[By Sahil Sachin Salve]
The author is a student of Maharashtra National Law Univeristy, Mumbai.
Introduction:
On June 5, 2024, SEBI issued a circular mandating that Clearing Corporations (CCs) directly credit securities to client demat accounts, effective October 14, 2024. Previously, SEBI had taken a significant step by discontinuing the use of pool accounts for mutual fund transactions from July 1, 2022. Initially, the direct payout into clients’ demat accounts was a voluntary practice but as per above circular from October 14, 2024 it will be mandatory for CCs to directly credit securities to client’s demat accounts. This move aims to enhance transparency and protect investors by ensuring that their securities are directly credited to their accounts, by passing intermediaries and reducing potential risks.
Such a new mechanism will replace the current practice where securities pass through broker pool accounts, which pose risks of misuse and lack transparency. The new mechanism aims to enhance investor protection, reduce misuse risks, and improve transparency. While it offers significant benefits like increased security and investor confidence, it also introduces challenges such as higher operational burdens, increased costs, and potential initial delays. Effective preparation and adaptation by stakeholders are crucial for a smooth transition.
Current Practice & Issues with current practice:
Currently, the payout process involves transferring securities from the seller to depositories, then from the depositories to the Clearing Corporation (CC), and finally, the CC credits the securities into the broker’s pool account. This pool account, however, poses significant risks. It contains the securities of all the broker’s clients, making it challenging to distinguish between client-owned and broker-owned securities.
If brokers face financial difficulties or insolvency, the pooled securities could be jeopardized, leaving clients uncertain about the status of their investments and weakening their trust in the brokerage system. This practice has led to severe issues in the past, one example of such misuse is the Karvy Demat Scam of 2019. In this case, brokers misused approximately Rs. 2300 crore of investor funds by pledging them to banks for their use, affecting over 95,000 clients.
To prevent such scams and enhance investor protection, SEBI has mandated a new regime. This new mechanism requires Stock Exchanges, CCs, and Depositories to establish the necessary procedures and regulations to ensure compliance. By doing so, SEBI aims to safeguard client securities and restore confidence in the financial markets.
New Mechanism:
SEBI has mandated that Trading Members (TMs) and Clearing Members (CMs) must now ensure the direct payout of securities to clients’ demat accounts via clearing corporations. This new rule effectively removes the broker’s pool account from the payout process, aiming to safeguard client securities and enhance transparency.
However, in some processes, the broker will still take part, for instance, “Funded stocks held by the TM/CM under the margin trading facility” must be handled differently. As per the amendment in the circular dated May 22, 2024, these funded stocks must be held by the TM/CM only through a pledge. These funded stocks, which are purchased with the financial assistance provided by the broker, must now be managed exclusively through a pledge system. This means that brokers are not allowed to retain full control over these securities; instead, they must be pledged as collateral to secure the loan provided for the purchase.
To ensure transparency and safeguard client assets, TMs and CMs are required to open a separate demat account named ‘Client Securities under Margin Funding Account’. This account is used solely for the purpose of margin funding, and no other transactions can take place within it. The separation of these securities from other accounts ensures that the client’s margin-funded stocks are clearly distinguished and protected from being mixed with other broker activities. Once a client purchases stocks using the margin trading facility, the securities are first transferred to the client’s demat account. From there, an auto-pledge is triggered, which means the stocks are automatically pledged in favour of the broker’s ‘Client Securities under Margin Funding Account’ without requiring specific instructions from the client. This pledge serves as collateral for the margin loan, ensuring the broker’s financial interest in the funded stocks while keeping the process seamless for the client. This new system enhances both operational efficiency and investor protection by keeping the broker’s involvement limited to secured pledges and reducing the risk of asset misuse.
Similarly, for unpaid securities (where the client has not paid in full), the procedure outlined in paragraph 45 of the May 22, 2024, circular will apply. The securities will be moved to the client’s demat account and will be automatically pledged under the reason “unpaid” to a distinct account named ‘Client Unpaid Securities Pledgee Account,’ which the TM/CM is required to establish.
The objective of these changes is to enhance operational efficiency and drastically reduce the risk of client securities being misused, which was a major concern in the old system where client and broker securities were pooled together. In the previous practice, brokers had control over pooled securities, creating risks of misuse, as seen in cases like the Karvy Demat Scam of 2019. SEBI’s new regime, by eliminating the need for broker pool accounts and directly crediting securities to client demat accounts, significantly strengthens investor protection. This mechanism not only prevents misappropriation of client assets but also restores and reinforces confidence in the financial markets.
Analysis of the New Securities Credit Mechanism:
Benefits of New Mechanism:
The new mechanism promises numerous benefits and enhanced protection for investors. By enabling the direct credit of securities to clients’ demat accounts, the risk of brokers misusing client securities is significantly reduced. Clients will have full control and visibility over their holdings, allowing them to track their investments accurately and reducing the likelihood of discrepancies. Separating client securities from broker-owned securities is crucial. This segregation prevents the mixing of assets and reduces the risk of brokers using client assets for unauthorized purposes such as leveraging or trading. This clear distinction between client and broker assets also aids in better risk management, ensuring that client assets are protected in the event of broker insolvency or financial difficulties.
Eliminating the pooling of securities and ensuring direct credit to client accounts is likely to boost investor confidence in the market. This increased confidence can attract more investors to participate in the securities market. Investors will benefit from having direct control over their securities without the need for intermediaries. This simplification makes managing and transferring securities more straightforward. The direct payout mechanism can streamline the settlement process, reducing the time and complexity involved in transferring securities from brokers to clients. This can help in achieving a speedy settlement process, potentially moving towards a T+0 settlement cycle, and promoting a more disciplined and ethical market environment.
Overall, while the transition to this new mechanism may present some initial challenges, its long-term benefits for investor protection, market transparency, and operational efficiency are substantial.
Difficulties in New Mechanism:
While this proposed mechanism is expected to be largely beneficial, some limitations are important to consider. The direct crediting process might increase the operational burden on Clearing Corporations (CCs), requiring them to handle a significantly higher number of individual transactions. This could lead to increased costs and necessitate enhanced infrastructure and systems to manage the volume efficiently. Consequently, investors might face higher transaction fees or service charges as CCs pass on the costs of upgrading systems and managing the increased transaction load. Additionally, the increased complexity and volume of transactions could lead to initial delays in the settlement process. Both brokers and investors might experience a steep learning curve while adapting to the new system. Brokers who previously managed the pooling of securities will need to adjust their processes, and investors may require additional guidance and support to understand the changes.
The transition to a new mechanism always carries the risk of systemic errors or issues. If the systems implemented by CCs are not robust enough, there could be mistakes in crediting securities to the correct demat accounts, leading to potential disputes and a loss of investor confidence. Brokers often use pooled securities to offer additional services or benefits to their clients, such as margin funding or lending against securities. Although the circular is clear about these services and allows brokers to use separate accounts for margin funding and automatic pledges for unpaid securities, it will be a daunting task for Stock Exchanges, Depositories, and CCs to develop appropriate systems and procedures for the smooth functioning of the new mechanism with the current infrastructure. By considering these potential disadvantages, stakeholders can better prepare for the transition and work towards mitigating any negative impacts.
Conclusion:
In conclusion, SEBI’s mandatory direct payout mechanism is a crucial step towards enhancing investor protection, reducing misuse risks, and improving transparency by eliminating broker pooling accounts. While the change offers significant advantages, such as bolstered security and investor confidence, it also brings challenges like increased operational burdens, costs, and potential initial delays. Looking ahead, the long-term outlook for this regulatory change is positive, as it can further strengthen market integrity. However, to ensure sustained success, stakeholders should explore technological advancements, streamline operational processes, and consider phased implementation to address the current system’s challenges more effectively.