RISKS FACED BY BROKERAGES IN INDIA By Himanshu Kaji
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Disclaimer
This Presentation should not be regarded as or relied upon as being comprehensive or being equivalent to a formal legal opinion concerning any matter referred to in it. The Consultant has prepared it based on applicable regulations and accepted market practise, and the same should not be treated as a substitute for specific legal advice concerning individual situations or concerns. 2
Confidentiality
This presentation is being submitted under the condition that the contents of this presentation will not be divulged to any third party without the express written consent of the consultant.
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Principal Risks In Broking Business
Regulatory and Reputation Risk
Credit risk
Operational risk
Business risk 4
REGULATORY AND REPUTATION RISK
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Introduction
Broking- one of the most tightly regulated businesses in financial markets Regulations spread across Exchange bye-laws, Rules & Regulations, SCRA, SEBI Act, SEBI regulations, Depository Act, FEMA and circulars issued by exchanges, SEBI, MOF, RBI…. Some of these requirements are conflicting, out of date and vague Law has been used to micro-manage the intermediary’s operations thereby leading to increased risk of technical lapses Regulatory and reputation risk arises out of Brokerage’s inability to comply with many of these regulatory requirements The consequences of violation of various securities laws therefore define the regulatory and reputation risk 6
Consequences Penalties Under SCRA
Failure to: furnish documents/information to stock exchange (SE); maintain books; enter into client agreement as required by SE byelaws; redress investor grievances within time stipulated by SEBI or SE; (But see SEBI Stock broker Rules - Stock broker shall take adequate steps for redressal of grievances of the investors within 1 month.) Penalty: Rs. 1 lakh per day or Rs.1 crore, whichever is less.
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Penalties Under SCRA
Failure to segregate securities or moneys of clients or using client money for self or another client – Penalty < Rs. 1 crore. Failure to comply with SCRA, rules, bye-laws and regulations of SE where no specific penalty provided < Rs. 1 crore. In addition to penalty – contravention or attempt to contravene or abetment of contravention of SCRA or rules, bye-laws or regulations made there under, where separate penalty not provided for - imprisonment up to 10 years and / or fine up to Rs.25 crores.
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Broker Specific Penalties under SEBI Act
If a stock broker fails to issue contract notes in the specified form and manner - penalty not exceeding 5 times the amount for which the contract note was required to be issued; fails to deliver any security / make payment due to the investor in the specified manner / within the specified period - penalty of Rs.1 lakh for each day or Rs.1 crore, whichever is less. charges brokerage in excess of maximum specified penalty Rs.1 lakh or five times the amount of excess brokerage charged, whichever is higher. 9
Some of the most frequent violations observed
Dealing terminals situated at un-authorized places Incomplete KYCs or non-availability of KYCs Non-collection of margin for F&O trades Client order book not maintained in prescribed format Acknowledgment copies of contract notes are not obtained and preserved 10
Some of the most frequent violations observed (Cont.)
Receipt of shares and money from third party Non-segregation of client funds and misuse of client securities Funding of clients in violation of margin funding guidelines Aiding and abetting client in price manipulation 11
Areas of Regulatory Focus Going Forward…
Suitability of advice PMLA Insider trading FUTP (surveillance related) Applicability of cross-border laws
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CREDIT RISK
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Myth
As broking is : an agency business, it involves time bound payment schedules, regulations require business to be not conducted on credit
It should therefore face very little or no credit risk 14
Reality
However in reality credit risk is perceived to be the most critical risk faced by Indian brokerages especially Retail broking houses The factors responsible are:
Banking facilities have not kept pace with advances in capital markets Severe completion has led to dilution of standards Settlement is still not and can not be real time Market volatility leads to ever fluctuating asset prices 15
Challenges
Exchange risk management models are robust and stringent while broker risk management models are often lax and subjective Business is often run based on relationships where exceptions become rules and rules are followed only in exceptional circumstances Arithmetical rather then statistical approach to manage risk is still favored Variety of “free for all” funding products are made available to attract and retain clients that pose severe credit risk Proprietary positions are often not subjected to stringent risk management Insufficient use of technology to measure and monitor risk Many industry players still favor decentralized approach to manage risk rather then centralized approach
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OPERATIONAL RISK
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Introduction
Operational risk management is probably the most neglected area in the broking industry Industry has failed to realize the fact that efficient management of Operational risk leads to effective management of both Regulatory and Credit risks 18
What is lacking…
Most Industry players do not have comprehensive operational manuals These manuals if available are mostly outdated Training of staff in areas of Operational risk management is non-existent Technology is not used effectively and extensively to manage Operational risk Minimal resources are allocated for formal management of Operational risk 19
Conclusion
Management of Regulatory, Credit and Operational risks require substantial investment in terms of money, manpower and technology It also requires strong commitment from senior management Reputation and business risk arising as a result of poor management of these risks however more then justifies these investment requirements 20
Thank You
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