The race to Zero – Can the Indian brokerage industry survive?

October 3, 2019
Rainmatter

October 1st, 2019 was quite eventful for the brokerage industry. In the US, Interactive Brokers introduced a“Lite” plan with no commissions, followed by Schwab, TD Ameritrade, E-Trade, and more. These firms were charging up to $7 per trade. Stock prices of most of the large brokerage firms dropped 10% to 30% in one day. These aren’t small stocks. The market cap of some of these firms is greater than three times the market cap of the entire Indian broking industry. The combined drop in market cap in these stocks was close to $15 billion dollars in the last couple of days!

10 years chart of US brokerage firms

In India, the new regulation that doesn’t allow brokerage firms to pledge client securities to an NBFC or any third party went live from 1st October. This means that brokerage firms who offered margin funding (allow clients to buy stocks for more money than what’s in their account, and charge interest for the shortfall) by keeping the unpaid securities in their own account, and in turn pledged it to another NBFC to raise funds, can’t do it anymore. So brokerage firms going forward can only lend to the extent of their own capital. This will cause more damage to most of the traditional brokerage firms than the pricing disruption Zerodha started.

Margin funding clients would not only generate more brokerage due to leverage but also pay an interest of between 18 to 24% on the additional funds used. For the brokerage, with stock as collateral, the broker could earlier borrow as much based on the collateral and at rates of around 10% since it is secured. Under the new regulation, not only will the cost of borrowing without a collateral go up, the maximum funding a broker can take will be limited by the profitability and size of the business. 

Over the last couple of days, news articles of US brokers going to 0 commissions have been forwarded to me by countless people, wanting to know my view on all of this and what happens if this happened in India as well. Over the last year, we have been working with a US partner to enable investing in US securities for Indians, and a result, I have spent significant time researching the markets there. With that, I think if this race does catch up in India, it will be a certain end for traditional brokers who rely mainly on retail broking for revenue, especially with the new limitation around margin funding. 

The reason US brokerage firms can withstand this 0-commission onslaught is because they have many more ways of earning compared to their Indian counterparts. 

Float Income

Idle balances lying in a trading account earns interest income for a brokerage firm. In India, due to quarterly settlement rules, brokerage firms are required to send back any unused balance back to the client’s bank account. This rule was brought in thanks to a handful of bad apples misusing client funds. This also hurts brokerage revenues indirectly. Clients having money in their trading accounts have a much higher chance of trading than when in the bank account. If you were to compare this to US brokerage firms, most have internal rules set saying that they will not send back any money to the client’s bank without a fresh KYC if there was inactivity for a quarter, the exact opposite to our quarterly settlement rule. What this has meant is that US brokerage firms earn billions of dollars on idle client float. When I speak to our US counterparts about the quarterly settlements, they are shocked to hear that such a rule exists in India and question how brokerage firms manage to survive. 

Payment for order flow

In India, all orders placed on a broker’s trading platform are sent to the exchanges in real-time for matching and fulfillment. Exchanges here earn by charging transaction fees on such orders. Contrary to this, in the US, exchanges’ main source of income is from selling data feed. So, to generate more transactions and better quality data, they offer rebates to brokerage firms to attract order flow. Typically exchanges have a maker-taker model, they pay rebates for providing liquidity (limit orders) and charge for taking away (market orders). For example Nasdaq will pay you 20 mils ($0.002) per share to post and charge 30 mils ($0.003) per share to remove liquidity.  Brokerage firms this way have another source of revenue. 

The crazy bit is that the order flow isn’t required to be sent to the exchanges at all. This can be sent to high-frequency trading firms or matched internally. These HFT firms, in turn, pay the brokerage firm rebate for all orders sent to them instead of the exchange, typically around 10 to 20 mils ($0.001 to $0.002 per share). This is not legal in India. The SEC (Securities and Exchange Commission, US capital markets regulator) mandates non-exchange matched trades to be executed at least at the National Best Bid and Best offer (NBBO) at that point, so client trades aren’t compromised. But HFT firms can make money by market-making with this order flow even within this tight range. For a retail client, this makes no difference at all if orders are matched at an exchange or sent to an HFT. According to my friends in the industry, Robinhood’s largest source of revenue is payment from selling order flows. The company is valued at $5 billion. 

Securities Lending

The structure of our depository system, like our payments system, is a newer and advanced system as compared to the US. This is mainly because India didn’t have a legacy when we went online in the 1990s. We have depositories like NSDL and CDSL where we hold Demat accounts that remain unaffected even if a brokerage firm goes into trouble. In the US all securities are essentially held in book or street name with the respective brokers, what they call a “books and records system”. This means the securities are all held by brokers. This also gives an opportunity for the brokerage firm in the US to be able to lend these securities to people looking to short stocks or borrow for various trading strategies and earn an additional source of income (Unlike India, borrowing stocks to short is extremely popular in the US). The earning potential for these stocks held by the broker is typically based on the number of people wanting to short the stock. For example, early this year when Marijuana stocks were moving wildly, there were periods of time where one could earn as much as 100% or more annualized returns just by lending these stocks. Regulations in the US does mandate the brokerages to share some of the lending fees with the person who owns the stock, but the entire thing is quite opaque to the customer. Most never get to know how much was earned. 

In India, brokers can’t lend securities as they sit in the clients’ Demat accounts with the depositories. Also, with the new set of regulations that came out on the 1st of Oct 2019, even securities bought by a customer that are unpaid for, cannot be pledged. 

India does have an SLB (Stock Lending and Borrowing) platform where clients can participate directly, and know the exact lending fees being earned. This platform sees very little activity today, but may grow over time. 

Support of the humongous advisory industry

A brokerage firm in India can grow its footprint either by hiring employees or through partners/authorized persons (AP). An AP introduces the client and then gets a certain share of the brokerage generated for as long as the client continues trading. While it is possible to add clients, the biggest issue is that most clients end up making mistakes, losing capital, and then turn inactive. To sustain and grow the business meaningfully in such conditions, a brokerage has to actively keep adding more clients. It is almost like being on a treadmill. If you were to look at the number of active direct equity investors in Indian capital markets, the growth in numbers has been abysmal. We have been stuck essentially at the same number of active investors for a long time.

 We as Zerodha have put in immense amounts of effort in building solid educational initiatives and tools that help clients take better trading decision. I don’t think this is enough. There is a need for a large professional advisory ecosystem like in the US. Advisors who have spent their entire professional lives learning the markets, who have much better odds of helping their clients survive volatility. This, according to me, has been one of the main reasons for the growth of capital markets in the US. Professional advisors who end up turning their investors into professionals. While we might be ahead of the US in terms of technology in the capital markets, but we are decades behind them when it comes to retail customers’ professionalism and understanding of capital markets. 

In India, historically, distributors of products have been advisors as well. Mutual fund distributors advising on mutual funds, brokers advising on stocks, insurance agents advising on insurance policies, and so on. Since the distributors also earned from the manufacturer, there is significant conflict of interest, and high yielding products get sold the most. SEBI has been taking the right steps by pushing the RIA (Registered Investment Advisors) business, who can only earn from advisory fees and not through distribution. Advisory fees that the client has agreed to pay upfront knowing there is no conflict of interest in the product being sold. But this hasn’t really taken off like it should have, mainly for one reason. 

In the US when a client agrees on advisory fees, there is a tripartite agreement with the broker which allows the advisor to send his invoice to the broker and have his fees collected from the client account with the broker. Let’s be honest, how many of us would make the effort of paying separately to the advisor every month or quarter? The advisor would have to spend crazy amounts of time and effort to get the fees. But in the US, the ability to collect fees easily guaranteeing cash flows, has spawned off an advisory business that has flourished, significantly helping the overall markets grow in size. Brokers in the US also earn a portion of the advisory fees collected.

Similarly, SEBI has to solve the problem of easy collection of advisory fees to help the ecosystem grow. For enough good-quality qualified professionals to look at advisory as a business, they should know that there is a way to build certainty in their cash flows to sustain. Until then, the Indian broking industry wouldn’t have the support of an advisory industry for introducing new customers, or retaining existing customers.  

The day SEBI comes up with a regulation that disallows brokerage firms to advice and place trades on behalf of customers, that would be the final nail in the coffin for the traditional brokerage industry. Most old school firms today survive only because they are being run as a quasi wealth-management firm using a brokerage license.

So, as things stand today, and for all the above reasons, I think if all brokerage firms in India like in the US did start dropping the price to 0, the industry in its current form will not be able to survive. At the current very shallow market size, I don’t think there is space for more than 3 to 4 zero cost brokerage firms to sustain. There will be dissolutions and forced consolidations. The current 500+ active retail brokerages might end up getting reduced to a fraction of that number. I think traditional firms have to stick to their core competency and build a business around advisory services, which gives them an option to charge more. We need such firms to grow the Indian capital market ecosystem as well.

Let us know if you want us to write about anything related to the world of investing and trading by posting in the comment section below. Here is a link to all the posts till now, and do check out https://rainmatter.com.

Best,

Nithin Kamath

CEO @ Zerodha and partnering startups through Rainmatter to help grow and improve the capital market ecosystem in India. Love playing poker, basketball, and guitar. @Nithin0dha on Twitter.

40 comments

  1. Abhishek says:

    Very informative article!

    Really glad to learn that Zerodha will soon allow Indian investors to invest in US-listed shares.

  2. Padmesh Badkar says:

    Very nice comparison.
    Zerodha is a benchmark for discount broking

  3. Ashish Kumar Gupta says:

    Sir this is only one part of story. I would like to further extend this line and say that with AI touching every field., Brokers will extinguish. No NEED OF THEM.Exchanges have smartly used brokers & their setup to acquire all the information about investors. Then making the settlement period smaller and smaller, brokers role & their services are reducing. Now combination of banks & exchanges will facilitate stock trading. Cost will reduce. Any mischief by broker gone.Banks will grow bigger by entering full fledged financial services. Technology will be state of the art. That will be the last day of broker species.

  4. Mohit Jindal says:

    Great article.
    Infact there should be more articles on exchange and broker practices around the world so that we as retail investors can learn more.

  5. Parag says:

    This is activism. This is not wrong. First fix the internal problems before the external ones. You provide a good service but not a reliable one .. your platform and tech fails on many crucial and other days .. fix that first bro

    • jeet says:

      dear if you not satisfied leave zerodha simple, why are you acting as chairman of zeordha.

    • Leo says:

      What according to you is a good service in all aspects, Zerodha over a period of 5 yrs has improved drastically by providing a good platform, products and technology. It is every adapting and evolving. There will be many glitches on the way, but cant take away the good work done by them.

  6. AD says:

    Why don’t Indian brokerage houses pay a small amount of interest to clients on ideal funds lying in the client account unlike US brokers. This will have more clients keep their cash in the brokerage account before quarter settlement.

  7. Omkar says:

    Zerodha is really doing great in broking industry with lowest brokerages. The streak and sensibull platforms are great for traders. And at last my question to Mr. Nithin Kamath, CEO (if he reads this message) why zerodha doesn’t provide margin in future segment, i mean to say that if you want to buy 1 lot of IBULHSGFIN FUT then you will be required margin based on your lot size and your stop loss points i.e, lot size 800 × stop loss of 3 = 2400, finally you will be required near about rs 2800 to buy 1 lot. Why I am asking this question because zerodha’s platform is best trading platform and if retail traders start getting margin like this in zerodha then it will be good for traders of future segment.

  8. Arjun Kalavadiya says:

    I think..this type of articles should be published on weekly or daily basis..mostly related to markets and sebi regulations and team should take interviews of successfull investors in indian stock market like..etnow,cnbc etc…just to provide better guidance to clients…and their money will not be wiped in the race of earning supernormal profits without having proper knowledge of markets.

  9. Ramesh Babu says:

    Very informative article sir. You are truly investor friendly. I should say except Zerodha no one else gives this kind of information. You as Zerodha always think about giving awareness to the customers. Hats off to you sir.

  10. Radhe says:

    I started with Zerodha in 2014 as a client and immediately within 3 months knew they would make it big. Then I visited Mumbai Andheri office in 2015, they had recently moved to that place, that time.

    Now since last few years Zerodha has started deployment of So called BROKERS where you need to just pay a measly amount to Zerodha and open a association with them. You give them clients by making them join Zerodha. In return Zerodha pays as high as 40% of the Brokerage amount. That means even if you lose or make money, your BROKER makes money and I have seen idiots like a friend who doesn’t have even 1% of knowledge of Stock Market making more than 1 lakh per month.

    I used to take classes and teach people how to make money by investing or trading. We used to get entire Brokerage from Zerodha if account was positive in 60 days. That entire motivation stuff has gone. I have written to Sebi about this kind of idiot things Zerodha, Upstox or any so called brokers have started since last 2 years.

    I am sure such things have to end no matter what…

    • Radhe, brokers also leverage partners to build on the business. At Zerodha we don’t allow partners to trade on anyone’s behalf, their role is limited to just introducing business to us. This type of partner program runs in every industry.

  11. B Singh says:

    Thanks for the very informative article. I would like to suggest that our market holidays be in tune with the US market, as I assume that it’s the largest. The disadvantage being that if there are any spikes in the prices upside or downside on the days the Indian market is closed, there would be huge losses/profits for the clients depending on their position, if it’s not hedged properly and many such inexperienced clients tend to loose huge amounts. So if the market is kept in tune with the other major market like the US, it would be good. Better still if common holidays are made applicable for all the global markets.

  12. Prithish says:

    Hi Nithin,

    Want to know your views on the subscription based services in Indian financial industry especially in wealth management. As you know, in US Charled Schwab has started. Will it work in India?

    • None of the standalone subscription-based services have taken off. This is like I have mentioned in the post a big problem – advisors not able to charge and collect easily. But yes, if a broker who owns the client and charges the subscription-based service, potentially it could work. But in this form, it has to be a broker initiative and not an advisor first initiative.

  13. Umesh Chandra Panda says:

    Very informative.Broker as advisor must be stopped by regulations.I have never earned even a rupee acting on the advice of broker and the coaxing does not stop. I am all with brokers collecting and paying independent advisor the agreed fee. zerodha has sufficiently subdued such brokers.

  14. vm says:

    is there any plan for foreign securities launch on zerodha platform?

  15. Raj says:

    Been waiting to invest into US equities since Nithin said on Reddit that they are working on this. Much excitement.

  16. D k shukla says:

    Excellent article . I want to.open account with seedha but not ae to do so. Can u help

  17. Anshul Shrivastava says:

    This is a very good article.This is a very sharp truth for investing world in India that not much of the population is exposed to investing.India considering itself as a emerging economy with a large middle class base should start a big campaign for awareness and training people to give skills relevant to the world of investing.

  18. Shamik says:

    You told what traditional brokers should do…..
    ALso do enlighten on what discount brokers should do if they would have to charge zero brokerage in future

  19. Vineet Patil says:

    I suppose cross currency trading (eg. GbpUsd, UsdJpy, UsdEur,GbpSgd) etc is not permitted in India yet there are brokerages like Tradeapro, TopicMarket, Metaquote etc who provide you login via MetaTrader application, take INR from you, convert it in USD and enable cross currency trading for you. Either you trade your self or they trade on your behalf and you have to share some revenue with them. Is this system considered as LEGAL in India?

  20. Joyabrata says:

    Amazed at the captivating view of a discount broking leadership going contrarian on itself at industry level.

    Hope we are not served with a ‘almost’ zero brokerage model in future.

    Time for someone to go from zero to a NEGATIVE broking model. If anyone can do it, only an Indian can do it. And someone with a NK as initials has definite edge.

  21. Chandu says:

    Informative. Thanks!.

    If Indian brokers really not earning on the idle amount in trading account then,
    Why any Indian brokers not providing margin against liquid mutual fund?Thus we earn liquid fund return and trade whenever we wish to. This will make effective utilization of idle money in trading account.

    • Interest can be earned only on money which is sitting idle, but like I have mentioned, the idle money gets sent back to the client bank account because of quarterly settlement. If the money is being used, then it is not idle. Btw, you can pledge liquid funds with us for margins.

  22. Vijay Punde says:

    Really well explained the boosters to the USA brokerage industry, as below:
    1. Float income
    2. Income from order flow for the HFTs
    3. Securities lending etc.

    I hope it happens in India sooner. And when it does, there will be a real cut throat competition in between the brokerage firms, in terms of real zero brokerage for all types of trading and even rebates for frequent traders.

    Very good article, must read.
    👍👍😇🙏🏻

  23. Maneesh Gupta says:

    I request you to post an Article on CFD’s… How they work through out the world…. Can they be an option in India any time soon… Can Broking firms create a new business in the form of CFD providers.

  24. Amardeep Chadha says:

    I am a Fee only SEBI Registered Investment Advisor based out of Delhi.

    Towards the end of the article , you mention the need of a mechanism where the Advisor can raise a fees bill to the broker and broker and the fees is collected from the client and paid to the Advisor.

    That mechanism currently exists. SEBI permits LPOA for debit of fees.We’re currently working with Ifast Financial , Mumbai and have a LOE and Fees schedule signed.

    It’s a big opportunity but as adoption is low, very few are in the platform business made for Advisors. Wish more people like Zerodha can venture into the nascent market.

  25. Sundeep says:

    Hi Nithin,

    Have you ever considered providing Wealth Management Platform for Advisors as is popularly done by US Brokerages ? Shouldn’t be too difficult as you appear to be almost there already, except for a few practice management modules for Advisors. This platform would provide a huge boost to the Advisory business that you refer to in your post, because currently most Advisors would struggle with their practice management tasks, including billing challenges.

  26. Sagar Jain says:

    Nithin sir, thank you for writing this really nice article. I like the title “The race to zero…” 🙂

    Can you please also write about why we don’t get margin benefit in India for selling covered calls and trading defined risk option selling strategies?

    I don’t think technology is a problem for Zerodha to implement this.

    Thank you!

    • About covered calls, to consider the stock holding as margin, the stock should be lying with the broker. Like I have mentioned above, in India unlike the US, the stocks sit in the client beneficiary account. Btw, you can pledge these stocks and take margin for writing covered calls. This is possible with us.
      Margin benefit for hedged position is determined by the exchange/SEBI and not us. There is hope that soon it will get reduced from what is currently asked for. But not in our control again.

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