BY AISHANA AND NIKITA SINGH, THIRD-YEAR STUDENTS AT GNLU, GUJARAT
Introduction
In the past few years, The Securities and Exchange Board of India (SEBI) has taken several steps to safeguard investors’ securities and funds, but a significant amount of investor funds may still be vulnerable to the risk of potential misuse. To mitigate the same, in a recent regulatory move, it has released a circular that lays out a crucial framework for stock brokers (SBs) and clearing members (CMs) to upstream their clients’ funds to clearing corporations (CCs). The circular is a strategic step to protect customers’ money and guarantee its prudent use, with important ramifications for investors and the securities market alike.
The SEBI circular mandates the upstreaming of all client funds received by SBs and CMs to CCs in the form of cash, lien on fixed deposit receipts (FDRs), or pledge of units of mutual fund overnight schemes (MFOS). Specific conditions are outlined for creating FDRs, including the requirement that FDRs should be pre-terminable on demand and lien-marked to one of the clearing corporations (CCs) at all times. Guidelines for pledging MFOS units are introduced to ensure minimal risk transformation of client funds and exposure to risk-free government securities. The circular also emphasizes measures to improve operational efficiency and reduce transaction costs, along with compliance and monitoring mechanisms for stock exchanges and CCs.
In this article, the authors will explain the conditions outlined for creating FDRs including the guidelines introduced for pledging MFOS units, aiming to mitigate risk transformation and limit exposure to risk-free government securities, which will be examined in detail. Moreover, the article also encompass the circular’s overarching goals of improving operational efficiency, reducing transaction costs, and establishing robust compliance and monitoring mechanisms for both stock exchanges and CCs.
The Purpose and Rationale of the Framework
The principle behind the framework for upstreaming of clients’ funds by SBs and CMs to CCs is that no clients’ funds should be retained by SBs and CMs on end of the day basis. This means that all the clear credit balances of the clients, i.e., the funds that are not required for meeting the margin or settlement obligations of the clients, should be transferred to the CCs every day. The CCs are the entities that facilitate the clearing and settlement of trades in the securities market. They act as the central counterparties and guarantee the settlement of trades, thereby reducing the counterparty risk and enhancing the market integrity. The sole purpose of the framework is to protect client funds from abuse or misappropriation on the part of SBs and CMs. Additionally, it seeks to guarantee that the clients’ money is placed in low-risk or risk-free products, like government bonds, and that it is accessible to fulfil their obligations as needed. By including procedures for collateral utilisation and margin adjustment, the framework also aims to lower transaction costs and increase operational efficiency for market players. In addition, it also aims to improve upstreaming process compliance and oversight by requiring reporting and audits from stock exchanges, CMs, CCs, and SBs.
The Forms and Conditions of Upstreaming
The framework allows three forms of upstreaming of clients’ funds to CCs: cash, lien on Fixed Deposit Receipts, or pledge of units of MFOS. It also specifies certain conditions for creating FDRs out of clients’ funds such as FDRs must be pre-terminable on demand, allowing redemption without any penalty or loss of interest. Secondly, it should be consistently lien-marked to one of the CCs, serving as collateral and necessitating CCs’ consent for withdrawal or transfer by SBs or CMs. Thirdly, It also must be issued by scheduled commercial banks with a minimum A1+ credit rating, excluding co-operative and regional rural banks and should be in the name of the SB or CM, explicitly mentioning “client funds.” Furthermore, these FDRs should exist in dematerialized form within a depository, with daily reports sent to CCs by the depository, ensuring transparent oversight and compliance with the SEBI circular. These stringent conditions underline SEBI’s commitment to meticulous risk management and client fund protection within the securities market.
Moreover, the guidelines are also laid down for the pledging of Mutual Fund Overnight Scheme (MFOS) units derived from clients’ funds. To ensure transparency and effective oversight, these MFOS units must exclusively exist in dematerialized form within a depository, with daily reports dispatched to CCs by the depository. Pledging procedures involve the units being pledged in favour of CCs through the depository system, with the pledge remaining valid until released by the CCs. Valuation of the MFOS units is pegged at the previous day’s net asset value , and the application of a haircut by CCs is capped at 10% of the unit’s value, exemplifying a cautious approach to risk management. Crucially, upon the release of the pledge by CCs, the redemption of MFOS units must occur on the same day, with the proceeds seamlessly credited to the client nodal bank account of the SB or CMs. These guidelines underscore SEBI’s commitment to meticulous risk mitigation, transparency, and ensuring the seamless utilization of clients’ funds within the regulatory framework of the securities market.
The Applicability and Monitoring Mechanisms of the Circular
The framework applies to all SBs and CMs in all segments of the securities market but also holds some noteworthy exceptions include Bank-CMs, encompassing clearing members that are banks providing clearing and settlement services, and the proprietary funds of SBs and CMs, specifically reserved for their individual trading pursuits. Augmenting the effectiveness of this framework are various monitoring mechanisms outlined within the circular. To ensure meticulous implementation, stock exchanges and CCs are tasked with creating systems capturing daily details of clients’ funds received and upstreamed by SBs and CMs, with reconciliation against reports from depositories and banks. Periodic inspections and audits of SBs and CMs, conducted by stock exchanges and CCs, serve as a means to verify compliance, with a commitment to take appropriate action against any defaulters. Additionally, these regulatory bodies are obligated to submit quarterly reports to SEBI, offering insights into the circular’s implementation status, any deviations encountered, and the corresponding corrective measures taken. Simultaneously, SBs and CMs are entrusted with maintaining meticulous records of clients’ funds, readily providing them to stock exchanges, CCs, and SEBI upon request. With an effective date set for July 01, 2023, this framework reflects SEBI’s proactive stance in fostering transparency, accountability, and adherence to regulatory norms within India’s dynamic securities market.
The Impact and Implications of the Circular
The framework also necessitates the compliance of SBs and Clearing Members (CMs) in upstreaming all clients’ funds to CCs on a daily basis, following prescribed forms and conditions. This requirement curtails the flexibility and discretion of SBs and CMs in managing clients’ funds, potentially impacting their liquidity and profitability. They are also burdened with the operational costs and risks associated with the upstreaming process, including charges for creating FDRs or pledging MFOS units, and the risk of default or delay in the redemption of these instruments. Furthermore, they must adhere to the reporting and audit requirements imposed by the circular, facing consequences for non-compliance.
On the other hand, CCs stand to benefit from an increased inflow of funds from SBs and CMs in the form of cash, FDRs, or MFOS units, thereby expanding their collateral pool and enhancing their risk management capabilities. However, they are tasked with building mechanisms for collateral utilization and margin adjustment to facilitate the upstreaming process and reduce transaction costs for market participants. Additionally, they are responsible for monitoring the compliance of SBs and CMs with the circular and reporting the same to the Securities and Exchange Board of India (SEBI).
From the clients’ perspective, the framework offers several advantages. Their funds are safeguarded from misuse or misappropriation by SBs and CMs and are invested in risk-free or low-risk instruments. The pre-terminable nature of FDRs and MFOS units ensures that clients have access to their funds whenever required, with the possibility of same-day redemption. Moreover, the oversight of stock exchanges, CCs, and SEBI over the upstreaming process ensures greater transparency and accountability in the management of their funds. Thus, while the framework imposes certain constraints on SBs and CMs, it ultimately serves to protect the interests of clients and enhance the robustness of the financial system.
Concluding thoughts
It can be concluded that the implementation of the circular’s guidelines will require concerted efforts from all stakeholders in the securities market. SBs and CMs must ensure strict adherence to the conditions for creating FDRs and pledging MFOS units. Stock exchanges and CCs, on the other hand, must bolster their compliance and monitoring mechanisms to ensure the effective implementation of these guidelines. Moreover, continuous dialogue and feedback mechanisms should be established to address any challenges that may arise during the implementation phase. This will not only ensure the smooth execution of the circular’s mandates but also contribute to the overarching goal of safeguarding investors’ securities and funds. The circular represents a significant step towards a more secure and efficient securities market. By ensuring the prudent use of customers’ money and reducing potential misuse, it paves the way for a more robust and investor-friendly securities market in India.
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