers, who relied on client money to fund other trades, are shutting shop, said some industry executives, but this could not be verified independently. The managing director of a large brokerage said many firms do not have the back-office capabilities to implement the new norms.

Sebi has put the onus of keeping track of investors’ funds lying with brokers on stock exchanges. “Stock exchanges shall put in place a mechanism for monitoring clients’ funds lying with the stock broker to generate alerts on any misuse of clients’ funds by stock brokers,” the regulator had said in a circular in September last year.
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Broking officials said the new system will benefit clients. “From the customer point of view, enhanced supervision will increase transparency in the system as brokers will have to maintain their client credit balance separately and report to the stock exchanges on a weekly basis,” said Prakarsh Gagdani, CEO, 5paisa.com, a subsidiary of IIFL Group.
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