Market regulator Security and Exchange Board of India (SEBI) has released a consultation paper on 'blocking of funds for trading in the secondary market'. SEBI's proposal would allow investors to trade in the secondary market based on blocked funds in their bank accounts and eliminate the need to transfer funds to a stockbroker or trading members. This will likely have significant ramifications for all brokers as they will no longer be able to keep clients' money with them.
SEBI's proposal also provides client level settlement visibility, for both pay-in and pay-out, to clearing corporation (CC) by the direct settlement of funds and securities between client and CC. The market regulator says it will implement a process that, by design, safeguards clients' assets from misuse or broker defaults and consequent risk to their capital.
Following significant developments in the payment mechanisms, SEBI says the Reserve Bank of India (RBI)-approved unified payments interface (UPI) mandate service of a single block, and multiple debits can be integrated with the secondary markets to provide a block mechanism, similar to the pledge-like mechanism in securities, where clients will be able to block funds in their bank account for trading in the secondary market, instead of transferring them upfront to the trading member, thereby providing enhanced protection of cash collateral.
Under the proposed model, funds will remain in the client's account but be blocked in favour of the CC till the expiry date of the block mandate or till the block is released by the CC, whichever is earlier. CC can debit funds from the client account, limited to the amount specified in the block.
Further, SEBI says that, while a UPI block, on creation, will be considered towards collateral, the same would also be available for settlement purposes.
"For the clients who prefer to block lumpsum amount, their block can be debited multiple times, subject to the available balance, for settlement obligations across days. This comes with a dual advantage, where firstly it eliminates the need to transfer funds to the brokers and secondly, the funds blocked from savings account earn interest for the investor. Effectively, the amount which earlier used to get transferred to the stock broker for trading in the secondary market will remain in the investors' bank account and can now earn interest for the investor."
According to the market regulator, over the past couple of years, the Indian securities market has seen tremendous growth, both in terms of volumes as well as in terms of the number of participants. This increasing participation with an increase of new investors in the securities market also puts a greater onus on making markets safer for its participants, with a special focus on retail participants, SEBI says.
As per the existing framework, investors or clients post collateral with their stockbroker before executing trades and carry out the settlement of funds/securities through their stockbroker on crystallisation of settlement obligations. Stockbrokers, for their proprietary trades and for trades of their clients, post collateral with their clearing member (CM) and carry out the settlement of funds or securities through their CM.
CMs, for their proprietary trades and for trades of their constituents or clients in turn, post collateral with CC and carry out the settlement of funds or securities with the CC. Additionally, the existing framework allows retention of a certain portion of collateral at every level, e.g., when a client or investor posts collateral, part of it can be retained by a stockbroker and part by CM before passing on the remaining to CC.
In the existing process, the client's assets pass through the stockbroker and clearing member before reaching the CC. The pay-out released by CC follows a similar cycle of passing through the clearing member and stockbroker before reaching the client.
Given the process flow, SEBI says, there is a possibility that a client's collateral retained with stockbroker or CM can be misused. Similarly, the pay-out due to the client can also be at risk in case the stockbroker and/ or fellow client defaults.
"To retain investors' confidence, it is imperative that the investors' funds and securities should be adequately protected from the possibility of misuse or default by a stockbroker. The evolving regulatory framework has endeavoured to use technology in identifying early warning signs for any misuse of funds and securities by trading members. However, the need for more innovative solutions to plug in any possible loopholes and minimise the risk of misuse of investors' funds or securities by stock brokers is ardently felt," it added.
Most broker defaults have inflicted crippling losses on investors, although the settlement guarantee ensures no impact on the market itself. 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 little interest for the pledged shares; but, in many cases, investors were unaware of their shares being pledged.
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