Direct Market Access (DMA) for retail investors?

Negative news generally gets more views compared to happy news due to the Negativity Bias. Social media went berserk when the rumour broke out about the possibility of stock exchanges offering Direct Market Access (DMA) to retail customers without involving a brokerage firm, implying exchanges functioning as quasi brokers themselves. Several articles were published without understanding the market microstructure and its nuances. And to top it all off, the price of brokerage stocks went down, and exchange stocks went up on this rumour. I thought maybe someone from the industry should clarify, in layman’s terms, why it’s unlikely that the exchanges will deal with retail investors directly, at least in the near future.

Disclaimer: I have a conflict of interest in writing this. 🙂

Technology at Exchanges and the RMS

The core of an exchange is its matching engine — the technology that matches a buy order and a sell order against a bid and ask price to generate a trade. This trade price (LTP) and open orders are streamed to brokers who use this to feed their trading platforms (marketwatch, charts, etc.).

The hardest part of the capital market business though isn’t the matching engine but risk management. This entails ensuring that the person trading has sufficient funds to trade or cover any losses, or enough stocks to give delivery on a sell trade, etc. One question doing the rounds yesterday was “if UPI can do it for payments, why can’t there be a similar structure for trades at the exchanges?” Unlike UPI, where full money is taken from one customer and given to another, every single trade on the exchange carries a risk. Imagine UPI where payment apps or NPCI itself had to take a credit risk on every transaction, could UPI even exist in the current form?

The next logical question would be — what if this system is used only for trades where full money or full security is available in the customer’s account (stock delivery trades)? Well, over 99% of all exchange turnover is non-delivery margin trades—futures, options, and intraday stock—where full money or stock is not involved. However, even in the 1% where there is full money or stock available, there is still a risk. For example, an illiquid stock is trading at Rs. 100, and I place a market order to buy 1000 shares. Before the order is placed, the Risk Management System (RMS) validates if there is Rs. 1L in the account. But by the time order goes through the RMS and hits the exchange, the price may have changed to Rs. 103. The order now will get executed at 103 or Rs. 1.03L worth of stock bought with Rs. 1L in the account, resulting in a shortfall of Rs. 3000. This risk today is borne by the entity facilitating the trade, as the seller is owed Rs. 1.03L, i.e., the broker.

Now consider that you have to do risk management for millions of customers and take that risk on tens of millions of trades daily. And this is not just the risk with delivery trades illustrated above, but also the 99% leveraged trades where the risk is significantly higher by several orders of magnitude. So exchanges around the world delegate client-level risk management to brokers and don’t look at individual clients’ risk. So if Zerodha has 3 million customers, for NSE and BSE, Zerodha is just one entity who has kept funds on behalf of all the customers lying with them on which exchanges allow trading. If there is a client default, the onus is on the brokerage firm and not on the exchange. If exchanges as one large entity were to take such a risk, it would be systemic and put everyone participating in the markets at risk on an extremely volatile day (like in 2008). One fat-finger trade by a large trader could potentially bring down the entire exchange, and with it, all the people trading the market.

The exchanges manage risk in multiple ways. Firstly, to be a member of the exchange, the member/broker has to maintain security deposits, and qualify in terms of credentials. The exchanges then block all new orders from a broker if the total margin utilised is over 90% of what the broker has placed on the exchange. The exchange risk management software has to manage the risk of only a few thousand entities (brokers) instead of millions of customers directly.

So, I don’t know if regulators will allow exchanges to carry such a large systemic risk. Even if they do, I don’t think any exchange in the world has risk management technology that scales to millions of customers right now. It is like exchanges having millions of brokers registered directly with them. This technology has to be built first, which in itself is going to be a herculean task.

Here is an example – On April 20th, 2020, Crude Oil prices closed at a negative price. The brokerage industry in India lost upwards of Rs 330 crores in client defaults. If there were no brokerage firms, this loss of Rs 330 crores instead of being across multiple brokers would have been on Multi commodity exchange (MCX). While MCX has networth of over Rs 1500 crores, it may not be all in liquid instruments, hence meaning that this incident could have put the exchange and hence everyone else who trades on MCX at risk. Click here to read more on the incident. 

How does DMA currently work for institutions then?

There is a misconception that the current DMA available for institutions somehow gives them access to place orders directly on the exchange. This is incorrect. The order still goes through a broker’s Order Management System (OMS) and RMS. The only difference is that in DMA, no one at the broker’s RMS team or dealing team can modify or cancel any orders placed. If there is a risk management issue, the broker will have to call the institution and ask them to modify or cancel orders, exit positions, or add more funds.

Can this DMA which is currently offered only to institutions be made available to HNIs or large retail investors? It is possible, maybe something might be at work and also maybe what created the rumour, which led to what I think is fake news, and caused broking stocks to fall while exchange stocks rose. But, the current way of offering DMA to retail involves a brokerage firm.

Broking is complex. It is not just order placement

• The reason for the success of our business isn’t just allowing order placement on the exchange at low cost. It’s the user interface, user experience, all the different order types, charting, mobile and web apps, analytics, reporting, and more. For example, something that sounds as simple as calculating the “buy average” price of a stock holding factoring in FIFO, corporate actions, stocks which are transferred in and out, is a mammoth task.
• Stock markets are complex for retail investors. The broking industry has tens of thousands of people employed to help cater to customer queries. Even the most experienced traders have queries. For example, this frequently asked question on why a trade is executed but not visible on the chart. The query usually starts with the customer calling us frauds until he or she understands why.
• Checks to prevent money laundering, while onboarding and continuously
• Handling short delivery of stocks, when you buy stocks and don’t receive delivery.
• Handling fund transfers and withdrawals across millions of bank accounts.
• Handling the trade process, reconciling millions of trades daily, sending out contract notes, etc.
• And of course, never-ending non-critical customer requirements like 25 or 75 min candles, dark mode, trading from charts etc.
• And the list goes on.
• Can an exchange do all of this? In theory, it could. But could it do it efficiently at scale for millions of customers? Building each one of these processes can take a long time.

Exchange as a regulator; self-regulation?

Exchanges in India act as first-level regulators. That is, they monitor all brokerage firms and ensure they adhere to the prevalent rules and regulations, and also hear customer complaints and act as arbitrators. But, imagine exchanges themselves starting to directly deal with customers. Who is going to regulate the exchanges and who is going to handle grievances? This would not be possible without a complete change in the Indian capital market structure.

Stockbroking is an extremely complex business that carries infinite risk in terms of compliance, operations, and technology. Stock brokers mitigate risk which otherwise can be systemic. Stock broking isn’t just another middleman like in real estate or agriculture or selling mutual funds who can be easily replaced, if at all that is even possible.