Why the new SEBI circular on margins in cash segment won’t affect you

SEBI put this circular on November 19th 2019 which will be in effect from Jan 1st 2020. This got recently covered by press on how it is probably the worst thing that can happen to a retail trader. Various convoluted versions of what the press said is being shared on social media. So here is an explanation on why this circular is positive for the industry and won’t affect most retail traders. Let me start off with first explaining why SEBI may have put in this rule in place to collect margins from customers and report to exchanges.

Over the last couple of years, especially after the financial frauds at a few brokerage firms, SEBI has been working hard to fix a legacy issue of the broking industry which was a loophole that got misused by these firms. This was essentially a way to use one client’s balance (cash or margin from pledging securities) for another client trades, or by the brokerage firm itself.

We already had a rule in place for collecting and reporting margins in the derivative segments (Equity, Currency, & Commodity). All brokerage firms receive a file from the exchange at the end of the day detailing the margins required for positions taken by their clients (SPAN + Exposure). The brokerages are then required to upload back details of margins available in the client’s account. If the available margin is lesser than the exchange stipulated margin, a penalty  is levied on the shortfall. This reporting ensures that a client can take positions only to the extent of margin in the account.

This circular, issued earlier this year now disallows brokerage firms to pledge client securities to any third party, even if the client hasn’t paid the entire money to purchase the security. Even so that clients aren’t allowed to do an off-market transfer for a loan anymore, it can be done only by marking a pledge to an NBFC directly from client demat, and funds from pledge get credited directly to the client’s bank account. This has ensured that client securities can’t be mis-utilized by the brokerage firm.

The last fix needed was for the equity (cash) segment. The traditional practice of brokers allowing clients to buy stocks for delivery without asking for upfront margins still exists. A client is asked to remit the purchase through a cheque or online transfer after the execution of the purchase transaction. If the client takes longer than 2 days to remit, the broker earns additionally by charging interest on the debit balance. While this acts as an additional source of revenue for the broker, it increases the risk for the brokerage firm, as well as the capital market ecosystem as the stock price can go down and if no money/margin is collected from the client, the client could default.

The other issue here is that despite the fact that the client hasn’t paid for his purchase, a brokerage firm would still be required to pay the settlement obligation due to the exchange on T+2. The broker could potentially use unutilized credit balances belonging to other clients to fund such purchases of a different client. With this new circular of collecting and reporting margins for stocks, the equity (cash) segment becomes exactly like the derivative (F&O) segment. Instead of SPAN + Exposure, VaR+ELM margin  is required to either buy or sell stocks. This not only reduces the overall risk, but the reporting mechanism ensures that one client’s funds can’t be used by another client or the brokerage firm itself going forward.

How does life change for you?

Nothing changes at Zerodha, or at most online brokerage firms for that matter, since we have always asked for accounts to be funded before placing a purchase order. It will definitely change for people trading with traditional brokers where the practice was to pay money or deliver stocks only after taking a trade. Now they will have to maintain some margin with the broker (for purchase transactions) or transfer stocks to the broker in advance through DIS slips (for sale transactions).

Intraday trading?

Most online brokerage firms already charge margins to either buy or sell, so this practice will continue. What could change though is the intraday leverages provided by the firm. Check this exchange list  for the minimum VaR+ELM margin for various stocks. A stock like Reliance requires 12.5% margin which equates to 8 times leverage. However, since all margin reporting is done at the end of the day, a brokerage firm could potentially continue to offer higher intraday leverage. But the broker will have to do it from his own (clearing member) funds. This means that if a brokerage (clearing member) firm isn’t well-capitalised, they’ll be forced to reduce leverage for intraday trades.

Equity delivery based trades?

For buy delivery trades, the brokerage firm will have to now collect minimum VaR+ELM. So if clients got much higher leverage for this until now (Margin funded trades), it will be reduced to minimum VaR+ELM. Since currently at Zerodha, we insist on the entire delivery purchase value to be funded in advance, there’s no other requirement to bring in VaR+ELM. There could be stray cases where you may have bought a stock for Intraday and are forced to take delivery for any reason, in such cases, if you are short on the margins, a penalty will get levied for the shortfall amount.

For sell delivery trades, the brokerage firm continues to run the risk of the client not delivering the stock after selling. This can’t really happen in cases where the brokerage firm has the POA on demat to debit shares when the client sells a stock, as the firm can ensure the client can’t transfer stocks out. But wherever the brokerage firm doesn’t have the POA, they will have to collect margins before allowing clients to sell stocks to ensure that in case the client doesn’t deliver, there is margin available to make good of any potential auction settlement loss to the buyer.

Almost all online brokerage firms today have POA on demat, so ideally when selling shares, no margin will be required. But wherever POA is not there (all our new accounts are non-POA accounts and we will soon give an option for our POA accounts to switch to non-POA) the brokerage firm can do an early pay-in of securities to avoid needing to ask margin from the customer selling stocks from holdings. By early pay-in I mean, the broker can move shares from client demat to the exchanges on the same day instead of on the settlement day i.e T+2.

So yeah, the above circular will only clean up the system and will most likely make no difference to the life of any retail equity investor/trader.

Happy Trading,