Markets regulator Securities & Exchange Board of India’s (Sebi) has banned Karvy Stock Broking from taking on new clients and executing trades for existing customers over defaults worth Rs 2,000 crore and allegedly misappropriating money to fund its real estate arm, Karvy Realty.

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According to the regulator, Karvy transferred client shares to itself and pledging client shares to raise money, which was then diverted to its real estate arm.

“Right from the beginning if the broker has pledged those shares or used client’s shares or whatever he has done with a client’s money, it is against the basic relationship agreement and it needs to be punished,” JN Gupta, former ED at Sebi told CNBC-TV18 on Monday.

What the rules say... a timeline

As per Sebi norms, securities lying in depository participant (DP) accounts belong to clients, who are their legitimate owners. If at all client securities are pledged, it should be done only in order to meet the obligations of the respective clients.

Furthermore, the regulator has asked brokers to start separate client unpaid securities accounts (CUSA), which will hold shares of clients who have not paid for the purchases and such shares cannot be held for more than seven trading days, after which they have to be sold if the client does not bring in money.

Sebi has also directed brokers to start client margin trading securities accounts (CMTSA) for shares brought through margin funding.

SEBI has laid stricter norms against such proprietary trades by the brokers. In a circular issued in June, the regulator made it mandatory for brokers to transfer the pledged securities to their clients' accounts within one day of receiving the payment.

Further, in case the client defaults, brokers can hold the securities only up to five days post which they are supposed to liquidate the securities in the market and recover dues, SEBI had said.

The regulator has specified that the securities lying with the brokers for non-receipt of payment from clients cannot be used by the broker as collateral margin for any of the proprietary trades. Also, it cannot be pledged with financial institutions such as banks or NBFCs.

The brokers were supposed to release such pledges by August 2019 while the deadline was further extended to September 2019.

It is noteworthy, that in December 2018, Sebi standardised books of accounts and records to simplify carrying out inspections and compare. Later, the regulator asked brokers for weekly reports of day-wise securities and balances of clients, DP accounts and International Securities Identification Number (ISIN).

Further, Sebi also initiated a reconciliation exercise of matching depository records and exchange records in March 2019.

Between April and June, National Securities Depository Ltd (NSDL), Central Depository Services Ltd (CDSL) and depository participants were directed to provide pledged details of all brokers.

In case of default by brokers or if the exchange expels the broker, then as per guidelines, the National Stock Exchange (NSE) compensates individual investors up to Rs 25 lakh from the investor protection fund.

Immediate impact on brokerages

Brokerage firms that used this arrangement to boost their margin funding capabilities are struggling and scaling down businesses.

Sebi’s set of rules on separation of client shares from broker accounts aimed at preventing misuse of investors’ stocks and money have left brokers jittery.

These regulations have implications on the business models of brokers with an increase in the cost of business, experts have noted.

Earlier in October, Sebi had also banned BRH Wealth Kreators (formerly BMA Wealth Creators) and its promoters from the stock market after a National Stock Exchange investigation found that misappropriation of Rs 100 crore from client accounts by the broking firm.