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SEBI Pledging Rules and Chaos!

The recent mess in markets, clients and brokers not able to sleep as stocks are not to be “located”, has brought to light the mega system that exists in what is considered the simple activity of buying and selling shares. This mega system – called Market Infrastructure (https://www.sebi.gov.in/intermediaries.html) – is gradually evolving to take into account the specific risks faced and over a period of time, and has grown into one that regulators intend will allow smoothe growth.

So why does it exist? And How did it come about and who all are these people?

The 123 of Share Movement

Lets say you are the owner of a share called ABC Corp. You for some reason feel you should exit this stock now and hold a paper certificate given to you personally by the promoter and he has kept a note of this in his diary as you have in yours.

How do you find somebody who is willing to buy them from you? You could maybe have put an advert in the papers or walked around town blaring on a loudspeaker proclaiming your desire to sell.  But it’s not ideal for obvious reasons. The obvious answer is that it would all be so much easier if there were a place – a market venue where people commonly in the business of buying and selling shares could get together and find each other.  That’s how stock exchanges were born. Over time, they became formalized. But the idea is the same: get all buyers and sellers in one place to maximize the chance of matching them with each other. But since there is such a big crowd here – you might not want to dirty your hands by jumping into the chaos – also you may not know how to negotiate – so that’s how the broker was born who will come out from this crowd on trading days, take your order and dive right back into the mess!

Lets say the trade is done – your broker shouts out to you and you nod happily! For a small price, he saved you the trouble of greasy hair and roughed up clothes.

Then what? We now have the tricky problem of settlement.  The broker has just sold your ABC Corp shares and the buyer is going to want the certificate pretty soon.  And you want your cash.

One option is you go back to your car parked outside this mayhem , hand over your certificates to the broker and leave. And ask him to send you the cash. But that means placing a lot of trust in that individual.

Instead, lets say you had another smart guy in a different part of the market who’s willing to keep the certificate safe , has no relationship with the broker and has his office set up right outside a police station. That would be trustable! So we call these people custodians. Keeping your assets in their custody.  And while the share certificate is sitting at the custodian, they can deal with all the tedious things that can happen to a share during its life: dividends, stock-splits, voting, …  It’s as if the shares need regular attention, like an old car that needs constant regular servicing!

Now lets imagine your broker has more clients apart from you and more stocks to handle apart from ABC Corp. At the end of the day, this tired person will have to go to a corner and create a list of what is to be received and what is to be paid and by whom and to whom. However, he may not be trusted for this – he is fatigued and has information that may be adverse to client interests as he knew the value while you knew the price- so someone else has to set up shop to do these independently. This calculation of “what to pay in and what to pay out and for whom and for what” is the function of clearing – done by a “clearing house”.  The clearing house was watching from a high rise building what the broker was upto and independently also noting down the trades so has all the information on what he did. The clearing house however didn’t know the individual clients that the broker kept on going out to meet – so that’s left to the broker back office to calculate.

And there’s a second, more subtle, problem: how does your broker know that the person they’re selling to is good for the cash? And how does the buyer know that your broker can deliver the shares?

clearing house is intended to solve both these problems. Here’s how: after a trade is matched (both sides agree on the details), the information is sent to the clearing house by the exchange. Apart from orchestrating the clearing process and getting everything ready for settlement, the clearing house does something clever: it steps into the middle of the trade.  In effect, it tears up the trade and creates two new ones in its place: it becomes my buyer and it becomes the seller to the buyer. : if a client turns out to be a fraud, the buyer still gets their shares (the clearing house will go into the market and buy them from somebody else if it really has to).  We call this “stepping in” process novation  As an example, the London Stock Exchange uses LCH Clearnet Ltd as its clearing house while NSE has NCL and BSE has ICCL.

Now back to the custodians – if there was only one, it’s not a problem: they can just set up an electronic book-keeping system to keep track of the share certificates under their safekeeping.  But it doesn’t work if the buyer and seller use different custodians: you’d still need to move paper between them in this case. What if we had a “custodian to the custodians”?  If the custodians could deposit their paper certificates with a trusted third party, then they could transfer shares between each other simply by asking this “custodian to the custodians” to update its electronic records and we’d never need to move paper again! This is the role depositories play- NSDL or CDSL.

Of course, no one would guarantee anything or step in between unless they have some buffer of safety available from the person who can do the fraud – client or broker or the other market intermediaries. This is where margins come in – each trade requires a margin so there is no chance of default – Imagine you sold the share but your neighbour told you that the stock would rise 50% overnight – you might want to then hide the certificate from the broker under your pillow right– and the clearing house monitors all this – remember its at risk if you or the broker default – and always ensures it covers risk of such defaults by various means including an upfront deposit from the broker! The clearing house wont allow the broker into the market unless these deposits are there in advance each morning.

So what Happened in India this week!

So whats been happening these last few days! Well, in summary, imagine – the margin used to be a simple share certificate (POA Holdings) – with the nice portrait of the promoter and very colourful – and everyone was used to it. But either under your pillow or with the broker. The policemen realised that this causes issues – as the entire market is open to potential problems. So they changed the rules – they said you need to collect a specific frame for the certificate, add it to your picture and take a receipt of this from a neighbourhood depository. Everything is actually fine so far.

The tired lady in the depository building down the road knew there would be some additional demand for frames – so she created some space on the adjacent road. The clearing houses knew that they cannot accept the old portrait style certificates so asked the frame maker to add additional stock of wood and carpenters to the fray. And waited for the queues to start.

And we all went about our normal business of trading from September 1, 2020.

Things turned out to be different though. The wood suddenly was in dearth. How much wood t to pile – someone asked?  The roads to the forests were packed with frantic woodcutters but no information on how much was needed. The lady was shocked – she anticipated two queues of orderly gentleman and suddenly faced 18 disorderly and chaotic queues. She couldn’t even talk to the carpenter shop next door as the noise was high decibel! And since clients weren’t sure whether they could get the frames, they also piled on to the ladys shop which she didnt expect.

The brokers could hear the mess but went about their normal business anyway thinking it will get sorted – after all the ladies and the carpenters were all at work – but didn’t know that the lady couldn’t talk to the framing guys any more. And suddenly, there was more to do at the end of the first day of trading even as the previous demand wasn’t met! There was a pileup. She called home to say she might be late – not knowing she would spend the entire week in the shop!

The next day the brokers werent sure – So whose shares were sold and where were they – were they framed or not? The lady’s searching as of September 4, 2020. So they tried to call the lady very early in the morning to check whether they can assume certain things – the lady just shook her head and said – do the best you can!

Two days of a break and its possible roads may clear, the police may come in and maybe, the carpenters would be available. The police says you had so much time to do it – so just do it. We have Covid curfews to keep so move along! Of course they have talked internally and must be watching – they dont mind the 24 x 7 that the lady or the carpenter is putting in but doesnt want any prolonged queues either.

That in essence is whats up. So don’t worry, Your money and your stocks should be safe and as soon as  the tired lady gets up, she will display your frame to you – exactly the way you wanted it!

For More updates on Blogs related to Mutual Funds & Research Report, Please visit us at: https://www.plindia.com/blog/

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