Client funds: Are brokerage houses exploiting new SEBI rule?

Mr Mohan is a long-term equity investor and, to make his transactions, he has a ‘three-in-one account’ with a bank, broker, and depository participant. There is a tie up among the three i.e., bank, brokerage house, and depository participant, and he has been provided with online access to trade.

His trades are executed by the broking house and his bank account is credited and debited for the sales and purchases he is executing. His holdings are maintained in the demat account by the depository participant. His demat account will be credited and debited for the securities purchased and sold.

On November 3, he wanted to buy some shares through the National Stock Exchange and placed his orders with a limit-price. The system promptly earmarked the required funds from his bank account. At the end of the day, as the market price had not come to the level of his order-price, the purchase order was not executed.

He noticed that the earmarked funds had been debited to his bank account, which were re-credited to his account only on the next market working day, i.e., on November 5. He wondered why his bank account should be debited and he should be deprived of his funds for two days for a purchase order that had not been executed.

Upon inquiry, he came to know that brokerage houses nowadays follow a system called “up-streaming” and “down-streaming” of funds. In the earlier system, his account would be debited only for the purchase orders executed and not for those not executed. For the unexecuted orders, the earmarked funds would be simply reversed to the bank account.

New system of up-streaming

But there seemed to be something missing in the system, which has been changed now. By its circular (SEBI/HO/MIRSD/MIRSD-PoD-1/P/CIR/2023/84) dated June 8, 2023, the Securities Exchange Board of India (SEBI) has introduced the system of up-streaming of all client funds.

According to SEBI, the system has been introduced to safeguard clients’ funds placed with stock brokers/clearing members (SBs/CMs). As per this direction, SBs/CMs cannot retain client funds on an end-of-day (EoD) basis. All client funds received by SBs/CMs must be up-streamed to the clearing corporations (CCs) — only in the form of cash, lien, on FDR (subject to certain conditions), or pledge of units of Mutual Fund Overnight Schemes (MFOS).

Generally, brokerage houses allow purchase orders based on actual funds transferred to them or based on some Fixed Deposit over which lien is marked, or against the pledge of mutual fund units. The up-streaming system applies only in the case of actual funds transfer (cash advance).

The following are the key provisions of this new direction:

- This up-streaming is applicable to client funds with SBs and CMs and not for FDRs linked and MFOS.

- Funds received by SBs on a given day shall be transferred to CMs and by CMs to the CCs anytime during the day but not later than the respective cut-off times.

Cut-off times

- CCs will decide the CMs’ up-streaming cut-off time. But it cannot be earlier than 6 pm.

- CMs will decide SBs’ up-streaming cut-off time. But it has to be within an hour before the CM’s up-streaming cut-off time.

Assume that the CMs’ cut-off time is 6 pm. Therefore, the SBs’ cut-off time cannot be before 5 pm.

Misuse of powers

The market functions up to 3.30 pm. Therefore, the SB has ample time to return the funds to the client for the unexecuted orders. So why should the funds be transferred to a CM/CC? Why should the investor forego his interest on the funds for the intervening days.

When a buy-order is pending execution, it may be a contingent liability and hence there is a need to maintain required funds. But when the market hours are over without the order being executed, there is no liability or contingent liability, and transferring the clients’ funds to the CC is simply a misuse of the powers delegated.

It remains to be seen whether the SEBI studies the ground situation and safeguards the interest of investors.

(The writer is a retired banker. The views expressed here are his own, and do not constitute investment advice.)