Regulatory changes from 2nd May: Segregation of client collateral

SEBI turned 30 years old on the 12th of April, and the number of regulatory changes they have instituted in the broking industry in the last 3 years must be more than the combined total done in the previous 27 years! While it has been quite painful operationally for the industry to implement the slew of changes, almost every single one of the big regulations will probably help our capital markets in the long run.

On 2nd May 2022, a new regulation on the segregation of client collateral (PDF), perhaps the most impactful change in the last few years, went live. While this regulation does not affect your trading experience with Zerodha, this post describes the mammoth changes that are being implemented behind the scenes. Thanks to its impact on the broking industry, these regulations are bound to make big headlines in the media.

That said, with these regulations, India seems to be one of the safest markets in the world when it comes to not only systemic risk, but the risk for retail investors in trading and dealing with brokerage firms.

Background 

The brokerage industry in India is marred with legacy issues of several brokers defrauding customers, which has served as the main impetus for the many big regulatory changes over the last few years. Most changes have been around ensuring that brokerage firms can’t take excessive risks and misuse client funds or securities. A few examples:  

• Brokers first collect funds from customers which get pooled, allowing client transactions on the exchanges. While unused customer funds could sit in the broker’s pool accounts indefinitely until 2009 when quarterly settlement of funds was introduced, SEBI recently mandated that any unused funds be returned back to the customer’s bank account within 30 days.
  
• When a broker’s customers buy stocks or securities, exchanges credit them in bulk to the broker’s demat pool account in T+2 days, after which the broker splits the bulk units and credits them to individual customer’s demat accounts. This is now monitored and reconciled actively by the exchanges, where as previously, there was no direct supervision. If a customer has paid for the stock fully with their own funds and the broker has not funded the purchase, brokers are disallowed from keeping those units in their own pool account, warranting immediate settlement to the customer’s demat account.
  
• When a customer sells stocks from their holdings, earlier, a broker would debit stocks from the customer’s demat account and move the units to the broker’s demat pool account, before settling with the exchanges at the end of the day. New regulations remove this intermediate step of having to move securities to the broker’s pool account and instead enable settlement with the exchanges directly. The industry has also slowly transitioned away from seeking a blanket Power of Attorney (PoA) from clients to debit stocks from demat for sell transactions. Instead, the depository eDIS system authenticates demat debits via an OTP directly with the customer when they sell stocks, almost like a bank transaction.

Transferring back unused funds in the trading account regularly, and disallowing brokers from holding client stocks in the broker pool accounts, are regulations unique to India. In many markets including the US, a brokerage firm can almost act like a bank, not only holding idle funds and securities but also using them to lend to others. See this post for more context on this. 

While brokerage firms cannot utilise any unused client funds, it was still possible to use one customer’s balance to fund another customer’s trading as all funds were pooled with the exchanges until recently. Here is an example of how most brokerage firms could offer additional intraday leverages until it got removed last year. 

Assume a stock has VAR+ELM margin of 20% (the minimum that the exchanges ask for any equity trade). Say a broker asked for only 1% margin for intraday trades from the customer for this stock. The broker would still need to put up the remaining 19% with the clearing corporation when the customer took the trade. A brokerage firm could potentially place the additional 19% margin from the unused pooled client funds. This is how additional intraday leverages or funding was provided by almost all brokers without any cost until it was disallowed by regulations last year. 

As you can imagine, there are huge risks in offering untethered leverage to one set of customers using funds from another set of customer’s. If a customer who trades loses more than the capital available in the account on a volatile day and if the brokerage firm, in turn, does not have sufficient funds to settle the customer losses with the exchanges, the risk gets transferred to the other unwitting customers of the broker. This is similar to how a bank with large bad debts can affect all the customers holding any deposits. This systemic risk got addressed last year when SEBI removed all additional intraday leverages that brokers could offer. Today, a customer needs to have the minimum margin stipulated by regulations before taking a trade. And, brokers are not allowed to fund additional margins neither with the funds pooled from other clients, nor with their own capital.

While this addressed the big systemic risk of one customer’s funds getting used to fund another’s trades, there were still scenarios where similar things could happen. SEBI categorically did not want one customer’s funds being used for anything at all except for funding their own trades, paving the way to the new regulation of segregation of client collateral, which went live on 2nd May 2022. 

The Clearing Corporation (CC) sends emails and SMS to clients to comply with the SEBI guidelines (WEB). As per the regulations, stockbrokers are required to allocate client funds segment-wise with the CC. This means that the balance maintained with Zerodha will be segregated and allocated segment-wise depending on the trades and margin utilisation. The clients are not required to take any action because the email and SMS are sent only to inform them of their segment-wise allocation.

Scenarios addressed by the new regulations

• When a customer sells a stock from their holdings, a VAR+ELM margin is charged until the stock is debited from their demat account and delivered to the exchanges. The margin is charged because there is a risk of the client not being able to deliver the stocks they sold (short delivery). Brokers typically settle these deliveries early with the exchanges so that the margin requirements are removed.
  
  However, until the settlement is done, which could be at the end of a trading day, the margin required by the pending settlements has to be provided by the customer or funded by the broker. If a customer with no cash balance is allowed to sell stocks from their holdings (which all brokers do), the resulting margin on such trades have to be funded by the broker until the stocks are settled with the exchanges. If a broker was not adequately capitalized with their own money to fund these requirements, it was still possible to fund the trades for a short period using funds from other clients. However, the new regulation stops this. If a broker allows a customer to sell stocks without collecting the required VAR+ELM margins upfront, they have to fund the margin requirements from their own capital.
  
• When a customer sells a stock, brokers typically (instantly) allow up to 80% of funds from the proceeds to be used for buying more stocks or for derivative trades, even though the proceeds come to the broker from the exchanges on T+2 day.
  
  So, not only is VAR+ELM required to sell the stock as explained earlier, an additional VAR+ELM is required to buy stocks or appropriate margins for new derivative trades taken from the value of stock sold immediately. If a customer sells stocks without any funds and uses the credit from the stock sold to buy other stock or trade F&O, margins are applied twice. Going forward, this has to be funded by a broker’s own capital.
• When a customer pledges their stocks for margins to use the proceeds to trade derivatives, a collateral ratio of 1:1 needs to be maintained. That is, for an F&O position, 50% of the margin has to be provided in cash, while the remaining 50% can come from the collateral from the pledge. Even if a customer has sufficient collateral margins to take the position but not enough cash margin, the cash component now has to be funded by the broker’s own capital.
  
• When a customer transfers money to their trading account using a payment gateway, the funds don’t get settled into the broker’s pool bank account immediately and can take up to T+1 days. However, the funds reflect in the customer’s trading account instantly, giving them margins to trade. This now has to be funded by the broker’s own capital.
  
• Most brokers allow funds in a customer’s trading account to be used for trades across equity, F&O, and currency. Going forward, a broker has to allocate margins per segment for every customer at the clearing corporations. If a customer trades in a segment where margins are not allocated, the broker has to fund the difference.
  
  For example, if a client has Rs 1 lakh and if the broker allocates Rs 50k each to equity and F&O at the clearing corporation, and the customer decides to take F&O positions worth Rs 1 lakh, the broker has to fund Rs 50k to this customer from their own capital until the allocation is readjusted at the clearing corporation.
  
• Until now, exchanges put brokers in a Risk Reduction Mode (RRM) when the total margin utilised by a broker exceeds 90% of the total margin available across all their customers. In this mode, exchanges block all new trades at the broker while only allowing exiting of existing positions. Going forward, RRM will be applied at a client level.
  
  That is, if a customer with Rs 1lk takes positions worth the entire Rs 1lk, Rs 10,000 gets blocked from the broker’s own capital. A broker has to now either disallow customers from trading for more than 90% of the available margins, or fund the additional 10% requirement from their own capital. 

These changes that went live on 2nd May 2022 could mean that some brokers who are not adequately capitalised may be forced to change the trading and investing experience they offer to customers, affecting multiple trading scenarios as described above.

Impact on the broking industry

The new requirement of ensuring higher capital based on the size of the business acts similarly to the cash reserve ratio stipulated for banks. Although the changes went live on 2nd May, there is a three month grace period to comply with the new requirements.

While there may not be changes that are noticed immediately, the working capital requirement for the broking industry is going to go up significantly starting 1st August 2022. While logically, this indicates a potential increase in brokerage charges, the current competitive pressure in the industry combined with the bull run may stave it off for a while. Traditionally, the industry charged a percentage brokerage for covering the costs of funding. In a flat fee or zero brokerage for equity delivery model, allocating higher working capital is going to be a significant added cost to brokers.

Brokers who are well-capitalized will be able to continue to offer the same trading and investing experience as before, while brokers who aren’t, will be forced to start enforcing certain restrictions on their trading platforms.

Does anything change at Zerodha? 

No, nothing changes. Over the last 12 years, we have grown slowly, steadily, profitably, and debt-free. Our networth has increased with the growth in the business. We have never had to use one customer’s funds to fund another customer thanks to our approach of being very conservative with the additional intraday leverages we offered, even when high leverage was the norm in the industry.

Today, Zerodha’s own capital is more than 10% of the total customer funds, which probably is amongst the highest in the industry. It is adequate to cover the scenarios described above, ensuring that there is no change to the trading and investing experience.

Hopefully, this post conveys the depth and the impact of the new regulations. If you have any questions, do post them below.