SEBI Watch: Client collateral safeguards in place, monitoring now key

2 Jun 2022

From May 2, a major gap in the client margin mechanism that enabled brokers to use excess funds or securities balance in one client to fund a shortfall in the account of another client was plugged. This is a substantial change.

Securities and Exchange Board of India announced this change along with others in a circular in July last year on client level collateral segregation and monitoring by brokers, clearing members and clearing corporations. It was initially scheduled to take effect from Dec 1 but market participants have got SEBI to postpone it.

After the Karvy Stock Broking fraud case came to light in 2019, the issue of client funds and securities misuse has become paramount for the regulators and market participants. The problem in the system was acute as many other cases of broker misappropriating client funds and securities came out in the open.

The underlying weakness in the mechanism of handling of client funds and securities by brokers and clearing corporations for margins and trade settlement purposes came as a shock to many.

But since then the capital market regulator has moved deftly and effected changes aimed at safeguarding client funds and shares.

The most important safeguard to have was that of one client’s funds and shares not getting misused to fund the shortfall in another client or the broker’s proprietary account.

At the same time, since mid-2020, the retail investor participation in cash and derivative markets has gone up exponentially and the need for changes became urgent.

It was leading to demand by some recalcitrant clients on brokers to take care of margin or other shortfalls in their accounts by any means possible. If the broker was not funding these shortfalls from its own funds or securities then it was dipping into funds or securities of other clients.

Broker proprietary account shortfalls also posed similar problems for the client funds and securities.

The changes that SEBI announced in July laid out in great detail on how the fund and securities collateral, including the recently introduced securities pledge and re-pledge for margins directly with the clearing corporation, will be handled at all stages from the client to the clearing corporation.

There is, since May, a strict bar o the broker from co-mingling client funds and securities with each other or with its proprietary account.

Now, if there is a margin or other shortfall in one client’s account, the broker will only be able to fund it from its own account and not accounts of other clients.

These much-needed safeguards are now in place, and credit goes to SEBI on persisting with the change.

But continuous monitoring by clearing corporations and SEBI will still be needed. They will have to be on guard against false allocation of client level margins provided by brokers to clearing corporation, and undue withdrawal of client allocation by brokers without intimation to the clients.

The markets will be safer only if adequate monitoring and enforcement happens.

Even before the Karvy scam took place, the principle of client funds and securities not getting misused by the broker was enshrined in the rules. But the underlying mechanisms were not foolproof to ensure that it was followed all the time.