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Prop Trading by Stock Brokers in India - A risky proposition

Posted on Friday, December 30, 2016

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Prop Trading by Stock Brokers in India - A risky proposition

Proprietary trading is a growing concern for safety of the clients money with brokers in India. Many brokers choose the path of Prop Trading to increase revenue as earnings from retail broking business is keep going down.

As of Dec 2015, As per statistics provided by SEBI, the proprietary trading contribution out of total trading volume is:

  • 50% in Equity Derivatives Segment of BSE and NSE
  • 20% in Equity Cash Segment of BSE and NSE
  • 43% in Agriculture Commodities Segment of MCX
  • 21% in Non-Agriculture Commodities Segment of MCX

Regulators and stock exchanges (NSE and BSE) require broker to maintain separate books and account for their proprietary trades. But this doesn't stop brokers from using the clients money for their intraday transactions, which makes it a dangerous proposition for its retail customers.

Most stock broker do not disclose this risk on their website or to the clients. As none of the discount stock brokers in India are listed in stock market, it's very difficult to find the balance sheet showing how much revenue is coming from prop desk.

What is Prop Trading by Stock Brokers?

Brokers putting their skills to make money for themselves

Prop Trading (or proprietary trading) is trading by the broker using it own money to make a profit for itself. The account used by broker for prop trading is called Pro-account or OWN account.

Stock broker's prop desk uses highly skilled employees, sophisticated algorithms, high speed servers co-located with the exchange servers and high bandwidth networks to execute the trades.

The revenue of stock exchanges also increases though prop trading as they charge the exchange transaction fee and rent the equipment and infrastructure (i.e. high speed server, data center, network lines) to the brokers.

As per a major newspaper, many brokers are rumored to have proprietary trading books worth Rs 100 - Rs 800 crore in FY2015-16. The business is so profitable that few broker even closed the retail business to focus only on active prop shop.

Low retail participation in India stock market and pressure to increase revenue is pushing more broker to get aggressive in the prop trading operations to increase profits.

How Prop Trading works for Stock Brokers?

Technically broker uses a separate trading account and its own money for Prop trading. But practically they use the same margin money which is partly paid by the customer for their own trading. Here are two popular scenarios:

  • Scenario 1

Client pays margin money for open positions. Clients also keep extra money in trading account in case need arise for additional margin or for trades in near future. Broker involve in prop trading uses this margin money and surplus cash for their own margin for prop trades.

  • Scenario 2

The stock exchanges has strict margin requirements for the open positions but the obligations is for the 'End of Day' balance.

In case of the Prop Trading by stock broker, almost all positions are closed on the same day (day trading). Thus it broker still meet the EoD margin obligation by the exchange with no additional money.

Some of the positions which cannot be closed on the same day are held overnight using the surplus money from clients.

What are the risks of Proprietary Trading?

The risk for a stock broker involve in Prop Trading as similar to the risk an individual trader takes when he borrows money (some or all) and trade intraday.

If market swings unexpectedly, technical issue happen or manual mistakes made by the trader working for the broker, the broker may hit with significant losses which could result in to:

  1. Broker may get bank corrupt
  2. Broker has to pay hefty penalties if End of Day obligation are not fulfilled with stock exchanges. Broker may also risk losing the membership.

The risk changes based on how aggressive your broker goes with prop trading strategies, the market  volatility and amount of surplus money the broker hold.

As there is no easy way to find out how your broker is involve in prop trading, it's very difficult to quantify the risk for the money clients keep with brokers.

Which brokers does Prop Trading?

Most traditional brokers does prop trading in one or more segments.

Some of the discount stock brokers like RKSV (Upstox), Zerodha and SASOnline does Prop Trading.

RKSV and SAS Online did confirm that they have scaled down the Prop trading operations significantly in recent year and will continue doing that.

 Zerodha, the largest discount stock broker is actually ramping up its Active Prop Desk. As of Dec 2016 Zerodha has a dedicated team of over 100 traders (employees) running the prop desk for them.

Which discount brokers doesn't do Prop Trading?

There are few discount brokers who don't do Prop trading. ProStocks and Tradejini are among few popular  discount broker who are not involve in prod trading.

ProStocks is Mumbai based online stock broker offering flat Rs 15 per trade and fixed monthly trading plans (unlimited equity trades at Rs 899 or unlimited currency trades at Rs 499 per month).

The brokers who are not involve in Prop trading offers significantly better security of client's money.

How to secure the money with the broker?

If you have an account with a broker who is involve in proprietary trading, extra precaution is required by the customer to safeguard  the money. Here are few tips:

  • Avoid keeping excess money in your brokerage account.
  • Transfer money from your bank account to your trading account just before a purchase.
  • If you have sold stocks and don't intend to use the money to buy shares using that money, don't leave the money lying in the trading account. Get it transferred to your savings account asap.
  • If you do not want to take hassle of taking the money out of trading account, invest in Liquid Funds (i.e. Reliance Liquid Fund - Treasury Plan - Growth Option) which pays interest on daily basis. By this way you can earn money on parked cash, your money is safe and you have liquidity as well.

For questions, comments or suggestions please post your messages below.

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User Comment

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2. Vinayak P  Feb 15, 2017 6:27:58 AM IST Reply
Thank you for explaining this. I was wondering how these broker making money. This page answered many of my questions. Good Information. Thank you for sharing.
avatar
1. Share View  Mar 11, 2017 2:58:42 PM IST Reply
I''ve heard that brokers misuse traders'' money but how , don''t know . Now I knew .
One more thing I would like to know whether is it safe to keep shares in the brokers pool idle or transfer in to demat account asap ?

Thank You
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3.1. Share View  Mar 11, 2017 6:50:27 PM IST
Dear Admin Sir ,

I kindly request you to answer which can also benefit to many others who are unaware.

Thank You
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