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Commentary

Karvy: What Went Wrong and What To Do Next

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We’ve recently had a podcast about this (Click here to read) But there’s more to it, and here’s a deeper take on it.

The recent Karvy Stock Broking Limited (KSBL) episode means: Can we trust the stock brokers? Times were different when Harshad Mehta and Ketan Parekh scams happened. After that SEBI has tried to continuously append the existing laws and try to plug loopholes. Even with all the regulations in place, SEBI has hardly any mechanism to detect early warning signs from fraudulent brokers.

In cases of Karvy, the story is not yet out. It is a case of taking out money by pledging client’s securities. So how did Karvy manage to do it without getting caught by SEBI? Before getting to know how, we need to understand certain terminologies associated with the broking business.

Depository:

You don’t own shares in “physical” form anymore. There used to be share certificates. Printed on heavy paper. Now, it’s all electronic, and the records are in electronic India-wide depositories.

In India there are two depositories viz National Security Depository Limited (NSDL) and Central Depository Services Limited (CDSL). These two depositories are responsible for maintaining the security holdings – stocks, bonds, mutual funds and what not. For instance you have two different brokers and both of them are mapped to NSDL, then you can directly view all you holding at NSDL. Typically all your securities which are paid in full will be reflecting at NSDL post 2 days of buy. In case of sells, It will reflect immediately next day. In most cases NSDL or CDSL sends a SMS when securities are sold, so you are aware.

Pool Account

Most stock brokers will have a pool account. The pool account consists the securities of clients with the following criteria.

  1. Clients who have bought shares using margins and not yet paid for the same. (“Unpaid Securities”)
  2. The securities bought by clients but not yet transferred to their demat. When you buy, the clearing corporation sends shares to the broker pool, which the broker must transfer to the client’s demat. Some brokers do it very fast. Others take their time.

Trading/Clearing Member:

Trading and clearing members are two separate entities. In Indian context most brokers perform the dual functionality of trading/clearing member. Trading members are the  one responsible for execution of trades for clients and clearing members are the one who settle the trades. In case of Karvy it is both trading/clearing member.

Power of Attorney:

All the brokers nowadays take power of attorney of client while onboarding. Power of attorney helps brokers in moving your securities from your demat to pool account and vice-versa. In absence of a power of attorney each transaction must be manually signed by client (through a depository instruction slip) and given to depository or exchange to move the securities in and out. If you are unable to submit the signed slip within one day of your trade then default happens. If you don’t give a power of attorney, most online brokers won’t allow you to sell.

What Went Wrong Inside Karvy?

There have been lot of regulations by SEBI for broking business. In Karvy’s it was found to be a breach of regulations and misreporting of accounts. The whole story centres around misuse of pool account and pledging of client shares. How did Karvy manage to pull this off goes as below:

  • Every time you buy a security (fully paid, without using margins) the security should automatically come to your depository after T+2 (read as “Trading + 2 days”) days. In case of short sell from opposite party the time period will extend. Once the trade is settled it the security should be transferred to your demat account (with NSDL/CDSL)
  • In case you have taken margins (essentially, borrowed money) and bought the security, your security will be held in pool account of broker rather than your depository. The client needs to pay up for the margins in next five days or else the broker will automatically sell the securities and debit/credit the difference to the client. If its a fully paid security, then broker needs to transfer the security to depository within one working day of receiving the security.
  • Brokers would offer margining like this: Brokers usually take a loan by pledging the securities at say 10-12% from NBFCs and then provide margins for five days (typically Monday-Friday) at 18% to clients.
  • For example, you are holding Rs 10 lakh worth of securities. You want to buy another Rs 1 lakh worth of securities for a holding period of 4-5 days. Then your Rs 10 lakh worth of securities are pledged to give you a margin of Rs 1,00,000. Assume the security went up by by 2%. You will be making Rs 2,000 from the investment. Out of which you need to pay Rs 250 as interest on margins to broker. If it went down by 2%. Then broker will end up selling your pledged shares and recover Rs. 2250 (or you can pay up in cash)
  • Karvy altogether had a different process. Karvy didn’t move the fully paid security to depository. You had to ask them to move it to depository. That’s the reason some of Karvy’s clients received dividends reflected at broker level rather than at their bank account.
  • Furthermore these pool account of securities (a mix of fully paid and partially paid securities) were used to pledge and raise money. Technically the money raised from pledging pool account should be used towards client margin funding only. (In fact, from October 1, the pool account can’t even be pledged – they have to move securities to a special account called client margin account, and pledge that instead)
  • To raise money to fund its other ventures, Karvy had to increase its valuations of pool account. So Karvy by default didn’t move client purchase of security to depository, rather held it in pool account and would give it back to client whenever he does a transaction (like selling it).
  • Even SEBI was unable to track the pool account as it was mix of both unpaid/partially paid and fully paid securities. It didn’t have a name on which client it belongs. Karvy could have managed to always maintain it to say all of them are partially paid/unpaid.
  • After multiple complaints. SEBI asked Karvy to adhere to regulations regarding to pool account. Post 2018, Karvy started a different process to bypass the regulations of pool account.
  • Karvy created a quasi-pool account (which actually is client account used as pool account) and started to move some of fully paid securities to this account. The NSDL/CSDL permitted this as Karvy had power of attorney of clients. In most cases clients didn’t come to know about this as securities were reflecting their account at Karvy’s online platform and Karvy was settling the securities in case of any transaction. Just that securities were not there in their own demat account.
  • Karvy by pledging this quasi pool account raised money to cater its real estate business and other business.
  • NSE did a client level auditing and found out that one particular client ID with DP account No 11458979 (quasi pool account) was not reported by Karvy. On further evaluation it was found that it consisted fully paid shares of other clients. The whole quasi pool account was pledged and part of the money raised was used to fund its real estate business.
  • NSE passed its report to SEBI (Ideally SEBI is responsible for keeping a check on broker) and SEBI passed order banning Kavy from doing any transactions from clients demat accounts, unless request comes from client.

What Does the SEBI Order Say?

SEBI after seeing the preliminary report from NSE has issued certain set of guidelines which restricts Karvy in doing furthermore damage. The order has below restrictions for Karvy.

  • Karvy cannot onboard any new clients for stock broking activity.

So effectively no new client enrolment will happen for Karvy until further orders. It needs to cater to current set of clients entangling the mesh.

  • NSDL and CDSL will not take any instructions from Karvy for transfer of securities from clients account.

As Karvy earlier had power of attorney of clients to transfer securities. Karvy had the authority to ask depositories to move client securities to whichever account according to their will. The current order puts a blanket ban and has asked NSDL and CDSL not to take any request of security transfers from Karvy.

  • NSDL and CDSL will monitor all the transactions related to DP accounts of clients. This is only to ensure client operations are not impacted.

So the clients need to request for security transfers in NSDL or CDSL. Even with clients request depositories need to evaluate individual request. As in some cases client might have signed the depository transfer form and might have given it to Karvy, which might be misused in these cases.

  • For the securities in pool account (DP No: 11458979), Karvy will not be allowed to do any transfers. Fully paid securities transfers are allowed on clients request.

For clients whose securities are not reflecting in their NSDL statement and are part of the above said pool account, their securities have been blocked from trading. If the client has bought those securities on margin or has only partially paid for those securities, then client needs to pay in full to release the securities and transfer into their depository. If its already fully paid, then client can send a request to NSDL/CDSL to release the security.

  • Disciplinary action will be taken by depositories and stock exchange against Karvy.

What Should Existing Clients Do?

Not all the clients at Karvy are affected by this ban by SEBI. However intraday trades and margin trades have been limited at Karvy and no one knows till when it persist.

Its better to shift your account with some other broker may be Zerodha, Upstocks, HDFC, ICICI etc. Before that you need to check whether your security holding are part of pool or in your demat account.

If your account is at NSDL (see your account details at Karvy),

  • Go to Speed-E at NSDL (Click here)
  • If you don’t have a login already create one (click here)
  • Login and check your holdings – are they the same as in Karvy?

If your account is at CDSL.

  • Go here to CDSL Easi (Click here)
  • If you don’t have an account, you can click here to create one. (Remember your BO id is the DPID followed by Client Id – total of 16 digits)
  • Once you login, go to Account Details and check your holdings against what Karvy is showing.

Note: You can do this with any broker. If you suspect your broker is keeping securities at the pool account, please follow the above steps.

You may also receive a monthly e-CAS (common account statement) at your mail address from NSDL/CDSL. The PDF is password protected. Follow the instructions in mail to open the document, and cross check your holdings.

Now, the below steps:

  • Check if your holding are reflecting in monthly statement from NSDL. If yes then, nothing to worry. Your securities are with the depositories.
  • If no, then write a mail to Karvy stating to move your securities to depository (NSDL/CDSL). Follow them up with call. Typically this will take a couple of days.
  • Once all your securities are moved to NSDL/CDSL. You need to open an account with another broker of your convenience.
  • Check whether the new broker operates on NSDL/CDSL platform. If your old Karvy Depository and new broker depository are same, then ask your new broker to move securities from Karvy DP ID to new DP ID.
  • If the old Karvy and new broker operate on different depository then write you need to fill an inter depository transfer form and submit it to Karvy. Later Karvy will initiate transfer. Post that check the holdings at your new broker.

Should You Go For Bank Brokers or Discount Brokers?

With Karvy under SEBI tangles, most of us might have second thoughts on the brokers. The preferential way of thinking is lets go for brokers managed by banks like HDFC or ICICI etc rather than going for online brokers (discount brokers). These brokers are managed by banks, so banks cannot do such shady stuff. We trust broking business with banks at the same level of our deposits at banks. This is blatantly untrue.

Even banks can be a mess. If you look at NSE’s broker reports – the biggest broker is Zerodha who has 0.02% of complaints with only one arbitration case (out of more than 10 lakh clients). HDFC Securities has 2 arbitration cases, and ICICI Securities has 3. (All this is info for April 2019 to October 2019)

Plus, have you ever tried recovering money from a bank? It’s next to impossible – they will go to any extent to ensure they don’t pay. No SEBI action is ever strict against banks because RBI will get into the issue of jurisdiction. There is no guarantee that a bank run broker won’t try to fraud you – and, because they now have full access to your bank account, they can take any amount they want, without you knowing! They have that power of attorney and mandate. We don’t think that’s the right choice.

(Btw, ICICI Securities does do margin funding also, with over 340 cr. in margin funding as of last year’s annual report. These funds are also via pledging of customer securities, and while I don’t think there will be a problem, you have to understand that you have no control over such things. In comparison, a discount broker like Zerodha does not do margin funding yet, and have stated that they will only do it in the future with the more strict recent regulations that segregate special accounts for such purpose)

Conclusion: What’s the solution? Technology and Surveillance.

Why is it complicated to know if the broker has credited your demat account? If a security is bought by a customer, and that security does not hit the customer’s demat account within two days, there are easy ways to know:

  • Surveillance technology at CDSL/NSDL can track every contract note of every customer from the NSE where delivery is given (i.e. it’s not squared off intraday)
  • If a customer has bought something and not sold it within two days, the stock should be in the customer’s demat account the next day.
  • If it’s not there, the technology can quickly throw up an surveillance flag and the broker can be pulled up.

You have to work at edge cases like “auction” notices for short delivery etc. but this can be done through tech.

Apart from these a number of checks can be done during share pledges, and you’ll detect a lot more fraud. Unfortunately, we don’t want to really detect this kind of fraud because too many big people will fail. However, the only way to clean up the system is to have big people fail, and ensure it’s a deterrent going forward. Let’s hope the Karvy mess teaches us the right lessons.