Karvy mess: How to curb misuse of client securities and fix loopholes

India has witnessed a number of defaults by brokers such as Fairwealth, BRH Wealth Kreators, Guiness and now Karvy Stock Broking. This has led to heavy losses for investors and customers in terms of money and morality. Hence, it was imperative to perform a root cause analysis in order to address such misuse of delicate fiduciary positions in the securities market. Delving on these causes is crucial as the regulator might take up these reforms and more to fix the loopholes in the times to come.

There are two causes of such defaults. The first is because it is not mandatory for brokers to disclose transactions with related parties to the exchanges and SEBI (except at MCA), even though it is mandatory to inform about their proprietary trading transactions.

Eventually, these transactions get unnoticed in the whole scheme of things where there is no concrete framework for their approval. Secondly, brokers resort to excessive or inappropriate leverage in order to trade in proprietary accounts and when things go bad, they sell client's shares without their consent.

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However, prop desks are now well regulated by the authorities after circulars on Enhanced Supervision dated September 26, 2016, and on Handling of Clients Securities by Trading Members dated June 20, 2019.

However, in several cases, brokers may still do trading through related party transactions that don't come under proprietary trading. Therefore, this is a misrepresentation of actual proprietary trading under the garb of related parties.

The malpractice puts a dent on the investor community's trust and confidence in the brokers. These issues can be controlled by several reforms which can be sub-divided into three categories - Governance reforms, financial reforms and disclosure reforms.

Firstly, broker entities should be made part of an ecosystem and rules akin to what SEBI has for listed companies and mutual funds, which is, having at least one independent director on the board. This will certainly help improve corporate governance by bringing about transparency and accountability among broker entities.

Secondly, there should be rules around a broker's capital adequacy requirement. In today's time, capital requirements are static and not dynamic with respect to the size of the business of a broking company. To take an example, if the net worth of a Depository Participant (DP) is less than Rs 10 crore, the total value of securities held can't exceed 90 times the net worth in DP's custody.

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In case the DP crossed this 90x threshold, they would go into freeze mode and would not be permitted to accept fresh accounts. While this can be considered a healthy practice, the same is not applicable to entities which have a net worth of more than Rs 10 crore. In that case, DPs can be custodians of securities disproportionate to their own net worth.

The ratio could go as high as 1000x or 1500x. Additionally, the net worth requirement for brokers hasn't been revised for the last 20 years compared to the same for mutual funds and portfolio management services. Therefore, this calls upon a relook.

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Thirdly, brokers should actively disclose any related party transactions carried by them with any associates/subsidiaries/others along with necessary disclosures about proprietary turnover and proprietary gains or losses at regular intervals to clients. Furthermore, brokers should mandatorily be made to disclose annual statements at least on their website for clients to know about their financial position.

These reforms, if introduced, will truly empower the clients to make an informed decision while choosing a broker or shift the broker immediately in case of red flags. However, regulations in India have evolved fast. With every crisis, markets have become more robust and transparent. Such situations may well be averted in future if related party transactions are adequately disclosed and ring-fenced. Tables have turned. If financial institutions emphasise on KYC (Know Your Customer), investors may empower themselves by doing a KYB (Know Your Broker).

(The author is Founder & CEO, Samco Securities)