Podcast: The Strange Happenings at Karvy (Ep-15)Podcast: The Strange Happenings at Karvy (Ep-15)

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"When you've given your shares to Karvy, it's just a place holder that holds securities. It should not be funding itself by using your securities... At this point I think the Karvy situation demands action by every person who is a customer of Karvy"

The year 2019 has been quite eventful for the Indian markets! Right from corporate governance issues in major corporates, the collapse of NBFCs such IL&FS and DHFL, the shady practices in scheduled banks such as the PMC Bank and now comes the Karvy fiasco.

Deepak Shenoy (CEO) and Aditya Jaiswal (Analyst) discuss in detail how the Karvy fiasco unraveled followed by series of questions such as:

1. What is a pool account and are brokers using it as means to fund themselves?
2. Can brokers misuse the power of attorney signed by their clients?
3. Is it better to have demat accounts with banks?
4. What should the existing clients of Karvy do?
5. What happens to the banks/NBFCs who have lent money to Karvy?

 

Transcript:

Aditya: Hello everyone. This is Aditya and welcome to the Capitalmind podcast. Today we'll be talking about the Karvy fiasco, and as usual I have the very special guest, Deepak Shenoy. Welcome, Deepak.

Deepak: Hi Aditya and hi everyone.

Aditya: So Deepak, we'll quickly start it, and I'll start with the basics. So over the past one year we saw a lot of brokers getting banned. So there was Amarapali and they misappropriated around 200 crores. And then there was Fairwealth brokers, they did around 88 crores. And then there was Kassa Finvest, which was around 40 crores but to be honest, I wasn't shocked when I came to know about these defaults because these were small and shady brokers anyways. If someone had come up to me saying my broker, Amrapali cheated on me, I would have simply told him, dude, why the hell would you keep a Demat account on with such shady brokers? Why did you not go with a pan in their players such as Zerodha or maybe Karvy, so but the Karvy fiasco is really shocking. They were everywhere, they were even in in wealth management. So there was an illusion of quality and genuineness. What do you think Deepak?

Deepak: You know Aditya. The more you look at this, you're going to realize that the system itself has been favoring a lot of entities that have done a certain set of practices, which are probably no longer in question. There's a reason why broking has had a bad name in a way. You know that in India when you own float income, you can put your money, you can give someone your money and then they will earn interest on that money. So bank can do that and then NBFC perhaps can do that. The only other person who can earn money, out of float is a broker. Brokerages when you give them your money. You can give them the money, they put it inside some kind of a pooled bank account and if there is any interest to be earned out of it, due to the margins you are to place with them though that interest can be owned by the broker instead of by you.

Therefore, this is actually a different a float because you don't earn any interest on the balances you keep with your broker, but at the same time you can withdraw it whenever you want. You can add more whenever you want and so on. So this wasn't enough as an income source. Obviously, brokerages there, there's this float income, some brokers have in the long ages have been saying that, listen, we buy stocks for our customers. Those stocks can be, are held with us and for a very long time, what these do was keep the stocks in their Pool account. Pool account is simply a place where when you buy stocks, you can, the broker will get the stocks delivered into his pool account.

And then he will transfer from the pool account to your individual Demat accounts, right?

So this was earlier, very loosely held regulation where it said, okay, listen, the broker can choose to transfer or not. Based on whether he wanted, if the customer of course wanted to take the stocks, then you will take it back. So what would happen is the brokers some of the brokers would keep the securities in the Pool account. This Pool account tried to grow to a very large size and overtime or a fairly large period of time, the Pool account itself was large enough where what some of these brokers were doing, and I'm not sure if Karvy was doing this, but assuming that some customers, some of the entities were that they were keeping the securities in the Pool account and are taking a loan on the Pool account. So they would pledge the entire Pool account and some in NBFC would give money and the brokers would take that money at say 12% and then lend it as margin money to their customers at 18%.

Aditya: And this was legal.

Deepak: This is legal because what had happened is they will tell the customer, listen, you can buy today, sell after five days. The securities don't move from the Pool account to your demat, they sit in the pool account. We don't pay fully for them because the full payment is coming from a loan from the NBFC, which is on the Pool account, and then that money is used. Let's say, so for instance, if I buy shares with one lakh, I'll pay 10,000 rupees, 90,000 rupees is my margin money. Margin money is an interest bearing money, so I paid in 18% on it, so 1.5% per month. Now if I hold it for about five days, I'll pay a certain fee, let's say 600 or 700 rupees and I expect to make that much when I sell it. So if I buy on Monday, I'll sell on Friday.

Karvy actually offered the service of buying on Monday and selling on Friday. Obviously, they were doing some kind of financing at the Pool level and taking these loans on these Pool accounts. What's bad about this is that the loan is on the Pool account. It isn't actually two individual customers, although individual customer taking the loan. Margin financing by the broker through this method doesn't actually help because it you should actually know who the eventual receiver of these modest margin funding is and therefore the over leverage of any customer can be identified at a systemic level, which is not available in some of these cases. The other problem was that default was actually a broker problem, but then it could percolate into all the customers who are holding securities in the pool because of the broker default would mean that the NBFC would try to forcibly sell shares in the Pool account and then anybody who has shares in the pool gets damaged, now who are in the pool?

If it were a person who was saying buy today and sell on Friday or buy on Monday, sell on Friday and he defaulted, he doesn't care if the securities are sold because the default he wants a security sold, so that he can, the money can be returned.

Aditya: Right.

Deepak: But there are lots of people who would buy shares and they will not even know. Shares have not been transferred into their account. It's sitting in this Pool account and their shares have been margined. Now, when I say margined, it means the NBFC actually owns a pledge on them. Why would a broker do this? Because, and NBFCs will not provide you a hundred percent loan, right? They will provide you a loan for a hundred rupee loan. They will say, give me a security, what? 200 rupees. Now you want a margin, your own security. You want to buy a one lakh security with 10,000 rupees in cash.

You actually want effectively a 90% loan or out of 40% ,70%, 80% loan. You want a high loan. So you're not going to accept a 50% loan that's not leveraged enough for you. So what they do is, it's a little bit of a shady practice. A lot of brokers will keep a lot of shares. That means even of people who haven't asked for margins in the pool account, simply saying, listen, if you want the shares back, we'll give it to you. So what's the big deal? So people used to keep them in the Pool account. Now this practice had been specifically banned by a SEBI in 2016. What they said was, listen, if the shares are coming, you need to transfer it forcefully into the customer account. This is a problem because now you have a situation where loans haven't given at the pool level, margin loans and this loan cannot immediately be repaid, create a lot of consolations or a lot of brokers use innovative techniques, so they would create a client account where they would transfer these securities.

Tell customers, listen, your shares are there but we'll transfer them to your Demat account, whenever you want, but they weren't sitting in the actual Pool they were sitting in one of these Quasi accounts that were created. Karvy was guilty of doing that. They had an account like this where they had certain securities of customers, which are not a designated Pool account. It was just an account on which a loan was taken. The beneficiary of this loan turns out to be a few Karvy entities, including Karvy Realty Limited. This easily illegal practice in the sense you cannot take client securities pleasured and take money for one of your own companies and group companies. That's what SEBI has found and here's what is interesting, say we didn't find this themselves. NSE did a spot inspection found out there was such an account.

This account was not even reported as a broker's own account. You're supposed to report all your Demat account to NSE. They found all those one extra account there. All these things were going on where after 2016 a lot of securities have been transferred to it from it, unpledged, pledge. Bunch of thing created a loan created on top of it and the loan proceeds have been used by Karvy related companies and this is prima facie illegal. So NSE then went and said, listen, we are going to appoint a forensic auditor but please SEBI take care of this now, SEBI then acted in an exparte decision, which means they didn't even ask Karvy to come and defend themselves as head boss. They said, we have to take action before we ask Karvy to defend itself that that particular Demat account. It's not a Pool account. It's actually a sub account.

That is frozen now, which means no more shares from that account can be sold. It can only be transferred to the underlying clients own demat accounts, if the security, the share has been fully paid for. Which means if I, if my shares are there and are actually fully paid for those shares, then CDSL will be allowed to transfer from them to my Demat account. But otherwise it will not be allowed and the rest of the functioning of Karvy is okay. Except that Karvy cannot onboard new customers now. This is a problem because one more thing, there is this concept called unpaid security. So a lot of brokers were early bird earlier sale, listen to your share coming from Pool account. You could say, listen, I'll pay for it tomorrow because you've got 24 hours for them and then you could vanish. So these shares would then be paid for by Karvy from its own pocket effectively and they would be sitting in the Pool account as unpaid securities.

So when a lot of companies earn a lot of regulations are to come in 2016 onwards thing. That pool account cannot have securities of customers. There was one loophole, unpaid securities could still sit in the Pool account. So a lot of brokers simply started calling these securities unpaid securities-

Aditya: Even if they were paid for.

Deepak: Even if they were paid for. And there was no easy way to verify that payment had been full receive for them because you could always structure as a payment coming, Oh you owe me for something else. It's a balance sitting in his account, all that stuff. This gave the opportunity for a broker like Karvy to say or ,any broker really to say that some securities are unpaid for and then what the main interesting thing that happened with this new regulation, which started October 1st of 2019 by the way, is that you could no longer classify something as an unpaid security and make it sit in the Pool account. What SEBI said was, shutdown the Pool account. Because you would, I don't know what all your pledged in this shut it down.

Make the pledge, unpledged and finish it. Don't do, don't keep mixed account free. Create a new Pool account. Then in this pledge in this current Pool account, you have a bunch of unpaid securities, put them into another account called unpaid securities account. Where shares can live in only for five days, in after five days if they're still unpaid, please tell them or transfer them to your own Demat account or whatever. But don't keep them there for more than five days. So the other point was they said that the client has given me securities and I have taken margin against those securities. What's the problem? So then you create a separate account called client margin securities. In that margin securities, you're going to take a loan, but there you are now, tell me and identify, which client has how much out of that margin.

So if you have one lakh worth of shares and five customers giving 20,000 shares each, you have to say that five customer brings a 20000 rupees shares each have taken margin against one lakh worth of shares. When you do this, the whole old business model goes for a six because the idea was to take current client money, which the client hasn't placed as margin and put them in the Pool account and take it as a bunched pool and call something unpaid call something else. The whole model breaks. So now when these new rules are to come in, how do you adjust against this? We'll start moving things around. You'll say, Oh, let's create a new account and move some stuff into that account. In that process that a particular customer, again, I mean that particular customer is me only in as a different entity. So as a broker, I could then try and get a pledge on that account and try some stunts around it because I can't do the old business model.

Aditya: And basically doing shady stuff.

Deepak: Many brokers will not admit to doing shady stuff because they don't think this is shady. This has been a business model for 20 years. They don't think it's shady. They think it's perfectly fine, but it's not. It's obviously not, which is why SEBI banned the practice, but therefore what you've got now is a situation where Karvy saying, listen, even in its letter, it has now said or you know, the new regulations come, we are trying our best to adhere to them. What is trying are best? You don't, so somebody tells you don't kill people. Is it like you'll try to adhere to it from next time? You just don't, you know, it's just stop doing it. But obviously that's not what Karvy did. In this case, the suffering people are customers of Karvy, some of whom were impacted directly because their shares are stuck in these Pools.

Last semi-Pool accounts where, when they look at their portfolio, then on the Karvy website, everything's fine.

Aditya: Actually that is my question. That's a very important point because I am pretty sure many people would not know this. Suppose if I buy some shares and after T+2 days when I go to my brokers portal, the shares maybe present in my portfolio, but that doesn't necessarily mean that they have been transferred to my Demat account. So is there a possibility that after T+2 days my portfolio shows that those share are there but they haven't been transferred to my Demat account, they are still lying in a Pool account, is that possible?

Deepak: Yes. In fact in a lot of brokers, I don't know Karvy specifically. I've heard this is the case with Karvy is that, when you buy shares, they go sit in your Pool account they don't transfer for it, unless you ask them.

This is illegal and has been addressed way many times recently, but what they do is they in a way abuse the Demat facility, Power of attorney that you have given them. In a way because they say that Power of attorney gives them the right to transfer to your Demat account or from your Demat account to at-will. You don't even realize when shares are move from your Demat account, which is why recently CDSL and NSDL, which are the effective depositories are sending SMS every time a debit is made, that means people are taking things out of Demat. To save that these guys don't even transfer into your Demat account at all. Because you will now know. Whenever your shares move out of your Demat account. You'll call up the broker and say why have you done that? So they don't even let the shares come in and in their own internal interface, which when you go to Karvy website

Aditya: They will show it.

Deepak: They will say that it is there in your Demat account, but you will know how to note. So what do you have to do now is you're to go to something called the CDSL or an NSDL. And get something called a CAS, a common account statement. This is a monthly statement at the end of every month you will get it. You have to log into CDSL. There's a page you can search for Ecas, it's called electronic CAS. Which will usually come once a month to your email ID where you can go and get it from any of these sites. The way the idea in CDSL works is you have a CDSL broker ID in your Demat account. It is identified by a broker ID and client end, BOID effectively. So if you add the both as in, if you say your broker ID is 12085591. And then your client account is 5600. So 12055 is your main one and then add the digits of your client ID.

That can really become like a 16 digit number. So one after the other. That is something called a BOID. You give your BOID, your PAN and your date of birth to get an OTP from CDSL and then you can download a CDSL common account statement. This statement actually specifies how much securities you have in the depository Demat account. So don't what Karvy's telling you. Please go and get your common account treatment from CDSL or NSDL, whoever your broker is, you'll get it from your contract notes where your Demat ID is, if you find that whatever shares are supposed to exist in your Demat account, which means you bought them maybe years ago, months ago, even a few days, more than two or three days ago, those shares aren't sitting. So of course you'll get your cas only once a month. So right now you'll only get like September end CAS. But you see, if one bought shares on August and they don't reflect in my September CAS.

Aditya: Definitely there's something.

Deepak: There's something wrong. So you can do this for any broker in the country.

Aditya: It's good that you brought the Power of attorney thing and I believe a lot of people including me maintain multiple Demat account. So for example, I maintain two Demat accounts. One is for investment purposes and one is for simply trading and the problem with me is that I don't check my investment Demat account regularly, like some stocks I have just bought and kept and I have not checked. Actually, this scares me because if I have signed my Power of attorney, have I given that right to my broker to move shares out of my Demat account without my permission? Just because I've already signed Power of attorney?

Deepak: Yes, the short answer to your question is yes, because the quest, the idea, the way the system works is when you sell shares from Demat, sell some online thing tool, you sell it, you get 24 hours to deliver the shares. In the earlier days, you had to give a depository instruction slip signed by you and all orders to your broker. The broker would then submit this to the depository.

Then the depository would transfer it from them to the exchange clearing corporation who then further transfer it to whoever was supposed to be receiving the share.

Aditya: For every transaction.

Deepak: For every transaction. Now since you don't have to do this anymore, why don't we have to do this? Because power of attorney to your broker saying I you please do it , so now he can do the debit. Your broker can debit your Demat account whenever he wants because the power of attorneys are like that. They're saying, listen, yes, agreed. They say that you can only do it if I have actually done a trade. Yes, but the Power of attorney allows him to debit for other reasons. Also, for instance, you are, you owe some money and you are not paid some fees or something like that. He can then take your shares and sell them. He retains that right.

Therefore, he is taken an unconditional kind of power of attorney, so it should be verified. Now they can invent paper work saying I took the shares because of that reason, not because of this reason, not because we thought you owed us money. But you don’t, so we will return it. Don't say you won't give a Power of attorney because none of you have the capability of going to your broker physically every time you sell a share with their depository, and remember your share signatures must match. If they don't match, you will be a defaulter. You have to have the signatures match. Every single transaction has to be vetted at a per se script level on a daily basis. Many online brokers will do and allow you to do this operation because of come on, I mean your transaction costs will definitely go up. I mean they will not be able to service you with this kind of charge. This concept of not giving a power of attorney is completely unworkable. You have to give it at best we can hope that some brokers are respected, and many brokers do. A brokerage system is largely based on trust.

Aditya: Okay, so a quick question, Deepak. As you mentioned that the shares have been pledged with some and NBFCs and bank. So suppose I'm the unfortunate one, whose shares lie in that Pool account, Karvy's Pool account, which has been pledged to some Bank or NBFC. So what should I do right now? Like one thing is you asked, you suggested that maybe people can change the broker. Suppose your demat account is with zerodha, and my Demat account is with HDFC so am I in more safer hands because my broker, which is HDFC, is also a bank. So two questions for you. First one, what should I do, second when I try to find another broker, is it necessary that I have to go to a broker, which is also a bank?

Deepak: So I think to answer the second question first, the broker being a bank of alone, making a difference to your life. Have you ever tried to recover anything from a bank? It is going to take years because of the bank decided it doesn't pay. Nobody can make it and force it to be, and this is across the system, across all banks. If the bank decides it doesn't want to pay you, then you will take months and years to recover your money. Most online brokers, at least the smart ones, the good ones, the ones that are do things honestly, including zerodha, they actually never even used a Pool account. They transfer the shares directly from the exchange to your Demat account without the Pool account coming in the middle in a lot of cases. So they actually don't, they try to remove themselves from this practice, so there is no fear at this point of misuse at brokers like. discount brokers like Zerodha.

We haven't seen it with an upstox, we haven't seen it with many others. There are no such. There are no such things that you would notice and the red flags are to be taken care of. Now you tell me that HDFC is better or ICICI is better just because it has a bank that is, that makes absolutely no sense.

Aditya: Some people say you have to pay higher brokerage to HDFC, but you can sleep peacefully.

Deepak: I don't think you can because if an HDFC employee has fraud and he does this, who is going to pay you back anything? I can guarantee you this. Nothing will happen. You can complain. You can go through SEBI and there are a lot of complaints against ICICI and HDFC also on SEBI on routinely such a complaints will come against all sorts of brokers. You can see the number of complaints against them in the NSE because NSE has an online link that tells you the number of customers and number of complaints.

And you can see a lot more customer complaints against people who are banking with such companies because everything is fungible, right? Your money can be taken out of your bank anytime. So if they decided to charge you a fee and hit your bank account, you can't do anything. Whereas if the broker and the bank code are separate, they can just charge your bank account whenever they want. You have to transfer money to them if they have to. So the thing is actually separated. Point is that it isn't any safer to have an account with a bank versus the brokerage like Zerodha and I'm biased because I know that people at Zerodha. Actually I'm only biased towards them because I know the way they work. And it is actually more honest than a lot of bank brokers who continue to use Pools. So if you're using a Pool that is going to take T+3 days before you receive the shares.

And that process honestly has discrepancies and flaws. It's not a great argument to say just go to banks or it's just, this is just, fearful nonsense that banks have used to, cheating and coning people for long time and they're good at it. So just going, changing a broker because you think that Karvy has hurt you and going to a bank level DP, I don't think it's going to make any difference.

Aditya: The first question, Deepak. If I am the unfortunate one and my share is lying in their Pool account. So what should I do? What is my recourse?

Deepak: So I would suggest this. If you're lying in a Demat account, go create a new account. Go the Karvy would have given you a deposit instructions slip, DIS slip, give it to Karvy and tell them please transfer out of my account into my new account. It will take you two or three days. But you have taken action now.

If your shares are sitting in a Pool account, immediately send a query by email, not by phone, but follow it up with a phone request as well. Please give me back my shares. If they don't give you back your shares, not to worry. There is an investor protection fund. If Karvy goes into default that investor protection fund should be more than enough to take care of ensuring that these shares come back to you, it will take some time. If yours is in the Pool account, you haven't taken a loan on it, that means you haven't done a margining on it. Then transfer the share back to your Demat account and then transfer it out into another Demat. I'm just saying get out of Karvy right now. Because given the fact that Sebi has made an ex party interim order, which means they didn't even let Karvy be heard, they said, boss, let's do this before this damage gets worse.

It is your job to protect your interest and move your money out of Karvy. This does not hurt Karvy like it hurts some bank because when you take out money from a bank, it hurts it because it has to know funded itself from another source. When you've given your shares to Karvy, you aren't funding Karvy. Karvy just a place holder that holds a securities. He should not be funding himself by using your securities. So when you take your securities back from him, by you're doing this, you are not going to hurt them if they're doing the right thing. And if they're doing the right thing, they willingly and very happily give you your shares or let allow it to be transferred out and prove themselves to that transfer it back another day.

Don't sell them on Karvy platform. Don't sell shares on their platform. Because when you sell they will automatically debit your shares and move to the pool, sell them, take the money and then you have to wait for the money to come to you, which can take six or seven days. And if they are in really in trouble, they will not be able to pay you the money. So don't sell shares on the Karvy platform transfer them to your Demat account, move from their Demat to another Demat of another broker. And then you can do whatever you want to sell.

Aditya: So you talked about the investor production fund. So when we did the podcast on the PMC bank debacle, you said that the DICGC ensures every depositor up to one lakh that is the amount of insurance we have. Now, what is the case with the investor production fund? Like to what amount? What is the quantum of insurance that a Demat account holder gets?

Deepak: So the idea of Demat account insurance is largely about the fact that your broker misuses or abusers, it's a protection fund, which means that if you lose money due to broker fraud or default, not your fault, broker's fault that caused you to do this, the investor protection fund should pay for it. It will do so in case of systemic default, But it will take years. So if it goes through the investor protection fund, please guarantee that nothing will happen in at least within at least two years. If NSE and the SEBI system is smart, they will do it faster than that. But let's hope that this matter does not go there too.

Aditya: So lastly, Deepak. Let's come to markets. If we, I mean we have come across information that Karvy has pledged client shares and took loan. I want to know what happens to these NBFCs and banks who give the loan. For example, ICICI has lend around 875 crore, Axis bank has lend 25 crores.

Deepak: So what's interesting about this whole situation is we don't know where the, where this whole thing about banks has come from as a bad thing. I mean a lot of loans could have been given in business itself. But when you pledge shares and provide as collateral, banks are not allowed to provide us or more than a certain amount. I think it's 10 lakh, rupees or 20 lakh rupees for a loan that is backed by collateral, which is why you find all this pledging stuff doesn't happen to banks. It happens for NBFCs, mutual funds because those are the ones entities are allowed to lend purely against the collateral of shares. Now, I don't think banks have lent large amount of money against these illegal practices of, pledging shares or client securities without their knowledge. Even with their knowledge. It would be an NBFC that provides a loan, not a bank.

If that is the case, then anybody who is at risk is the NBFC who gave the loan against that. We don't know what NBFC is and we'll find out soon enough, but that NBFC is the one that might be in trouble. It may not be any other bank or loan, which may be actually secured with different sets of assets, which may not necessarily be impacted by whatever's happened. So I don't think the banks exposures would be taken as critical here. It could of course get critical if Karvy becomes bankrupt, but I don't think Karvy is or will become bankrupt because of this case and that they have sister entities. They've said there's only a hundred crores remaining and they will pay. Let's hope that that comes from a lot of people. That said a lot of things in the recent past and nothing has happened. So let's hope that Karvy doesn't fall into that same bandwagon and that they do pay and they remain a growing entity.

And if anybody's in trouble here, it's the NBFCs that are lend against the stocks, which suddenly they find out weren't supposed to be pledged in the first place.

Aditya: So that's it, Deepak. That was the last question and thanks a lot for your time. We had a wonderful discussion and I hope our listeners enjoyed it as well.

Deepak: I hope so too. Do write in at capitalmind_in at Twitter. I'm at Deepakshenoy and Aditya is at astuteaditya.

Aditya: We're looking for feedback. Love to hear your questions. Please do understand that we are only providing an opinion and it is not something that is legally binding or advise that is to you. So please take your action based on the information you have. Don’t just blindly follow us. But at this point I think the Karvy situation demands action of every person who is a customer to Karvy. So do consider taking action wherever, necessary. Thanks a lot Deepak.

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