When Brokers Go Bankrupt

Approximately 7,000 out of 10,000 stock brokers in the cash segment have closed shop between 2012 to 2016.

We think in the next 10 years the number of stock broking firms will reduce to less than 500. That means approximately 2,500 more will shut shop.

Why?

In today’s challenging economic landscape, we have seen some of the most well-known and long-standing financial organisations fall by the wayside. Organizations that carried a great deal of financial clout have partnered with other firms to endure competition or in some cases remain viable. Naturally, if you have capital with any brokerage firm, you may be asking yourself if your money is truly secure.

With a big spurt in share prices this year and a surge in retail investment flow in equity mutual funds the competition amongst stock brokers has just got even more intense to expand their client base.  Some of these brokerage houses have years of experience while others flaunt their performances.

The Financial Crisis of 2007

From 2003 to 2007, Indian Broking Industry showed solid growth before crippling to the global financial crisis. That led to painful job losses, shutdowns, downsizing and selloffs.

Data from the markets regulator SEBI showed that around 450 brokers shut down or left the industry in 2013-2014. Some of the prominent examples include HSBC India exiting its retail broking business and Sundaram Finance sold its stake in an equity broking joint venture to BNP Paribas. Despite a drastic drop in brokerage fees, retail trading volumes did not expand along expected lines, squeezing revenues even as overheads kept going up.

But the economic downturn was not the sole villain of this story. A credibility crisis also has led to the decimation of brokers. Many of the brokers offered clients advice that was inappropriate just to overcome the greed for easy brokerage fees. The buy now sell tomorrow idea proposed by the brokers has led to their downfall.

Brokers and Bankruptcy

The brokerage business is very dynamic and as such is a very perilous one, in which some of the companies ultimately disappear. The stock market business is a make or break game. Its filled with bankruptcies and scandals that hit most of its shareholders. The rate of losses in the brokerage business is huge, primarily that of customers. The brokers, as any business endeavour is open to bankruptcies. Hence, we will never have the assurance that our broker is not going to go bust. In fact, several brokers disappear, but not as many as we could think.

 

The bigger question is precisely what happens when a brokerage firm abruptly goes bust, and they were maintaining your stocks, bonds, mutual funds, and other securities.

The brief answer is that brokerage firms are under a vigilance of the regulators as to the commingling of their investor’s funds with the firm’s capital.  In other words, firms are expected to divide customer assets from firm assets. Entering client accounts would be perpetrating fraud. This means, in most cases, that your capital should be fine.

Still, what if your firm commits fraud?

In the last one year, at least 12 stock brokers have shut down and have been accused of not repaying client money worth over Rs 300 crore. Some of the brokers were indirectly operating as non-banking finance companies. They collected money from investors by opening broking accounts which was later used to fund other clients. While investors were assured of a fixed return of 12-14 per cent, brokers collected 18-20 per cent for margin funding.

 

 

Steps Taken by SEBI to Protect Retail Investors

 

Broking firms lend the idle cash lying in a clients account to others to earn interest. For brokerages, it is a free source of funding as firms do not pay any interest to clients, many of whom do not withdraw their money after every trade. Most of the larger established brokers also fund clients through their non-banking finance companies (NBFCs). But if a broker funds a client through the NBFC, the client has to bring in an upfront margin. Also, there are restrictions in the stocks a client can invest in through the funded money.

 

However, if the broker is funding clients without going through the NBFCs, it does not need to comply with these rules.

Brokers said a lot of buying in small-cap and penny stocks in the past year has been funded by brokerages, which in turn used clients’ idle money. Many of these stocks would not be eligible for funding by NBFCs.

SEBI has put the onus of keeping track of investors’ funds lying with brokers on stock exchanges to generate alerts on any misuse of clients’ funds by stock brokers. the regulator had said in a circular in September last year.
The new system will benefit clients due to enhanced supervision which will increase transparency in the system.

 

New Challenges For Brokers

 

There has been a surge in stock trading volumes in the last 15 months due to falling returns on fixed income asset classes and a gradual decline of physical assets such as real estate and gold are driving more investors into equity.

 

With new opportunities come new challenges. Broking is a business of high volumes and economies of scale. One of the key pain points for the industry is the squeezed margins due to increase in competition. For this reason there is an urge to increase client base.

 

Discount brokers, who offer vanilla services of buying and selling stocks for a nominal fee, are giving the traditional industry a run for their money. From 2014-2017, the market share of discount brokers increased from 1 per cent to 4.15 per cent. Independent brokers are mushrooming in small-town India. Technology disruptions such as algorithm-trading are threatening to transform the business in no time.

 

The Way Forward for Stock Brokers

The Indian Stock Broking Industry is undergoing a consolidation phase with profitability pressure expected to continue. Diversification, digitalisation and client growth are the three key survival strategies brokerages are banking on. Survival of the brokers will depend on:

  • Establishing personal relationships with clients for client stickiness.
  • Diversify and grow related businesses to minimize the dependence on core broking income and by growing the product portfolio to include financial services like insurance, mutual funds, SIPs etc.
  • Building online and mobile broking capabilities for its convenience, low costs and fast execution.
  • Provide niche services to differentiate from the market.

 

This article has been penned by Uttkarsh Sogani, Investment Adviser, Moneybee Investment Advisors Private Limited. For more details you can call on +91 22 4030 2050.

Leave a Reply

Your email address will not be published. Required fields are marked *