Employees at a securities brokerage in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

SEBI Vs Brokers On Product Suitability Norms - Who Will Certify Investor Networth?

Market regulator SEBI’s proposal to limit equity and derivative market exposure to the networth of an investor has run into a logistical hurdle. Brokers don’t want the onus of certifying client networth.

In a meeting earlier this month brokers’ associations told the Securities and Exchange Board of India that networth determination should be left to chartered accountants or self-certification by the investor, said two people with direct knowledge of the matter.

But SEBI is not convinced and wants brokers to take on the responsibility, said the first person cited above. It’s also mulling the right way to determine networth, the second person said. SEBI wants to include income data in determining networth, he added.

What’s This About?

On Jul. 12, 2017 SEBI issued a discussion paper on ‘growth and development of equity derivatives market in India’.

In that it expressed concern about the large number of individual investors in the derivative segment and observed that “these investors may or may not have adequate financial capability to withstand risks posed by complex derivative instruments”.

The turnover of equity derivatives markets in India was 15 times that of the cashmarket—which suggests ‘excessive speculation’.
SEBI 2017 Discussion Paper

Noting that derivatives are “complex products” the paper raised the need for introducing a product suitability framework in the country including setting minimum contract size and open position limits for equity derivatives.

On Mar 28, 2018, after a meeting of its board, SEBI proposed linking equity market exposure, in cash and derivative segments, to the income of an investor. This, the regulator said in a note published on its website, could be done by determining a computed exposure based on income formulated in consultation with market participants.

For any exposure beyond the computed exposure, the intermediary would be required to undertake rigorous due diligence and take appropriate documentation to satisfy the credit/exposure suitability of the individual investor. 
SEBI Board Meeting Note

Product suitability norms are common in many jurisdictions. So is the concept of a professional investor or accredited investor - an investor with a certain defined networth and risk profile to invest in complex products. But in almost all cases this applies to high-risk investments such as venture funds, hedge funds, commodity and equity derivatives. SEBI is the only regulator that wants to apply this to equity cash market investing as well.

The Deadlock

By expanding this to both cash and derivative markets SEBI will require networth certification of at least 3.3 crore investors (based on active demat accounts with NSDL and CDSL) across 4,421 registered brokers and 25,642 sub-brokers in the cash segment and 2,695 registered brokers in the equity derivatives.

The logistics and costs involved are daunting for many brokers.

“SEBI’s objective is right however the implementation should change as brokers may not be the best suited to determine a client’s networth,” said Deven Choksey, group managing director at brokerage firm K.R. Choksey Investment Managers Pvt. Ltd.

Prakash Gadgani, chief executive officer at 5paisa Capital, a low-cost brokerage unit of IIFL Holdings Ltd., concurs.

The idea to curb speculation and prevent unsuspecting investors from losing money is good but asking brokers to determine networth may not be the way to go about it. It is difficult for a broker to determine the networth and will need at least one week of due-diligence and brokers are not equipped to do a good job.
Prakash Gadgani, CE, 5paisa Capital

According to Gadgani, this would also impact online brokerages as they may need to have physical presence or branches for verifying networth. "Having a physical branch is against the very idea of online brokerage firm," he said.

Only if the broker is tasked with determining networth will he be actively aware of the investor’s risk profile, said Dhirendra Kumar, CEO at Value Research, a mutual fund tracker and stock advisory firm.

A certification of networth from the investor or chartered accountant does not work. A broker must be aware of what he is selling to an investor and it has to be linked with the investor’s financial profile.
Dhirendra Kumar, CEO, Value Research

Any Alternative?

The current settlement and clearing mechanism which happens through brokers should be shifted to custodians for non-institutional clients, Choksey said. “This will help in managing risks better, address the concerns of excessive speculative trading and also help in reducing the fear of an increase in dabba trading”.

Having said that the regulator should implement this in a calibrated manner as the non-institutional segment may stay away if curbs are put in place without thinking them through,” he added.

“Perhaps a better approach is to have higher margins on futures that will restrict exposure,” said Gadgani.

Kumar suggested that the regulator, with the help of depositories and stock exchanges, can aggregate the data on how many people bought derivatives, how many made money and how many lost money. This should be read along with the trade size.

“If the exercise reveals that more than 65 percent of the individuals have lost money then the choice is very simple, that is, stop small ticket size investors from investing in complex products,” he said.