Karvy scandal fallout: Brokers fear escalation of compliance costs

Market regulator Sebi is expected to further tighten regulatory framework for brokerages

Broking houses fear escalation in compliance costs as the Securities and Exchange Board of India (Sebi) is set to further tighten the regulatory framework in the aftermath of the Karvy scandal. The domestic broking industry has already been under pressure amid falling yields, drop in volumes, and rising costs because of technological and regulatory changes.

Market participants say smaller brokerages are likely to find it more challenging to absorb the spike in compliance costs. The number of brokers is already dwindling. From 5,899 in 2014-15, the number of brokers stood at 3,542, down 34 per cent, as of December 31, 2018, shows Sebi data.

“We could see more brokerages shutting shops with operating costs going up,” said a senior official of with a broking house. “In the past few years, the soaring cost of compliance has already pushed several brokerages out of the industry. In our case, we are now employing 30 people in our compliance team, with separate people employed for dealing room, account opening team.” Industry players said a lot of brokers used to make money from use of clients funds, however, Sebi has shut this route in June.

“For a small broker running a pure-play retail business, it is not possible to survive with so many costs. Pledging of client securities or earning interests on idle client funds used to be a source of income. However, Sebi and exchanges have become strict with regards to brokers going near client securities or funds. This could spell a death knell for the broking community dependent on this income,” he added. 

In November, Sebi barred Karvy Stock Broking for fraudulently transferring client securities worth Rs 2,300 crore to avail loans by pledging them as collateral. The broker is alleged to have use the funds raised for its other businesses, including real estate.  Other brokers including BMA Wealth have been charged for similar wrongdoings.

Market players said use of client securities is not an uncommon practise in broking industry.

“Many brokers used client’s funds and securities. However, most didn’t use it for adventurous plays like real estate. It was primarily used for meeting other client requirements or for arbitrage trading, which is considered to be risk-free. However, due to misdoings of some brokers, the entire community has to bear brunt of tighter regulations,” said a head of a small-sized broking firm.

Earlier in June, the market regulator issued a new set of guidelines for broking industry. These norms required brokers to unpledge all client securities by August 31, 2019. Also, brokerages are required to maintain separate accounts to clearly demarcate client securities from their own securities. 

“In the past, Sebi’s response to such frauds has been to draft new regulations. However, as can be seen from the Karvy episode, regulations alone are not enough in averting such cases,” said head of a brokerage, requesting anonymity.

On the other hand, some market participants are of the view that if regulator decides to take certain functions away from the brokerages pertaining to handling of securities, there could be some cost savings. Apart from compliance costs, the broking industry is also expected to face challenges in accessing funding as Karvy had allegedly placed client securities with banks to borrow funds. Following Sebi’s interim order last month, the National Securities Depository decided to transfer these securities back to clients, which wiped off the collateral held by these banks. 

Brokers fear most lenders are likely to be wary of lending to them after the Karvy incident. According to industry sources, banks are already reviewing their exposures to various broking houses, following what has transpired in the Karvy case. 

Sources add that banks are worried whether the collateral given to them genuinely belongs to the brokers or these are client securities. 

“If the latter are the beneficiaries, then banks will be again caught sleeping on the wheel as Sebi had directed for unpledging of all client securities, back in June,” said an official of a broking firm.