Equity Broking in India - the road ahead!!

Investors are asking - is the current performance of the equity markets sustainable and are the markets reflecting a correct picture of the Indian economy?

A perspective from Uday Kotak and Shasktikanta Das :

"Why are capital markets buoyant even as we see a slowdown .... investors and analysts have already discounted earnings downside for FY2021 and are looking at earnings of FY2022 and FY2023." - Uday Kotak, MD Kotak Mahindra Bank

Sounding a note of caution, RBI Governor Shaktikanta Das on Friday said there is a disconnect between the stock market and the real economy and a correction will be witnessed, though its timing is hard to predict. The Governor said excess liquidity in the global system appears to be fuelling stock market exuberance. "There is so much liquidity in the system, in the global economy, that's why the stock market is very buoyant and it is definitely disconnected from the real economy. It will certainly witness correction in the future. But when the correction will take place, it is hard to predict," Das said in an interview to news channel CNBC Awaaz.

The retail focus, digital transformation, and growth in the equity markets are inspiring but the unprecedented optimism needs to be quickly toned down with caution.

• There has been an addition of 25 lakh new accounts in the equity broking industry between April to June 2020. Most of the new entrants are from Tier 2 and Tier 3 cities and 70% are millennials. All discount brokers have client acquisition growth rates in excess of 25% vis a vis last year. The full-service brokers and bank brokers are rapidly losing market share and their growth rates are festering in single digits quite contrary to the growth of the discount brokers.
• Brokers who are completely digital and selling a discount brokerage structure ( delivery trades are free) have grown @ 30% + a month on month since March 2020.
• Activation rates of such brokers in June 2020 have grown in excess of 30 percent vis a vis activation rate of March 2020.
• Zerodha with a 3 million customer base, is completely debt-free, has no expenses towards marketing or advertising and the growth is only through word of mouth. their knowledge-sharing platform Varsity( 9 lakh app downloads by customers) and Finshots (incubation partner) have had very strong success in attracting first-time users /new customers. They have been growing @100% month on month.
• A case for example - Upstox, a discount broker ( with investments from Ratan Tata and Tiger Global) who had a client base of 1 lakh in June 2013 has grown the client base exponentially to 10 lakh clients - with a projection of 10 lakh clients in the next six months. The upside is 70% of their client base is active.
• The trading in the retail segment is skewed towards derivatives trading ( futures and options) - 70 % of the total trading volumes are in derivatives trading - a high-risk segment for retail investors.
• Cash segment equity volumes are 30 % of total trading volumes but most of the volumes ( 28% of the total trading volumes) in this segment are in intraday trades.
• Demat accounts have grown from 23 million in 205, 36 million in 2019 to 41 million in 2020.
• Depository participants have grown from 854 in 2015, 875 in 2019 t0 899 in 2020.
• Cash equity brokers have grown from 6147 in 2015, 2315 in 2019 to 4249 in 2020.
• Derivatives equity brokers have grown from 2990 in 2015, 2435 in 2019 to 3460 in 2020.
• Average Daily Cash Equity Turnover has doubled in the last 4 years. ( 240 Rs. Bn in 2017 to 400 Rs. Bn in 2020 - NSE + BSE).
• Average Daily Derivative Equity Turnover has grown 5X in last 4 years. (3200Rs. Bn in 2017 to 14000 Rs. Bn in 2020 - NSE).
• The pandemic has resulted in practically 100 % WFH ( Work from Home ) and a huge reduction of premises rentals/closing of all brick and mortar branch offices across the country resulting in at least 50% reduction of operating expenses for digital brokers who have adopted WFHas a standard model on a permanent basis.
• PBT in April May June quarter 2020 of most large brokers have grown in excess of 50 % vis a vis the same period in 2019.

Pros and cons of this exponential growth and activation :

1. With every account opened, Brokers are crediting free ETF ( exchange-traded fund)units in the client account and selling it within seven days. This results in all accounts which are opened also shown as activated. This practice though yielding positive results for the broker - may not be reflective of the correct numbers of clients who are genuinely active. This is also the primary reason that bank brokers have such a large passive client base as they are not following this practice of forced activation of all clients.
2. The client referral program introduced by the exchanges now permits brokers to open accounts based on a friend's /family member referral. The brokerage earned from such clients is shared by the broker, with the client who has referred the account. This has created an Amway Multilevel Marketing model in the broking industry and clients are generating additional income from the trading activity of their friends/families - whom they have referred to open an account with the broker. The non - conformance to regulations that permit sharing of income only with registered entities in the market ( i.e registered franchisees/ sub-brokers/authorized persons) can become a difficult issue for the broking industry in the future.
3. All accounts are being opened free of account opening charges and delivery trades completely free. This implies that the revenue model of the brokers is dependent on the trading volumes by retail investors in the derivatives segment ( options and futures). The entire brokerage fee is dependent on the trading by clients in the derivative segment ( where clients are charged Rs20/-per order) which results in clients being pushed into the derivative segment - where it is highly unlikely the retail investor will make money and grow their capital.
4. This derivative segment is fraught with high risk - volatility and complexity. Unless the retail investor fully understands the nuances of derivative trading - is always avoidable. The risk appetite of retail investors and the propensity of loss makes this derivative product less suitable for retail investors.
5. The high dependency on the interest income ( 40% - 50% of the total income in the balance sheet)from clients by brokers, implies that there is a bias of pushing retail clients to margin funding (monetize free collateral for enhanced trading limits) - without a proper evaluation of the product appropriateness for clients. In any case, the high interest cost @18% to 22% for such a margin funding facility, implies that the retail investor will not be able to make money at such a high funding cost.
6. The large US brokers Robin Hood, Charles Schwab, E-trade who also provide free delivery trades to their customers - have the leeway of making float income from the deposits of their clients and earn significant interest income. In India, float income from client deposits is not permitted and all client deposits have to be flushed out every 90 days.
7. Cash discounts, cashback, and incentive vouchers are doled out to induce clients to open accounts and trade. This incentivization, though now an accepted market practice, is contrary to extant regulations that prohibit the use of any incentives to induce the clients to trade.

Changes in regulations that may impact the market :

1. As a fall out of the Karvy scam and similar misappropriation of clients' funds and securities by brokers which have ailed the broking industry multiple times - the Pledging of client securities ( debtor securities) with banks/ NBFCs to raise funds for working capital is not permitted anymore. Brokers will need to infuse more capital in the business and can only use their own funds to do business. Without Bank funding against client receivables, the cost of doing business will go up significantly and may become unviable for brokers who do not have adequate capital.
2. The mandatory margin collection requirements at every individual client level and penalties for nonconformance in the cash segment ( which was earlier restricted to derivatives segment only) will see clients who were so far trading without furnishing adequate margins, now finding the cost of trading much higher than they were used to. the trading volumes may withness a dip with this correction in mandatory margin compliance in the cash segment.
3. The intraday product as it exists will be passe with the mandatory margin collection for all trades irrespective of whether buy and sell trades were executed on the same day or not. There will a further onus on the client of furnishing margins applicable for the peak volumes traded during the day by the client. This is expected to impact the traded volumes as the traders used to the largesse of brokers who permitted margin free trading for intraday trades - can no longer trade without furnishing appropriate margins for every trade.
4. The mandatory cash delivery, intraday, and derivative margin collection, reporting, penalties imply -"enhanced leverage"- a USP of many brokers will disappear. Every trade, irrespective of the segment, will attract relevant margins and there will be stringent penalties for non-conformance to applicable margins.
5. The shares which are furnished as margins to the Exchanges ( Clearing Corporation ) by the client will now continue in the client DP account and will be pledged to the Broker who in turn will repledge it to the exchanges. There will be a one to one audit trail of clients open positions and the corresponding margins pledged to the exchanges. In the legacy process, shares used to be transferred to the Broker's Collateral account, maintained with the Clearing Corporations, and the Clearing Corporation was oblivious of the actual ownership of the shares. This anomaly has now been addressed with the pledge - repledge process.
6. Additional Base Capital ( Funds deposited with Clearing Corporation ) by Brokers against which trading limits were provided to Brokers - had earlier included clients's funds/deposits which resulted in a non - conformance with clearing Corporation regulations. The revised guidelines from the Exchanges on clients' margin deposits for trading will not permit brokers to use clients' funds as deposits( FD and Guarantees) towards Additional Base Capital. All funds with Clearing Corporation as Additional Base Capital has to be the Broker's own funds.
7. It is also mandated that what you buy or sell as a client, has to be against clear available funds in the client's funds ledger( for buy) and free unencumbered securities lying in client DP account (for sale). Notional credits/credits in the pipeline of funds/securities - cannot be considered for allowing trading/margin compliance. This is expected to affect the ability of clients to indulge in BTST ( Buy Today- Sell Tomorrow) trades as the settlement cycle that exists today is T+2.
8. The markets will go through a radical change in the settlement processes where funds and securities settled against trades done by a client will directly be routed to the client's account and will not be routed through a transient broker's pool account. All Broker Pool accounts have been closed and the exchanges + depositories are editing the workflows to ensure an STP process for funds and securities settlement - between exchanges/depositories and the clients.
9. The Direct Market Access by clients through the stock exchanges has again revived the heated debate of what is the role of a broker in the capital markets and what are the services that add value yo a client and hence can be charged to the client.
10. The revised regulations also mandate a clear Chinese wall between entities providing financial advisory to clients and the trading execution on behalf of the clients. The need to segregate advice from execution has been adopted by the developed financial markets in the USA and Canada. This step will in all probability see clients willing to opt for a fee arrangement for receiving advice and the quality of advice will become the USP to attract new clients. Competition and price-cutting ( a fast disappearing USP in the industry) will move the industry to provide more of the trading activity free of cost to clients.

In summary, market intermediaries who invest and focus on educating investors and transparent sharing knowledge of the markets with clients, are completely digital (SMAC), have the capital to run a debt-free business, have a state of the art trading platform with very simple UI /UX, and deploy significant amounts in CSR ( Corporate Social Responsibility) will rule the roost in the years ahead.