At 18 broker defaults on the National Stock Exchange (NSE) and 16 on the Bombay Stock Exchange (BSE), the year 2020 has seen the highest number of broker defaults in the past 20 years. In fact, since the dotcom bubble burst and the Ketan Parekh scam of 2001-2002, this is the highest number of broker defaults this century, raising serious questions about the quality of supervision of the capital market and stock exchanges.
Almost all these defaults have inflicted crippling losses on investors. In many cases, brokers used investors’ shares to obtain leverage and take speculative positions on the derivatives market leading to losses. Sometimes, they passed back a small interest for the pledged shares but, in many cases, investors were unaware of their shares being pledged.
In the period since November 2019, the near monopolistic NSE has declared 18 brokers as defaulters and expelled them. This impacts the BSE as well and it invariably has to follow suit and has declared 16 brokers as defaulters and expelled them. Karvy Stock Broking, the biggest brokerage firm to be expelled, along with Anugrah Stock Broking are the latest additions to the defaulter list last month. This list does not include the two firms which abruptly closed down their capital market business of their own accord (voluntarily). One is India Nivesh, whose voluntary closure has led to litigation between HDFC Bank and Edelweiss Custodial Services and exposed the shady practice of 'funded fixed deposits' being accepted by the clearing corporation as collateral. In this case, the dispute is over a Rs100 crore funded FD, which HDFC Bank refused to honour.
The other is a listed brokerage firm called Action Financial which has not paid all investors but there is little information in the public domain.
Interestingly, NSE, which accounts for 90% of trading on the Indian capital market and the largest number of broker defaults, has not even updated its website since April 2020. See here
. NSE was the world’s No 1 derivatives exchange in the year 2019 based on contracts traded and has now launched weekly futures & options (F&O) contracts on the EUR-INR, GBP-INR and JPY-INR currency pairs in the currency derivatives segment from 7 December 2020.
The list of BSE broker defaults is posted below.
According to a broker, “A host of new regulatory measures introduced by SEBI in the last one year were instrumental in unearthing the unfair trade practices by a few brokers and finally resulted in defaults. There is already a shake-out in the industry.” But this only hides the fact that SEBI (Securities and Exchange Board of India), despite having real-time surveillance software, was unaware of what is going on. It also raise questions about the alertness of stock exchanges and their clearing houses.
Probably for the first time in decades, this large number of broker defaults has not caused any outrage in parliament. Another shocking discovery by lawyers, such as Advocate Ravichandra Hegde, during the Karvy and Anugrah investigations, is that the settlement guarantee fund, which was the bedrock of the anonymous order matching system, has not been used even once in two decades. In many cases, clearing brokers have been ruthlessly liquidating illegally pledged investors security, probably under pressure from clearing corporations not to touch the settlement guarantee fund. This makes this fund completely meaningless and has cheated thousands of investors who are forced to file litigation.
Instead of addressing this shady practice, SEBI has created a series of new hurdles to trading because it is unable to identify and act against rogue brokers through early warning signals.
Most of these instances occurred last year, when brokers had access to client shares through power of attorney. Brokers who defaulted in 2019 had pledged securities belonging to their clients to raise funds for other businesses or to provide higher trading margin to other clients. After the Karvy episode last November, SEBI put in place rules that prevent brokers from gaining access to clients’ shares.
Another shocking discovery by lawyers, such as Advocate Ravichandra Hegde, during the Karvy and Anugrah investigations, is that the settlement guarantee fund, which was the bedrock of the anonymous order matching system has not been used even once in two decades.
Many investors, who were caught unawares when their broker defaulted, face a tough time getting their money back and are running pillar to post. Many have lost on the claims process and Moneylife Foundation has been hosting a series of interactive webinars
on helping address such issues. The claims process is often a long-drawn process and police investigations need to be completed before the compensation steps are undertaken.
Many investors have decided to turn away from smaller brokerages in favour of larger players. The recent industry report from rating agency ICRA gives credence to this fact. The ICRA report
highlighted the consolidation underway in the industry — larger players with lower rates have been gaining market share. The report says “The increased regulatory oversight, coupled with the cost of implementing the processes, may also act as a deterrent for smaller brokerage entities and is expected to result in consolidation in the industry. Larger and well-established brokerage companies are expected to garner market share.”
The ICRA report adds “Over the long term, stronger regulatory framework is expected to strengthen industry structure and improve financial discipline, which is critical, given the fiduciary duty of broking entities.”
SEBI was earlier said to have been examining if brokers should be barred from offering clearing and settlement services. After the Karvy Stock Broking scam, SEBI was said to be mulling over a proposal that custody of client collateral, settlement and clearing of trades would be managed only by well capitalized bank custodians. The market regulator is also said to be considering a proposal to increase the net worth requirement for stock brokers by linking it to the risks undertaken by them. In principle, the measure is similar to capital adequacy at banks.
In September, SEBI released a circular advising the bourses
and clearing corporations to approach the necessary courts for liquidating the movable and immovable assets, not in their possession, of such brokers within six months of the declaration of default. However, stock exchanges have so far shied away from taking brokers to court. As a result, the deficit in recoveries from defaulting broker have led to a long wait for investors to recover their dues.
Through this circular, SEBI reminded the exchanges and clearing corporations that they have all the necessary legal powers under the Securities Contracts Regulation Act, 1956 and various SEBI circulars, to act as the first level regulator of brokers and claim even those assets of the defaulters which are not in their immediate possession.
As per current rules, non-financial assets of the broker or other firms controlled by the broker remain unaffected.
As per the latest data from BSE, from April 2020 till date, around 4,000 investors have filed their claims with BSE and around 1,100 claims have been processed as per extant norms and Rs45 lakhs have been disbursed from the IPF.