Margin of safety

ASBA must be properly tested for secondary markets

The Securities and Exchange Board of India (Sebi) has released a consultation paper “Blocking of Funds for Trading in Secondary Market” for public comment on an important change proposed in the funding of secondary-market trades. In essence this seeks to extend the application supported by the blocked amount (ASBA) system, which operates in the primary market, to the secondary market. The objective is to eliminate the need to transfer funds in advance to a broker, and thereby reduce chances of misuse or losses caused by broker defaults. In the primary market, ASBA has been operating smoothly for years. When an investor applies for shares in an initial public offering (IPO), a lien is placed on the requisite funds, which remain in the investor’s bank account and generate interest. If the allotment occurs, the funds are transferred. If it doesn’t occur, the lien is lifted.

In the secondary market, investors have to submit collateral (in the form of shares) or transfer funds in advance to the broker before executing a trade. This results in brokerages holding substantial sums in such floats — the average daily float is about Rs 30,000 crore. While the broker may pay interest, this practice also places the investor’s funds at risk in case the broker defaults. It also leaves funds and collateral open to misuse by the broker. The regulator believes that it can use the new multiple debits facility for the Unified Payments Interface (UPI) to create a new ASBA mechanism. This will allow investors to block funds in their bank account for trading in the secondary market, instead of transferring upfront to the broker. As and when the trade occurs, the funds would be transferred directly to the clearing corporation.

Sebi suggests brokerage and securities transaction tax may be deducted by the clearing corporation and passed on to brokers, or paid directly by investors to them. Obviously, this could be beneficial to investors since it would improve the safety of funds. It would also reduce the chances of brokers making dangerous over-leveraged bets, which lead to defaults. However, there are several things to consider when designing the mechanism. One is ensuring a level playing field. Brokerages that are subsidiaries of banks can offer what is known as 3-in-1 accounts where the brokerage can access the funds and demat account when the need arises. Standalone brokerages currently compete by charging lower fees, offering more advisory support and more flexible margins. This move to ASBA may skew the field in favour of bank-backed brokerages, especially if the mechanism is slow.

The technicalities are much more complex for secondary market trades. An IPO is a static process with only one security involved, only one agency handling allotment, and so on. Reconciling IPO accounts is not difficult. Secondary-market operations involve far more stakeholders and far more instruments, including equities, derivatives, and forex and commodity futures, each with different prices and different margins. A trade may be placed simultaneously on both exchanges, and may be configured in multiple ways and the price of the asset will change within seconds. There are massive volumes of such highly dynamic trades. The secondary ASBA mechanism would have to be well designed and stress-tested to prevent slowdowns, and glitches in practice. If it can be made to work, however, this would definitely reduce concern about misuse of investor funds.