Sebi's new rule: Stock brokers can't use clients' funds for bank guarantees

Existing bank guarantees that were created using clients' funds will need to be wound down by September 30, Sebi said

The Securities and Exchange Board of India (Sebi), on April 25, issued a directive prohibiting stock brokers and clearing members from using their client's funds for bank guarantees (BGs) beginning on May 1.

Banks usually provide stock exchanges with bank guarantees for security deposits and margin requirements on behalf of stockholders. These guarantees are submitted to clearing corporations, who then decide the trading limits for the brokers. However, brokers often pledge their clients' funds with banks, which in turn issue BGs for higher amounts.

Banks issue BG at a rate that is two times the amount that the broker has pledged, which exposes the market to risks.

According to a circular issued by Sebi, no new BGs may be created using clients' funds from May 1, 2023. 

Existing BGs established with clients' funds must be closed by September 30, 2023. it added.

Sebi's concern

Sebi has expressed concern over this practice's potential risk exposure to the market and clients' funds. 

Some brokers reportedly obtain bank guarantees worth twice the amount of fixed deposits they have made with clients' funds, resulting in a big discrepancy between their true net worth and the guarantees they use for trading.

To address this issue, Sebi mandated that brokers use their own working capital to obtain higher Clearing Corporation limitations, thereby increasing their need for working capital.

In addition, Sebi has directed brokers to terminate any existing bank guarantees created with clients' funds by September 30, 2023.

Sebi's new rule and its outcome

The Reserve Bank of India (RBI) and Sebi have been monitoring the collateral system closely due to the potential systemic risks this practice may present. The new regulation aims to lessen these risks and guarantee that investors' funds are better protected.

This move of Sebi further increases the working capital requirements of stock brokers. This will only affect brokers who have the practice of pledging clients' funds to create BG for their own use, increasing clients' leverage and risk exposure.

This circular would only be of academic interest for brokers who have already complied with the recent implementations of Segregated Margin Reporting and online client-wise or segment-wise allocation of client collaterals.

The new requirement is interesting to note, especially when the discussions are on with the regulator's plans to implement Application Supported by Blocked Amount (ASBA) and the upstreaming of client funds.

Brokers must ensure that this new framework does not impact their own funds. To ensure that everyone plays by the rules, Sebi will keep an eye out for any infractions of this circular, report them, and ensure that brokers adhere to the rules within the stipulated time frame.