December 1, 2021, will see a major change in how the Indian markets operate, coming on the heels of the changeover to the 100% margining system and just prior to the T+1 settlement system. There are major implications for clients and the broking community at large of such changes.
This article presents a brief on the same.
SEBI has been strengthening the capital market and market intermediary infrastructure and this pace seems to have been hastened after a wide variety of issues faced in recent years including:
- Outright frauds and misreporting by brokers
- Misuse of client collaterals and Power of Attorneys
- Genuine default by one large client resulting in overall default at CM/TM levels
- Strain caused on entire market by one large default
- Finally, lack of quick and orderly management of client collaterals when defaults happened
The Enhanced Supervision circulars of 2016 created a series of regulations around how brokers and clearing members need to be monitored and that was followed by upfront margining in cash segment, reduction in leverages and of course, the introduction of the pledge/unpledged system.
The eventual objective is simple: The end-use of a clients money should be by the same client and one client’s default should be limited to the client herself and cause nil to limited damage to the connected trading and clearing members. And to that extent, attempt to create a straight line of sight across the system that ensures minimum damage in case of default AND rooting out unethical practices or weak brokers.
For example, when one client puts collateral as cash and securities, and while the client may get limits only against this at the broker end, the actual usage of some of the collateral may be for someone else’s debits or settlement obligations– so If this “someone else” defaults, an unrelated party may lose their deposit. This is unlikely only if the end limits at the Clearing Corporation are also given the same way as the brokers risk management system. This is the intended straight line of visibility!
The New Circular
Post-Sep 1 2020, client securities were effectively available only for the clients both at the trading and clearing member level via the pledge/repledge system. However, the risk of comingling and intermingling of cash equivalent still existed. A new circular puts an end to that. (https://www.sebi.gov.in/legal/circulars/jul-2021/segregation-and-monitoring-of-collateral-at-client-level_51265.html)
This new circular has comprehensive portions on how the line of visibility is to be created across the system and how the new system would need a revised style of working from December 1, 2021 (Reporting has already started from October 1 2021 but beyond that, the actual practices would start from December 1, 2021).
Instead of going into all aspects of the circular – which are very explanatory (for those who are interested, please do visit the Youtube pages of ANMI and BSE BROKERS FORUM for more on this), we present below the salient aspects of how this may impact clients.
Note that a lot of these aspects are still open and not concluded so the content below is on a best effort basis to educate you on changes:
- Currently, brokers give limits on combined basis across segments. However, the circular talks about allocation of collateral versus each segment – and therefore, this system will necessitate changes to how traders and brokers operate and clients would have to indicate in advance where (cash, derivatives etc) they wish to trade.
- Clients currently provide in many cases the entire stock collateral as a deposit and no cash or cash equivalent. The clearing member however is expected to maintain a 50/50 (minimum 50% cash) ratio at the clearing corporation. Commercially, many brokers charged interest on the cash deficit while others didn’t – its likely however that brokers would now charge interest on this portion funded OR not allow limits beyond 2x of the cash available. Remember the definition of cash equivalent includes fixed deposits, liquid mutual funds so please start to plan accordingly.
- Brokers are at times giving limits during the day based on uncleared cheques expected to clear by T+1 – however, this practice may reduce as this would create mismatches between the data at the clearing corporation and the actual limits utilized at the broker level.
- Finally, as of now, the broker was put on a risk reduction (RR Mode of 90%) based on excess utilization versus excess funds at the broker level. This excess utilization didn’t take into account individual cases (left to broker) at the clearing member level and didn’t impact RR Modes. Now the new formulae ask the broker to individually add the clients over 90% of margin utilization and this excess has to be instantly funded by the trading member else the member would be put on an RR mode across all clients. This would mean additional pressure on trading members to some extent to keep excess collateral and therefore tighter risk management as any ad hoc limits against promised cheques etc would mean potential risk to all clients.
All of the above information at various disaggregated and segregated levels would be available and monitored on a live basis to ensure limits are curtailed to the “optimal” level and hence, brokers would require to keep more proprietary collateral as a buffer to avoid the RR mode as well.
In addition to the above, there are substantial portions in the circular on how default management and provision of collateral back to clients of defaulting members should be handled.
The circular also asks the market intermediaries to ensure that the clients can be shown their allocated margins on web portals so they also have visibility along with the entire chain of intermediaries and that this prevents mis-utilisation or misrepresentation.
What Happens Next
The guidelines are meant to ensure basically the following behaviour
- Give enough liquid and stock collateral against your positions so that ones problem doesn’t spread to others
- Get a clear view of where your collateral is at any moment in time so that even if the regulator misses something, you don’t
- Trade only with the margins you have provided and don’t ask the broker for additional leverage that can create additional issues
- Regulators will ensure that what you see is what you get
- And finally, brokers need to have adequate cash flow and proprietary collaterals at any point of time commensurate with their level of business to ensure no major risk to overall system.
The intent is very simple and extremely sophisticated – most advanced countries do not have this level of disaggregation and India would be one of the first ones to achieve this landmark.
Having said that however, a large number of operational changes would need to be carried out to bring this entirely new system to life and including at the exchange level as well. For example, today when a position is taken by a client, it’s the members collateral that gets blocked and then immediately released and client collateral blocked. But now it would be the reverse. Or for that matter, the pledge and repledge processes would have to be more online instead of once a day so that client level collateral can be properly tracked. Bringing all the systems in sync is one challenge that is being overcome by brokers at this time.
However, since there are only two expiries left prior to this regulation going live, do plan your trades as well as deposits properly – keep approved collaterals to the maximum extent possible as unapproved collaterals may face hitches as its a massive burden on brokers to fund this. Keep diversified good quality portfolios at broker level and keep some extra cash handy – liquid mutual funds could be parked with your brokers instead of bank FDs as anyway its likely that these will yield better than Bank FDs.
Keep watching this space for more as we keep informing you on how things evolve and policies change over the next 45 days!
Meanwhile, do use this festive weekend to stay safe and also do drop us referrals of your friend who might want to open a trading account via https://www.plindia.com/clientreferral/ .