Karvy a tip of iceberg: Lens on 3 dozen brokers for Rs 10k-crore fund abuse

Market regulator Securities and Exchange Board of India (Sebi) has trained guns on more brokers for indulging in the practice of using clients’ shares.

Sources say the issue is not limited to just Karvy Stock Broking, with over three dozen more brokers under lens for misappropriating client funds to the tune of Rs 10,000 crore.

The issue has come to light after several brokers missed the August 31 deadline set by Sebi for returning client funds. Market players said the issue could snowball into a bigger problem if these brokers are not able to return client money or have incurred losses on their proprietary trades. On Friday, Sebi imposed restriction on Karvy for alleged misuse of clients’ securities.

Sources say Sebi is currently inspecting the books of several brokers who have used client funds to meet the liability of another client or pledged it with banks to meet margin requirement of other clients or their own proprietary obligations. Some brokers are being probed for divergence of funds in non-related businesses, such as real estate.

“In some cases, clients failed to take back securities despite no operations in their trading account for a long time, indicating high chances of these collaterals given as loan to brokers expecting high interest,” said a regulatory source in the know. “The issue needs to be handled delicately, as unassuming investors’ wealth is at stake,” informed a source. 

Until recently, it was common practice among brokers to use client securities as collateral another client trades or for proprietary trading. Further some brokers used these idle shares as a pledge with non-banking financial companies to raise capital. Brokers created a so-called ‘stock broker-client account’ to facilitate such transactions.

In June, Sebi cracked the whip on such practice directing brokers to wind up all such accounts. It directed all the players to unpledge and return client funds. Industry players said the move came as a big jolt to several brokers neck-deep in such practice and unable to wind up their positions even as the three-month deadline ended.

The practice was rampant as brokers enjoyed powers of attorney on their clients’ demat accounts and were authorised to transfer client securities to the collateral account.

“Use of client funds was a fairly widespread practice in the broking industry till the time the new regulation was introduced in June. One has to understand any transition takes time and if forced upon, can create disruption. The rot runs deep. We have seen many brokers defaulting or not meeting their commitments on time. Probably, a serious rethink is required to tackle this issue,” said Alok Churiwala, managing director of Churiwala Securities.

The new rules mandate securities payout cannot be directly transferred from a pool account to a collateral demat account. Instead, it should be first transferred to the demat account of the respective client, ensuring concurrence of the client to such collateral creation and to create an audit trail for the same.

Speaking on the issue last week, Sebi Chairman Ajay Tyagi said, “We have made changes to the regulations to ensure brokers handle client funds properly. A lot has been done; more steps will be taken in this direction.” 

Industry players said the recent rule changes aimed at brokers have brought distress to some players.

“While a Sebi clean-up is required, the unintended consequences were not thought through. With the broking business going downhill in five years, most brokers were making money using client funds. A ban on this practice will hit several brokers hard. It is possible that some may fail to meet client obligations,” said an industry player.

According to him, the regulator has missed out on the impact assessment of the June circular. Even after creating a mechanism to identify such collateral, brokers had no mechanism to replace client collateral from their own because of non-funding by banks.

Taking stock

• Brokers enjoyed power of attorney over client securities 

• Used it as collateral for proprietary trading, other clients’ margin

• Some used it to borrow money for NBFCs; diverted money into other businesses

• In June, Sebi imposed complete ban on the use of client funds 

• Set August 31 deadline to return client funds

• Some brokers yet to return client shares

• Could snowball if brokers fail to return money due to underlying problems