Karvy ban shows India must get rid of dodgy brokers to back healthy equity

Any attempt at sweeping out a corner of India’s financial system means bringing investors face to face with creepy-crawlies. Disagreeable as the task is, it’s also necessary.

More than $200 billion in bad loans tumbled out when banks were made to open their attics to the regulatory broom four years ago. That cleanup isn’t over, and already it’s the stockbrokers’ turn. Who knows what will emerge?

Investors are waiting to find out after the Securities and Exchange Board of India, or Sebi, banned Karvy Stock Broking Ltd., a middleman for nearly 250,000 clients, from taking on new customers. The regulator said in its interim order that the broker may have helped itself to investors’ money and securities and diverted as much as $150 million to its real-estate business.

Karvy’s management has denied the charges and told employees that it can provide “necessary clarifications” to the regulator. The amounts involved aren’t large enough to cause system-wide panic. What worries market participants, however, is that they all know the practice that Sebi wants to uproot — commingling clients’ and broker assets — is rampant.

Unearthing bad behavior is a welcome first step. At stake is the integrity of markets, including sanctity of contracts and guaranteed settlement of trades. The authorities are keen that assets, where the underlying risk emanates in India, should be traded onshore, and not via derivatives in Singapore, Hong Kong or London.

However, when a foreign investor enters into an option trade in India, he could risk facing off against a broker who’s using stolen client securities as margin. If such trades are then annulled, the party that won the market bet feels cheated. That’s what happened to Citigroup Inc. earlier this year in a deal involving Allied Financial Services Pvt, a broker whose owner has since been charged by India’s economic offenses wing.

This case, which has been keenly followed even outside India, seems to have woken up the regulator.

India is hardly immune to the global trend of sliding fees and trading commissions. Unlike other places, market pressures haven’t led to the kind of brutal consolidation that should have taken place. Too many small, independent shops are still open for business even as their owners try to sell themselves to bigger intermediaries. Meanwhile, nearly a million active, mostly younger Indian traders have moved to the likes of Zerodha, an online broker that charges nothing for shares held for longer than a day and collects less than 30 cents on intraday and derivative orders. 

To mask the underlying problem of missing industry-wide profitability, some traditional brokers are boosting their proprietary trades — or extending leverage to customers — by dipping into clients’ funds. The Business Standard estimates it to be a Rs 100 billion rupee ($1.4 billion) problem with three dozen brokers under investigation. The true extent will only become clear as Sebi presses on with enforcement. The regulator read the riot act in June and said that from September clients’ securities couldn’t be pledged to raise funds by brokers even with their owners’ permission.

Now that Sebi has started the cleanup, it must take its broom to the dark crevices. Fundamentally, the regulator must ask if it’s safe to let so much client money and stock be entrusted to so many poorly capitalized brokerages just to make equity investing accessible to the wider public. Even the conduct of bigger intermediaries needs closer supervision. Derivative contracts have built-in leverage. When brokers lure day traders to these products by offering additional leverage for trades they must enter and exit in five minutes, they aren’t helping foster a healthy equity culture.Technology and economics have done their bit to nudge the industry toward a much-delayed consolidation. It’s time for the regulator to do its job, regardless of the unpleasantness that crawls out.