Home » Posts » General » Trading with other people’s money

Trading with other people’s money

March 10, 2021

Greed and the ill-conceived lure of quick money is the biggest enabler of trading activity in the markets. Those who trade constantly try finding ways to make more by increasing their trading capital. And those who don’t, lured by greed, are constantly seeking out someone to trade on their behalf or manage their money. 

Like everything else in life, higher rewards when trading usually carries higher risk. An important fact that people ignore is that the risk of losing capital always accompanies any asset that earns you more than Government securities or bank FDs. There is no risk-free trading. From my experience in the markets, less than 1% of active traders make more than bank FD returns in the long run. While this 1% is minuscule, the odds of succeeding in trading are similar to those who attempt businesses. 

Traders can increase their capital size by waiting out until their own capital becomes larger over time if they make profits. But as I said, greed is the enabler of trading. Most often, traders try to find shortcuts to make money faster, either by borrowing money or trading for others. Usually, the easier option is to get carried away by the short-term performance and borrow money or take a loan, hoping that trading profits will be higher than the cost of borrowing. But the odds of succeeding drop significantly when trading on borrowed money, thanks to the looming fear of debt. The other way is by trading with others’ money, commonly, for a fixed % of the asset under management as fees and/or profit-sharing. While the intent is always to profit, the odds are always stacked against this. Most traders lose money in the long run, which means most people who allocate capital to such traders also lose money. Over 80% of all complaints that get lodged with the regulator are for losses due to unauthorized trading. A large portion of these are customers who are sold to greed without understanding the risks properly, allocating capital to trading, and then trying to get back the capital in case of losses by complaining to the regulator. 

Over the last few decades, there have been constant amendments in regulations around managing others’ money. We keep getting this query on social media and TradingQ&A from traders on how to build a business of managing others’ money. This post will explain the legally permissible ways, the grey ways, and those that are black or not allowed under current regulations. 

The legally permissible ways are registering with SEBI as an AMC, PMS, AIF, or RIA. Below is an overview (and here is a document with more details). 

Asset management (AMC) license or setting up a Mutual fund

Mutual funds are the most popular vehicle to manage others’ money. But, setting up an AMC is extremely tough. The net worth requirement of Rs 50 crores is just a start. A mutual fund has clear guidelines on how a fund manager should construct the portfolio and doesn’t allow as much freedom. Limited leverage is allowed, but intraday trading isn’t. F&O can be used only to hedge. Since mutual funds are probably the most regulated equity product, you can accept customers who are willing to invest as little as Rs 100. Fees can be collected as a % of the asset under management. 

Portfolio management (PMS) license

Easier to set up when compared to an AMC. A net worth requirement of Rs 5 crores and flexibility in terms of portfolio construction. But this also means higher risk and hence can be offered only to customers who can invest at least Rs 50L. Leverage or intraday trading isn’t allowed, and F&O can be used only to hedge. Fees allowed as % of AUM or a % of profits. Unlike MFs and AIFs, PMS doesn’t allow you to pool funds from clients and hence requires customization, making it tougher to run operationally. 

Alternate investment fund (AIF Cat 3) or Hedge fund

Easier to set up as compared to an AMC and broadly left to the law of contracts. The minimum size to start a fund is Rs 20 crores. No rules around portfolio construction; can use F&O to speculate, leverage up to 1 time, intraday, and short selling are allowed. Since this carries a higher risk, the minimum investment amount that can be taken from customers is set at Rs 1 crore. Fees can be charged as a % of AUM or a % of profits. 

Registered investment adviser (RIA)

While the above three allow you to collect capital from customers and flexibility to collect fees from the AUM, the entry barrier is quite high. On the other hand, an RIA can only advise, and the customer is required to execute the trade. It is much easier to be an RIA compared to others. The networth requirement is Rs 5L, and you can advise any customer (no minimum AUM requirement). But an RIA cannot trade on behalf of the customer. The fees have to be collected separately from the customer, either as a fixed fee or as % of AUM. No profit-sharing is allowed. 

Expressing your views on individual stocks or market direction is allowed on social media or public platforms so long as you do not hold yourself out as an investment advisor. You will need to get yourself a license if you start collecting fees for advice or holding yourself out as one. RIA license if the advice is specifically tailored for an individual, and RA (Research analyst) if the same advice is given out to a group of people for a fee. 

The regulatory black and grey ways 

While the above are permitted ways to manage others’ money, there are alternative structures used for this; some of which are in a grey area (tough to enforce or a loophole around an existing regulation) and some that are black (not allowed under current regulations). Here are a few.

Trading by using client login credentials

A customer willingly shares login credentials to their trading account with a trader or adviser. There is usually a profit-sharing arrangement, and in some cases, the trader/adviser also guarantees to take up either the full or portion of any losses made. This kind of arrangement is not allowed as per regulations but almost impossible to enforce. As soon as the adviser collects a fee, they are required to register as an RIA. And as an RIA, you are not allowed to execute trades on behalf of the customer. This arrangement is exceedingly common. There are also many cases where customers actively seek out folks on social media who seem to be generating trading profits to manage their accounts. 

Using Broker/Sub-broker/AP – Client relationship

Traditionally, stockbrokers have also doubled up as advisers. The broker is exempted from RIA registration for any incidental advice as part of running the broking business. Somewhere along the way, some brokers also extended this advisory to start trading on behalf of the customers. Often, relationship managers working for brokers who have brokerage revenue targets have resorted to mis-selling using supposedly “low risk-high return” strategies to customers to meet their targets. This trading on behalf of customers is easier because brokers and their relationship managers have access to dealing terminals where orders can be placed without needing client login credentials. This type of arrangement usually doesn’t have profit sharing as brokers aren’t allowed to take any money apart from brokerage from the customer. But to earn, the account is churned, and brokerage revenue generated instead. And as you’d imagine, the more the churn, the higher the risk of losing money. 

Brokers acting as quasi wealth managers is not allowed as per regulations. This is also the main reason for several brokers going bankrupt in recent years by losing money while managing customers with large accounts, and to cover losses, using one client’s margins for another’s or for the broker’s own account, move securities between clients until it became impossible to hide due to the tightening regulations.

But, becoming a broker isn’t easy. Brokers can appoint franchisees or sub-broker or authorised persons (AP) to help expand their business. Many brokers also offer dealing terminals to franchisees to support the business introduced by them. Many of these franchisees use this access to dealing terminals to manage money. Earnings could be both as brokerage revenue generated and/or potentially profit sharing as well. 

This quasi wealth management without a license by relationship managers, brokers, or sub-brokers/APs trading on behalf of customers by promising a certain return has probably caused the maximum loss to customers historically. SEBI even removed the concept of sub-brokers as the main broker could easily pass on the buck to the sub-broker who had their own separate SEBI registration in case of complaints around unauthorised trading. Today a broker can only appoint an Authorised Person (AP), where the AP has no SEBI registration, and all liability from the AP falls on the broker.

FYI: At Zerodha, there is no relationship manager concept, no AP has been given dealing terminals, and no one who is on our payroll has any revenue targets. 

Setting up a company & trading on investors capital

A company or limited liability partnership (LLP) is created with those wanting their money to be managed being shareholders or partners. Their pooled funds are then used as trading capital. There are a couple of issues with this. 

Firstly, an LLP with the objective of investing or trading is not allowed, so people use an alternate objective to create the LLP. This is a clear violation of MCA (Ministry of Corporate Affairs) rules. In the case of a Private Limited or Public Limited company, if more than 50% of revenue comes from financial income (trading), then the company is required to get registered as an NBFC (Non-Banking Financial Corporation) with RBI. One way to avoid this NBFC registration is by becoming a stockbroker and registering with SEBI. Both these registrations come with their compliance requirements, and as a stockbroker, an added cost of having to run a full broking stack as the firm cannot rely on other brokers for trading. 

This could also be set up as a partnership firm to avoid the NBFC or SEBI registration requirement, but the issue with a partnership firm is that all partners have unlimited liability. In trading, where potentially there could be unlimited losses, partnership firms are not the right structure for investors.  

While running trading through a setup like this allows flexibility in trading and collecting fees, you can’t actively seek new investors in the business promising returns from trading the markets. This would qualify the entity to register as an AIF. Check this SEBI order (Page 14, Point ix) banning the entity and the promoters for actively seeking capital to be invested into the stock markets as an LLP (without AIF license). So at best, if you did create a company or partnership firm, this can be set up only with family (white or allowed) and friends (grey) as a proprietary trading firm (grey). But you can’t actively seek capital from outsiders to manage (black). 

Hopefully, you find this post useful. Do consult your chartered accountant or lawyer if you act based on anything mentioned in the post above. 

If you have any questions or comments, join the conversation on Trading Q&A

Best,

Founder & CEO @ Zerodha


Comments are closed.