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Post Karvy, Sebi looks to impose limits on brokers

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Regulator examining if brokers should be barred from offering clearing servicesNSE has hired EY India to conduct a forensic analysis of Karvy’s trades to ascertain if there was diversion of funds

Mumbai: The Securities and Exchange Board of India (Sebi) is examining if brokers should be barred from offering clearing and settlement services, after the regulator found Karvy Stock Broking had illegally sold client stocks pledged to it for loans, two people directly aware of the matter said.

“We have been getting lots of complaints regarding defaults by brokers in payouts to clients. We are working on improving systems and processes with regard to handling of client money by brokers,” a Sebi official, one of the two people cited above, said on condition of anonymity. One of the policy changes that Sebi is considering is barring brokers from settling and clearing trades, the person said.

“There has been an increase in broker defaults in the past one year and it can leave the markets susceptible to systemic risk. In light of this, the regulator is considering that custody of client collateral, settlement and clearing of trades is managed by well capitalized bank custodians,” the second of the two people cited above said, requesting anonymity.

Sebi’s relook at the policy comes in the wake of its 22 November order banning Karvy from taking on new clients and executing trades. Karvy is alleged to have misused client securities for trades that were not authorized by clients. At an estimated ₹2,000 crore, it is one of the largest defaults by a stock broker in India.

“Sebi’s preventive order points out perhaps a need for policy change, especially the involvement of a stock broker in clearing and settlement process, and limiting it to facilitation of trading. Transferring client securities to prop account or pool account in any process needs to be avoided. Monthly online monitoring of unutilized clients’ funds/securities available with broker, by depositories, is desirable to avoid such instances,” said Sumit Agrawal, founding partner, RegStreet Law Advisors.

It is important for the regulator to put in place a foolproof system that would send an alert on real-time basis if a broker were to indulge in such shenanigans, said an analyst who did not want to be named. “It is the second instance in the last couple of years when such a crime has gone unnoticed till its full ramifications have unfolded. If you recollect, one of the brokers had sold off mutual funds units of a client totalling a few hundred crores lying in the depository account of that broker,” the person said.

Karvy Stock Broking manages accounts of 244,000 clients, according to National Stock Exchange of India (NSE) data. The matter first came to light when several investors complained to Sebi that Karvy was delaying their payouts. An annual inspection conducted by NSE also pointed to discrepancies in trading between 1 April 2016 and October 2019.

“Prima facie a net amount of ₹1,096 crore has been transferred by KSBL (Karvy Stock Broking Ltd) to its group company i.e. Karvy Realty Pvt. Ltd between from 1 April 2016 to 19 October 2019,” said Sebi in the order citing the NSE inspection report.

While Sebi is conducting an independent probe into Karvy, it is also relying on NSE as the primary investigator.

NSE has hired EY India Ltd to conduct a forensic analysis of the trades of Karvy to ascertain whether there was any diversion of funds, the second person cited above said.

Sebi’s interim directions preventing Karvy from taking on new clients, trading and settling trades on clients’ behalf pretty much bars Karvy’s operations as a broker. Karvy group services more than 70 million individual investors in various capacities, and provides investment services to over 600 corporate houses.

“The Sebi directive against Karvy bars the brokerage firm from executing and settling any trades on clients’ behalf. Even the trades that were executed on Friday cannot be settled by Karvy and depositories would need to monitor delivery for settlement of those trades,” said Anubhav Ghosh, partner, Law Point.

Brokerage firms’ business model for institutional and large traders is dependent on their ability to square off their positions. But considering Sebi’s restrictions on Karvy, it will not be able to do so.

This also spells trouble for banks which have a combined exposure of ₹1,415 crore to Karvy Stock Broking, according to documents uploaded on the Registrar of Companies website. Considering the firm’s operations have come to a standstill, the recovery of bank loans looks difficult.