The Securities and Exchange Board of India’s (Sebi’s) crackdown on the Karvy group has caused some apprehension within the stockbroking industry. Apart from barring Karvy from taking on more clients, the regulator has asked all brokerages to comply with its stringent rules for the separation of client accounts from the broker’s own accounts. This segregation is aimed at stopping the misuse of client assets. But a lot of brokers could be affected by this. An enforced rapid unwinding of affected positions could lead to big losses, leading to defaults. The Karvy group has been accused of diverting securities and funds from client accounts to other group companies, including its own real estate arm, as well as using those assets to meet its commitments in the stock market. This may be the tip of the iceberg and, indeed, many other brokerages are said to be in the same boat. The practice of misusing client assets is common across retail brokerages. It is easy to do: Brokers operate on the basis of power of attorney (PoA) from clients, allowing quick transfers of demat shares to honour transactions. This PoA mode of operation is both legitimate and necessary; otherwise, every transfer would require physical documentation from involved parties, slowing things and inconveniencing clients.
But PoA also makes it possible for the brokerage to dip directly into client accounts and use their assets to meet its own margin requirements. There are complicated variations. For example, a brokerage may buy shares on margin on behalf of a client, and then treat those margined shares as “unpaid” and, hence, place them in its own account. Misuse of shares pledged by clients as margin for their own trades has also been reported. The Karvy case, and others like it, came to light in an audit at the National Stock Exchange.
Only further investigation will reveal the dimensions of the issue. Tapping client accounts is, of course, an unethical practice. It allows a broker to deploy assets that don’t belong to it to generate a larger volume of trades than would be permissible on the basis of its own net worth. The Karvy case might be particularly egregious if the assets were used as collateral by the group’s real estate arm. However, the practice of tapping client accounts is widely prevalent and it has been ignored for years. The regulator must stamp it out. Indeed, Sebi
had already issued instructions, asking for a segregation of client accounts as far back as July.
Quite apart from the ethics, there are several dangers. If a brokerage, which is misusing client assets, runs into losses, it could default. This could lead to contagion in a situation where other brokers are also misusing client assets. Such defaults could lead to investors being left high and dry, and on a large scale, this would affect market operations. The regulator has to move delicately in dealing with this situation. There is this fear of contagion and that harsh action may lead to panicky investors selling off. Sebi
must work closely with the stock exchanges to reassure investors and to ensure that an orderly unwinding of outstanding broker-positions margined by client assets occurs. It should act against offending brokers but also ensure that common investors are not hurt.