Early Warning Mechanism for Diversion of Client Securities — How It Actually Triggers

SEBI has put in place an Early Warning Mechanism to detect and prevent diversion of client securities by stock brokers. The mechanism involves sharing of information between Stock Exchanges, Depositories, and Clearing Corporations to detect the diversion of client's securities at an early stage so as to take appropriate preventive measures. This article explains the early warning signals, the sharing of information between MIIs, and the preventive actions that can be taken.

The Regulatory Basis

SEBI Circular SEBI/HO/MIRSD/DOP/CIR/P/2018/153 dated December 17, 2018 specified the Early Warning Mechanism to prevent diversion of client securities. The circular notes that there have been instances where stock brokers had diverted clients' securities. The mechanism is designed to detect such diversion at an early stage.

Early Warning Signals

1. Deterioration in Financial Health

• Significant reduction in net worth over previous half-year / year.
• Significant losses in the previous half years / years.
• Delay in reporting of Annual Report, Balance Sheet, Internal Audit Reports, Risk Based Supervision (RBS) data and any other data related to its financial health to the Stock Exchanges / Depositories.
• Failure to submit information sought by the Stock Exchange / Depositories on its dealing with related parties / promoters.
• Significant mark-to-market loss on proprietary account / related party accounts.
• Repeated instances of pay-in shortages.
• Significant trading exposure or amount of loans or advances given to and investments made in related parties / group.
• Sudden activation of significant number of dormant client's accounts and / or significant activity in the dormant account/s.
• Significant number of UCC modifications.
• Resignation of Statutory Auditors or Directors.

2. Securities Pledge Transactions

• Alerts for stock brokers maintaining multiple proprietary demat accounts and opening any new demat account in the name of stock broker for client purpose.
• Movement of shares to / from a large number of clients' demat accounts or large value shares to stock broker proprietary accounts and vice a versa.
• Transfer of large value of shares through off-market transfers other than for settlement purposes.
• Invocation of pledge of securities by lenders against stock broker or his clients.
• Significant depletion of client's shares in the stock broker client account maintained by the stock broker.

3. Investor Complaints

• Increase in number of investor complaints against the stock broker / depository participant alleging unauthorized trading / unauthorized delivery instructions being processed and non-receipt of funds and securities and non-resolution of the same.

4. Alerts from Risk Based Supervision (RBS) or Enhanced Supervision

• Non-recovery of significant dues from debit balance clients over a period of time.
• Significant dues to credit balance clients over a period of time.
• Failure by stock broker to upload weekly data regarding monitoring of clients' funds for three consecutive weeks.
• Pledging securities in case of clients having credit balance and using the funds so raised against them for own purposes or for funding debit balance of clients.
• Mis-reporting / wrong reporting about the client funds / securities.
• Significant increase in RBS score.

5. Terminal Disablement

• Stock broker's terminal disabled for certain number of days in any segment / Stock Exchange in previous quarter.

Sharing of Information

Alerts triggered at one Stock Exchange / Clearing Corporation / Depository through early warning mechanism shall be immediately shared with other Stock Exchanges / Depositories with respect to the stock broker / depository participant. This ensures that the risk of diversion is identified and addressed across all MIIs.

Preventive Actions

Based on the analysis of the early warning data, if it is established that the stock broker's financial health has deteriorated and / or he has made unauthorized transfer of funds / securities of the client, in such cases Stock Exchanges / Depositories shall jointly take preventive actions. These may include:

• Blocking of certain percentage of available collaterals towards margin.
• Checking securities register in respect of securities received and transferred against pay-in / pay-out against settlement.
• Imposing limits on proprietary trading by the stock broker.
• Prescribing and monitoring shorter time duration for settlement of Running Account of clients.
• Conducting meeting with the designated directors of the stock broker.
• Uniform action of deactivation of trading terminals by all Stock Exchanges.
• Initiating inspection of the stock broker.
• Appointing forensic auditor to trace trails of entire funds and securities of clients.
• Cessation / restriction on uses of Power of Attorney (POA) given to stock broker by clients mapped to such brokers only to meet settlement obligation of that client.

How We Help

At Anuj Desai & Associates, we help stock brokers understand the early warning signals, implement preventive measures, and ensure compliance with the Early Warning Mechanism. If you need assistance with client securities protection, reach out to our regulatory compliance desk.