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A brokerage firm is in some ways like a bank. You can deposit and withdraw money. You can buy stuff with that money. Of course, you can buy a whole lot of stuff with money in your bank account, and only securities like stocks and bonds with money in your brokerage account. But the fundamental idea is similar.
Yet, the primary business models of the two are different. A bank is in the business of attracting deposits and using those deposits to make loans. It charges the borrower an interest, pays the depositor lesser interest, and pockets the difference. Brokerage firms, on the other hand, rely on commissions that they charge every time you buy something through them.
Sometimes, though, banks charge commissions! If you’re making a foreign currency transaction, for instance, your bank will charge a commission to convert the currency. Or if you’re using a credit card, your bank charges the seller a commission. And brokerage firms sometimes charge interest! If you’re in the mood to buy more stock than you have the money for, your broker might give you a loan and charge you an interest for it (in brokerage parlance this loan is called “margin”).
Lending is risky business, more so if your customers are going to borrow to buy stocks. Commissions, though, are quite nice for brokerages—they make money when you buy or sell, regardless of whether you make a profit or loss. But interest revenue (via loans) is risky! [1]
Really, the reason both banks and brokerages have multiple revenue lines is because, well, the goal of any business is to make money, and making more money is (nearly) always better than making less money. Some diversification is nice too, that way you’re not entirely reliant on just one business. [2]
But there’s a simpler way for a broker to make money. If you deposit money into your brokerage account, you might not necessarily intend to use that money right away. Maybe you’re waiting for a certain stock to fall a bit before buying. Or maybe you just deposited some money and forgot about it. Your broker can just take this money and park it into a fixed deposit. It gets some risk-free interest that way. It can even choose to give you some of that interest, just like a bank (well Indian brokerages can’t because they aren’t legally allowed to, but many in the US do, but many in the US do). In the grand scheme of things, this might not be a lot, but let’s not forget that more money is always better than less money, especially if it’s risk-free.
Brokers can make this risk-free interest because they (sort of) resemble banks by taking customer deposits.
Anyway, markets regulator SEBI is in the process of making it difficult for brokerage firms to make this risk-free income. Here is a circular it released last year that asks brokerage firms to return their clients’ money every month or quarter. And here is SEBI chairperson Madhabi Puri Buch last month telling journalists about how they’re figuring out a way for investors to bypass their brokerage accounts and pay the exchange directly for any stocks they buy. [3]
But why! Why would SEBI go after this cute little source of risk-free interest for brokers?
An important catch in this “risk-free” income that I keep mentioning (seven times already) is that it assumes that the broker wants risk-free in the first place. If you deposit some money into your brokerage account, your broker can make a fixed deposit out of it. That way it gets some interest, and it can always redeem the money and send it to the exchange in case you end up buying some stock. But your broker might be tempted to ditch fixed deposits (too boring?) and take a chunk of this money and instead buy some stocks with it. Or just steal it and pray you don’t find out.
This is obviously illegal. SEBI regulates all brokerages and it doesn’t allow them to do risky stuff with client money. In an ideal world, this would really be enough. SEBI would have a bunch of documents filled with do’s and don’ts and brokerage firms would try their best to follow them. They might slip up here and there, and apologise and pay a small fine if they do. That’s how it goes in regulated industries.
But there are more than 1100 brokerage firms [4] registered with SEBI! Monitoring exactly what all of them are doing is quite a task. And regulating brokers is just one of SEBI’s many functions. [5]
In the last 6 years, there have been at least 30 brokerage firms who have in some way or another misused clients’ funds. So SEBI decided that it would rather not get into the trouble of monitoring them and instead just ask brokerages to ditch the deposits and be a little less like banks. The loss of a little “risk-free” side income notwithstanding.
Footnotes
[1] Lending is generally just risky. Banks are heavily regulated and they still go bust every now and then. Brokers are also regulated and they lend with stocks (and bonds, etc.) as collateral and have their own risk-management practices. If you own ₹1000 worth of stock, you might get only about ₹700 as a loan, and this figure would vary depending on which stock you’re placing as collateral. And if the price of your collateral happens to go down, your broker will ask you to post more stock as collateral, and sell off your existing collateral if you don’t. If the price of your collateral goes down faster than your broker can call you to post more collateral (or sell off your stock), she loses money!
[2] While I’m not getting into the details of brokerages’ business models here, brokerage firms in the US make anything between 40-60% of their revenue just from interest! The relevant figure for brokerage firms in India can be anywhere between 12-30% (Zerodha, Angel One, 5Paisa)
[3] To be precise, pay the clearinghouse, which settles trades on behalf of the exchange
[4] When I checked, there were exactly 1117 brokers registered with SEBI to trade on the National Stock Exchange. In comparison, there are only about 40 banks in India
[5] If you’re feeling adventurous, here’s a 39-page document from SEBI about its powers and functions. Page 8 has a list of its functions including regulating stock exchanges, stock brokers, prohibiting insider trading and other fun stuff
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