Come August 2020, the mechanism of trading through use of shares as collateral is going to see a big change. Investors wanting to take exposure by using their demat holdings will now have to pledge their holdings in favour of the broker through which they trade as against the current mechanism where the investor’s shares were physically transferred to the broker’s collateral account from the investor’s demat account.
The mechanism which was to be effective from June 1 as per original timeline now stands extended to August 1 because of the pandemic.
Let us go through the basics as to what was the existing mechanism and how exactly the new mechanism will work.
What is the current mechanism?
Currently, in case an investor wishes to trade in the capital market, he/she can do so either by transferring funds or through transfer of demat holdings towards collateral/margin requirements to create positions. We will focus on the option of transfer of demat holdings, as that is the subject matter. This happens through the use of a power of attorney (POA) given to the broker on the demat account to ensure the investor does not need not give an instruction slip to transfer the holdings every time, and instead the broker does so on behalf of the investor, and this brings operational ease.
The broker, in turn, utilises the investor’s collaterals by pledging the same to the clearing members/clearing corporations (CMs/CCs) to get limits/margins for itself to fulfil the investor’s margin obligation. The current process has been in place for nearly two decades.
How would new mechanism work?
In the proposed mechanism, investor holdings will not get physically transferred to the broker’s collateral account, instead it will only create a lien in favour of the broker through which the investor can trade/create positions. This leg is referred as margin pledge. The broker, in turn, will get limits and further pledge the holdings in favour of CM/CC through a process called margin re-pledge. The investor will be able to view the status in the demat holding, as to how much is pledged and how much in turn is re-pledged by the broker.
To create the pledge, the investor may initiate a request on his/her own or may confirm the request initiated by the broker through use of an OTP (one time password). The new process will help resolve the major issues being faced under the existing mechanism, whereby the only use the broker can make is to re-pledge the pledged shares, and not anywhere else. Secondly, the CM/CC will give limits to the broker only to the extent of investor’s margin requirement irrespective of the value of shares re-pledged by the broker. Apart from this, transparency in the new mechanism will give confidence to investors with respect to their holdings being safe. Also after the shift to new mechanism, brokers would be mandated to release all the shares lying in their existing collateral accounts to the demat accounts of respective investors and close their collateral accounts and take shares only through the new mechanism.
Challenges in the new system
Many investors may not have updated their latest mobile phone numbers/ email IDs with their depositories’ database, which will make it difficult to get the OTP. Given the lockdown situation, updating the same will be a challenge in itself. Also this will also need a knowledge transfer to investors to effectively adopt the OTP culture, as this will be applicable to even the old generation investors, who may not be that tech-savvy.
Apart from the challenges at the investor’s end, depositories also need to be geared up to put the systems in place to ensure that the feature can be made available real-time through the use of API. If the pledge instructions are processed with any time delay, it may end up in investors not getting the limits on a real-time basis to trade/create positions and, thereby, end up executing trades at a different rate altogether.
After the implementation of this process by the depositories, brokers would need to change their back office and trading platforms to adopt the new mechanism and ensure that investors can switch over to the new mechanism seamlessly.
To summarise, the new framework would bring a lot of transparency in terms of handling the securities and shall surely boost confidence and comfort at investors’ end. However, this will increase the operational work at the client’s end to transfer the shares marking through OTP for trading. Investors would be required to learn to use the new methodology under the OTP framework.
(Anupam Agal is Head of Operations at Motilal Oswal Financial Services. Views are his own)
Source: ET Markets