How will it work?

The Securities and Exchange Board of India's initiative to have mandatory ratings for stock brokers is, at first glance, likely to be welcomed by investors.

Like any other financial intermediary, brokers too deal with the funds of the investing public, and they owe a fiduciary duty to their clients. It's important, therefore, that there's a mechanism that tells a prospective investor about the track record of the broker, his credibility, his distribution reach, his standard of customer service, his commission and how he is ranked on these parameters compared to other brokerages.

It's also important to know the net worth of a broker and the amount of business he handles, since any default would lead to considerable delay in obtaining redress, in spite of the transaction being guaranteed.

There is no doubt that an easily available, ready-made comparison of various brokers on parameters such as transparency, services provided, quality of advice offered and the diligence with which customers' orders are processed would help investors.

But while the concept of rating brokers is attractive in theory, it bristles with difficulties in practice. To be sure, stockbrokers deal with their clients' funds, but then so do bankers, insurance companies, mutual funds and even non-banking financial companies.

It's important to realise that rating agencies assign ratings to credit instruments and not to the companies issuing those instruments, and they deal with the limited issue of the likelihood of the repayment of that instrument. Even within that limited ambit, credit rating agencies have gone horribly wrong on companies ranging from CRB Capital to Enron, which makes their performance on the much broader parameters on which stockbrokers will be judged worrisome.

As a matter of fact, brokers are of many different types, and comparing them on a single set of parameters could well be like comparing apples with oranges. Some brokers have a predominantly institutional clientele, and while their standards may be very high, they may not like to take on the headache of dealing with many retail clients.

Some brokers may prefer non-residents, or high net worth clients, some may offer detailed research, others may concentrate on primary issues, while some may be online no-frills brokerages. Some investors may have longstanding relationships with their brokers. The difficulties of putting all these on a common rating platform are obvious.

Further, while there's no doubt that a broker's net worth is important, there are rules governing minimum net worth and the amount of business that a broker can do, rules which are enforced by the market regulator. Nor is it clear how a rating of customer service can be made without being subjective. At best, perhaps, attention can be drawn to the number of investors' complaints about a particular broker, but that can be only a part of the story.

In short, while investors do need more information on brokers, a rating may not be the best way to provide that information, and making such ratings mandatory is hardly the route to follow when so many other ratings are voluntary and left to the market to sort out.

More upfront disclosure on several of the key parameters may in fact be enough to address the underlying issue of investor education.