Keep a close watch on the cash you've left lying with your broker

If you are not going to trade frequently, don't leave excess cash in your trading account and make sure check weekly reports sent by the exchange carefully

Around 28 brokers affiliated to the NSE have defaulted since November 2019. Eight have defaulted in the current year. The regularity with which brokers default makes it imperative that retail investors entering the capital markets choose this intermediary with utmost care.

Why are brokers defaulting?

The most common reason is that in the past they may have used clients' securities and cash for proprietary trading, and suffered losses. Or they have used one client’s cash or securities to offer enhanced margin to another client, who may have suffered losses.

Over the past year and a half, the Securities and Exchange Board of India (Sebi) has tightened regulations, making it harder for brokers to continue with such practices. Reporting norms have also become tougher. “There have been many cases of the broker not being able to produce the funds and securities belonging to the client which he was supposed to have. Many such cases have come to light in this tighter regime, leading to a string of defaults," says Shrey Jain, founder, SAS Online, a Delhi-based discount broking firm.

According to industry insiders, the rapid pace at which these new norms were implemented meant that many brokers were unable to manage the transition to the new, cleaner way of functioning. Essentially, what we are witnessing now is a cleansing up of the system, which may continue for some time.

Key reforms of the recent past

Over the past year and a half, the regulator has introduced several reforms that are expected to reduce the frequency of broker defaults in the future.

Peak margin norm: Earlier, a broker was free to give as much leverage to his clients for intraday trading as he desired. Let us consider one example. Suppose that a client enrols with a broker and deposits Rs 1 lakh. In the earlier regime, the broker could give him margin of up to Rs 1 crore or even higher. There was no ceiling on this. However, this practice created a lot of risk in the system since the broker does not get any margin from the exchange. The amount of money he deposits determines the trading limit the exchange allows him.

The broker gave high limits to some of his clients by using other clients' money and securities. If the client lost money, the broker was unable to make good the money and securities belonging to the other clients. This led to a default.

Under the new rules, the limit that the client gets equals the money he deposits. “The 100 per cent margin limit that was there at the level of the exchange is now being implemented at the broker level as well,” says Jain.

Margin pledging: In the Karvy case, the broker either sold off clients’ securities or pledged them with banks to raise money. This happened because brokers had access to clients’ securities earlier.

In the system that Sebi introduced in September last year, a client’s securities remain in his demat account. If he wishes to pledge them to get margin, a lien is marked on them in the client's account itself. These securities are no longer moved to the broker's account. This reform has removed the scope for misappropriation of clients’ securities. “The broker does not have custody of the securities. Even if he defaults, the client’s securities are safe with the depository,” says Jimit Modi, founder and chief executive officer (CEO), Samco Securities.

The regulator is now developing a system that will provide clients with complete visibility of his collateral. “The client will be able to view the status of the securities he has pledged, thus creating greater transparency,” says Modi.        

Upfront cash margin: Earlier, if a broker was acquainted with a client who opened an account with him, he would allow him to start trading without collecting any margin money. If the client suffered a loss, the broker bore the brunt. This practice again created the risk that the broker would use other clients’ money and securities. Now, the client has to pay 20 per cent margin upfront before a broker can allow him to trade.

Enhanced supervision norms: Brokers now have to upload a weekly report to the exchanges on clients’ funds lying with them. The exchange (and not the broker) shares this information with the client. Any discrepancy can be spotted faster now.

Keep an eye on the cash

Thanks to the reforms that Sebi has introduced, it has become very difficult for brokers to misuse clients’ securities. However, cash belonging to clients still lies with the broker. That is where risk could potentially arise in the future. “Bank-led brokers, who provide three-in-one facility, do not keep customers’ money with themselves. If a customer has to trade, the money is withdrawn immediately from his account. Sebi needs to find a way to ensure that no money belonging to clients lies with any broker,” says B. Gopkumar, managing director and CEO, Axis Securities.    

Until recently, the rules pertaining to cash were that the broker had to settle every client’s account and return his cash every three months. “Now the regulator has tightened the rules further by stipulating that if a client has been inactive in a month, and he has unutilised cash lying with the broker, the latter must return the money,” says Modi. This is expected to reduce the misuse of cash further.   

The customer also needs to observe a few precautions on his part. “If you are not a frequent trader, then avoid keeping large amounts with the broker,” says Vikas Singhania, executive director, Trade Smart Online.

Keep your mobile number and email updated. When you receive the weekly report on cash holdings, check to ensure there is no discrepancy between the amount you have kept with the broker and what the latter has reported. “Treat any such discrepancy in the figures reported by the broker as a red flag,” says Modi.

Delays in payouts and closing down of the broker by the exchange (because he is unable to meet his margin requirement) are other signs that the broker may be experiencing financial difficulties.  

Do the due diligence while selecting a broker

• Choose a broker with strong financials (information on this count can be gleaned via web searches or from the Ministry of Corporate Affairs website) as such an entity will have greater ability to tolerate shocks   
• It is safer to avoid brokers who engage in proprietary trading because that could be a potential area of risk (information on whether a broker engages in this activity is available in the account opening form)   
• Go with a broker with a reputation for constantly improving its platform as that indicates the broker is in the game for the long term 
• Check social media and online reviews of brokers before selecting one