"SEBI the strict headmaster: Shocking Truth Behind The Untold Secrets and Revenue Sources of Broking Industry".

"SEBI the strict headmaster: Shocking Truth Behind The Untold Secrets and Revenue Sources of Broking Industry".

A few years back, I was reading a famous book by Jack D Schwager “Wizards of Markets”. A term that caught my eye in that book was “Dual Trading” by brokers. At that time, I lacked the knowledge that despite being illegal and hard for regulators to detect, “Dual Trading” had been a profitable source of revenue for many brokers. Now you would be wondering what is “Dual trading”.

“Dual Trading” is a form of trading where the broker places his order along with its customer's orders if he sees many orders coming from its customers on any security. Dual trading is banned in many countries as there is an illicit practice in which a broker prioritises their own orders over those of their clients, resulting in the broker making a greater profit. There are few such sources of revenue some are legalised, and some may not be legal any more, which are unknown to customers.

Today, we will talk about another such revenue source for brokers but a legalised one.

Have u ever wondered how much a broker would be earning from your unused funds in a trading account?

Yes, I am talking about a significant source of revenue for all brokers, which is float income on clients' unused funds. These days discount brokers are showing such a big revenue YOY, do you think it is all brokerage? The answer might be a big “No”.For many brokers, managing the unused funds of their clients accounts for 30% to 40% of their revenue. Unfortunately, it's regrettable that these profits are not shared with their clients.

The broking industry is highly competitive, with intense competition centred around offering lower brokerages. This has led to the emergence of prominent discount brokers such as Zerodha and Upstox. With their low brokerage model, if we remove this extra source of income (float income), that might lead to charging a higher brokerage fee and, in turn, a bad customer experience.

Why are we discussing Float income now?

SEBI recently declared that they are examining a “pledge-repledge” mechanism, where brokers have to move investors’ unused money to a clearing corporation on a daily basis. So this may mean no floating income on unused funds for brokers. This step is aimed at preventing the misuse of unused funds, as has been witnessed in the past with cases such as Karvy. SEBI has been closely monitoring such fraudulent activities and has taken strict actions in the past. SEBI intends to ensure that brokers are not involved in the flow of funds to prevent any misconduct.

There have been cases where some brokers have been observed to be illegally transferring clients' unused funds out of the business, and in some instances, these funds have been lost. SEBI recently issued a directive to brokers instructing them to allow mutual fund transactions from customer banks directly to clearing corporations without involving brokers in order to minimise fund flow. Allow me to provide you with a more detailed explanation of this matter.

A recent example of action by SEBI:-

You, all might have heard of and used Free Mutual fund platforms of all big brokers like COIN(Zerodha), Upstox, Groww and many others. What used to happen was you put your money into your trading account, and all your mutual fund purchases were made from that. So all the surplus and unused funds are used to stay with Broker’s pool account. Most of these Mutual fund investments offered by these brokers are claimed to be zero brokerage fee platforms.

How were they able to provide you with a facility to buy and sell mutual funds with no income at all? Nothing is really free in this world, right!!

The answer lies in float income earned from the surplus amount stored in the trading account by these mutual fund investors. And that revenue was big enough to help these brokers provide so-called free Mutual Fund investing. However, SEBI restricted the fund flow to brokers and mandated clients to pay directly to MF houses via a clearing corporation.

This is clearly causing a fall in Revenue for most of the brokers. And a big fall for those platforms that are only promoting their Mutual Fund investing as their main product. So in the coming time, I expect, we might see a fee charge by these brokers for their mutual fund investing to mitigate that revenue decline. Now you imagine the customer experience it will impact on.

What is going to happen now?

Brokers could have made more money from Float income if they didn't have to return unused funds every three months as per quarterly settlements. But to prevent brokers from misusing the funds, SEBI made it mandatory for unused funds to be returned to the bank account in every three months.

The SEBI's proposition for the daily transfer of unused funds from a broker to a clearing corporation has been met with opposition and voiced concerns by numerous brokers and clearing members. One suggestion that SEBI is considering is that brokers will invest the unused funds into liquid overnight funds or securities. This will let brokers earn returns from these safe investments as well as they can pledge them at Clearing Corporation for required margins for client tradings.

In conclusion, the proposed regulations by SEBI will change the way brokers earn income from their clients' unused funds, and it might also impact customer experience. However, it is a necessary step to prevent brokers from misusing the funds and to ensure the safety and security of investors' money