Sucheta Dalal :Expedient solutions to market problems
Sucheta Dalal

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Expedient solutions to market problems  

Dec 5, 2005

Sebi needs to correct systemic deficiencies and build infrastructure to eliminate market abuse


As a junior reporter covering open outcry trading on the Bombay Stock Exchange (BSE) in the mid-1980s, I frequently heard a litany of complaints about share transfers and settlements.


It was a vicious cycle of share transfers being rejected by companies due to mismatched signatures, problems of tracing sellers long after they had signed a transfer deed and collected payment and the myriad problems arising out of blank transfer deeds that kept shares in circulation until the next book closure. It seemed so frustrating that I often wondered why anyone bothered to take physical share delivery at all.


A senior broker then let me into what was clearly an open secret: many brokers used a master forger to copy the sellers’ signature on to transfer deeds to solve their problem or extend the life of a blank transfer. The solution was simple and inexpensive, but dangerous and prone to enormous abuse. But it allowed brokers and investors to solve the problem and move on.


Last week, CB Bhave, chairman of the National Securities Depository Ltd (NSDL) went public with his unhappiness at India Bulls forcing investors to sign a power of attorney (POA), allowing the firm to operate their demat accounts. He was also disturbed at audit trails being blurred when shares were not being moved directly from broker pool accounts into investor accounts in violation of regulations.


A little probing reveals that asking investors to sign a Power of attorney has almost become an accepted market practice among large brokerage firms. And, many of the problems and abuses that are beginning to surface are all part of the process of adjusting to a system which refuses to take cognizance of real and practical difficulties of investors.


It is not as though the Securities and Exchange Board of India (Sebi) is unaware of the problem. Nearly a year ago, a senior Sebi executive openly conceded that the T+2 rolling settlement system was pure fiction (trade settled two days after the transaction) and it only appeared to function smo-othly because brokers completed the pay-in on behalf of investors and collected the money later.


Similarly, share depositories have allowed India to switch to a paperless trading system. But, the share transfer process still needs investors to fill in physical depository slips and deliver these to brokers within 24 hours after trade. This is easier said than done.


The choice of Depository Parti-cipants (DPs) is also limited. They continue to be expensive and hefty exit charges make it difficult for an investor to switch DPs. Sebi has only recently ordered the scrapping of exit charges, which were a disincentive to switching DPs or depositories. The problem of inadequate infrastructure is further exacerbated in smaller towns and cities with fewer DPs. So, the market found a solution by asking investors to issue a POA giving brokers access to their accounts or allowing brokers to hold blank DP slips on their behalf. Both alternatives are dangerous, but they offer a practical solution and the stock exchanges have turned a blind eye to this practice, so long as their settlements proceeded smoothly.


• The market has found dangerous solutions to investors’ practical problems

• There’s need to widen retail participation and check investor exploitation

• Sebi will have to lower demat fees and make both depository systems uniform


The system is now so loaded against the investor, that complaints are pushed into an arbitration process that goes against all investors who have signed a POA giving unconditional powers to the broker to operate their trade account.


POAs are usually conditional to opening demat accounts or are slipped into broker-client agreements. Even when there is no POA, the broker-client agreement itself is one-sided and has clauses that allow brokers to withhold investors shares or money or dispense with written notices and communication.


The problem gets more complex when finance companies affiliated to brokerage firms offer margin funding to investors. Here, interest rates are allegedly changed without notice and leveraged purchases are not transferred to client accounts but held in custody by the brokerage firm, allowing the broker to use these as a hedge in other trades in special pool accounts. These shares are often used by the firm or its employees to deliver against their own day trades that cannot be covered and are replaced later. But such practices only set the stage for a massive fraud when the market turns more volatile or suffers a long correction.


Sebi must realise that systemic deficiencies cannot be corrected by disciplinary action. While it must ensure that investors who have suffered because of broker mischief are properly compensated, the regulator needs to focus on correcting systemic deficiencies and building adequate infrastructure to eliminate market abuse.


This would require it to lower demat charges to ensure a wider geographical spread of depository participants. This is imperative to increasing retail investor participation in the stock market.


Interestingly, it was always anticipated that broker pool accounts may be susceptible to abuse by brokers in order to get out of sticky situation on account of proprietary trades. Curiously, it is the Bombay Stock Exchange that worried about such an eventuality and ensured that its own depository, the Central Depository Services (India) Ltd, transferred shares directly into broker accounts.


Sebi must consider whether both depositories must be made to adopt similar systems so that the possibility of investor exploitation is eliminated. Finally, Sebi must also seriously examine whether a T+2 rolling system, which forces intermediaries to seek dubious short-cuts, is really workable. And if it makes more sense to opt for a T+3 settlement that will carry along investors from smaller towns without being exploited by brokerage firms.


-- Sucheta Dalal