How Serious Is the Issue of Fake Fixed Deposits or Funded Collateral in the Market?
A rather worrying message came to me from a top market intermediary, who said the content is plausible and the source fairly reliable.
It read (I have not corrected or edited the message): An interesting situation seems to have developed. Specifically for NSE Clearing House. Banks seem to be forced to pay Rs 3 cr per Rs100 cr Bank guarantee if they go above NSE’s counter party limits prescribed with each bank. How NSE can do this no one knows.
To avoid the concentration of Bank Guarantees now, NSE and some Banks seem to have devised a new method. To provide fixed deposit confirmation from broker to NSE clearing house.
It doesn’t require any capital charge for bank because it’s fully backed by FD real money in bank. It also doesn’t add upto BG exposure of bank to NSE.
I have been told (subject to verification) that many banks and NSE Clearing House put together have a mechanism where bank gives fixed deposit confirmation to NSE clearing house for say Rs 100 crores on behalf of a broker. However, the broker has deposited only Rs 10 crores as FD with bank in reality. Balance 90 crore is only an ‘illusion’ which bank and NSE Clearing house are carrying on. NSE clearing house, in a way is giving 10 times more exposure to the broker than it should have if the real money had been put in by a broker.
Does it remind of old Harshadmehta BR (Bankers receipt)? Creating money out of thin air and then taking speculative positions against that in speculative stock markets instruments? In Harshadmehta days it was supposed to be Badla. Now, it is future and options on Nifty.
No one knows how much of bank fixed deposit confirmations issued by banks have real money backing it in NSE clearing house. It might be true for bank guarantee too.
This message has reached many people, including journalists. I brought it to the attention of the top brass at the Securities and Exchange Board of India (SEBI), the Reserve Bank of India (RBI) and the stock exchanges.
While the SEBI chairman did not respond, off-the-record sources in SEBI and the Exchanges said that the market regulator had, indeed, been questioning clearing houses about collateral.
The RBI governor, however, seems more determined to check whether dubious collateral poses a major systemic risk. It has sought SEBI’s cooperation in conducting a specific reconciliation exercise of the margins in the form of lien-marked fixed deposit receipts, bank guarantees, ‘unfunded fixed deposits’, etc.
As part of the exercise, SEBI has begun to collect information about the extent of lien-marked fixed deposits receipts (FDRs) that have been submitted to stock exchanges and their clearing entities as margin.
A report in The Business Line
, about the SEBI enquiry referring to fake collateral or ‘non-funded’ fixed deposits being offered as margin, suggests that this is happening across equity and commodity markets. And that clearing corporations (CCs) of stock exchanges, that are primarily responsible for risk management, have been sanctioning trading limits to brokers based on these ‘non-funded’ fixed deposits.
In response to our query, a source at the National Stock Exchange (NSE) offered an explanation to justify how the Exchange and CC are protected. He says that the Exchange has ‘net worth based criteria’ for how much of bank guarantees (BGs) any bank can issue to its CC. We are told that “post an initial free limit, further limits up to a maximum threshold, based on net worth of the bank, are given against a security deposit by the bank. As far as FDs are concerned, the exchange has received lien-marked FD receipts (FDRs) on behalf of clearing members from banks, along with a confirmation of an effective lien and that there are no other encumbrances. The arrangements that a bank may have with a broker are not visible to the clearing corporation at all.”
Our NSE source seems to suggest that their fake or funded FDRs are within a manageable limit, since it imposes net worth-based limits on the extent of guarantees that a bank itself can issue. However, market sources vehemently disagree. They say, only bank guarantees have limits (there is also a charge on the bank’s capital on issue of bank guarantees or letters of credit), but there is no charge of limit on FDs that can be opened with a bank, because it donotes a cash deposit. We asked NSE for a response to this and have yet to hear from the Exchange.
This also means that the NSE and the CC would have no idea if the bank makes a false claim that the FDR was ‘without encumbrance’. In practice, the bank could have extended a loan to the broker which is held as a fixed deposit with the bank (so the principal is safe) and only the interest differential to be paid by the broker is at risk.
This subterfuge gives the broker great leverage to trade in the futures market. Whether NSE’s risk-containment criteria are adequate will be known only when the music stops and there is a payment issue. Even here, isolated blow-ups can be contained but is it good enough when there is a massive market movements? How big is the probability of systemic risk? Does anyone know? What happens when the bank refuses to pay and drags matters into expensive and long-drawn litigation?
At the moment, one case of a fake or ‘funded’ FDR has already blown up with a brokerage firm closing operations. On 2nd April, IndiaNivesh, a 14-year old firm, suddenly announced a voluntary shutdown of its broking, commodity and portfolio management businesses, citing a ‘liquidity crunch’ caused by the fall in stock markets immediately after the COVID-related lock-down.
IndiaNivesh, when it closed shop in early April, had issued a statement to say, “During all this turmoil, there has been mark-to-market losses which have been funded by Edelweiss Custodial Services Limited and Edelweiss Custodial Services Limited was covered with STL, which was available for the credit balances of the clients.” It also asked for all its collaterals and guarantees to be frozen. But this was clearly not true as the matter is now in court. Although the CC has reportedly settled a majority of investor claims (Economic Times – ET —says 95%), the case filed by Edelweiss indicates that there is a serious problem with the security offered by IndiaNivesh.
On 29th April, Edelweiss Custodial Services Limited filed a case in the Bombay High Court to claim outstanding dues by IndiaNivesh Securities Private Limited. HDFC Bank is understood to have issued ‘funded’ FDRs as collateral offered by IndiaNivesh and has refused to pay. The matter is now under arbitration.
Is this the only brokerage firm in serious trouble and caught up in the fake FDR issue? We don’t know.
While the market regulator has strictly enforced disclosure rules for listed companies and market intermediaries, the same does not seem to apply to SEBI itself or even the NSE and its clearing corporation.
Media reports indicate that SEBI is aware of the problem and has been quietly trying to correct it by asking stock exchanges not to accept ‘funded’ FDRs. According to ET, a SEBI communication to the Exchanges has said, “trading members are showing the full amount of funded fixed deposits (broker deposited plus bank funded) as collateral in their enhanced supervision reporting to the Exchanges.”
The term ‘funded FDRs’ itself puts a bland spin on what is essentially a fraudulent activity in showing a loan as a deposit in order to get enhanced leverage for speculative trading.
Hopefully, RBI will ensure a full investigation, if nothing else, to ensure that it is not caught napping like it was in 1992, when the issue of fake banking receipts (BRs) to back ready-forward transactions of banks and financial institutions formed a big component of the securities scam. No governor would want that under his watch, nor should Ajay Tyagi, who is all set to take fresh guard for another 18 months in SEBI.
Here is the regulatory submission made by IndiaNivesh...