The current article aims to highlight the critical aspects of the business of stock broking companies. After reading this article, an investor would understand the factors that impact the business of broking companies and the characteristics that differentiate a fundamentally strong stockbroker from a weak one.
Key factors influencing the business of stock broking companies
1) Cyclical, very volatile, and uncertain business environment faced by stock broking companies:
The business of stockbroking companies includes the core business of equity broking (retail as well as institutional), and other businesses like commodity, currency, and debt broking; merchant banking and underwriting, wealth/investment advisory services, distribution of financial products, arbitrage, and proprietary trading etc.
Revenue from almost all these businesses is highly dependent upon the state of capital markets i.e. whether the capital/stock markets are in an upcycle i.e. bull phase or in a downcycle i.e. bear phase.
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A broking firm’s performance is closely linked to the domestic capital markets, which, in turn, are exposed to various macro and micro factors. The broking industry is highly dynamic and less predictable, given the volatility inherent in the capital markets.
The situation of capital markets at any point in time is highly uncertain because numerous factors impact it like corporate earnings, govt. policies, current and capital account deficits, interest rate position, country’s forex rate changes, capital expenditure by public as well as private sector, investor sentiment, foreign inflows, availability of liquidity etc.
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External factors such as regulations, state of the economy, government borrowing programme, capital needs of the corporate sector, and liquidity in the capital and money markets also have a direct bearing on business potential.
As a result, capital markets undergo sharp boom and bust phases accentuated by general economic cycles, which in turn have a significant impact on the business of stockbroking companies.
When stock markets are in a bull phase and stock prices and indices are rising, a large number of new investors join the markets; many companies raise money from markets and come out with initial public offers (IPOs), and merger and acquisition (M&A) deals are at a high. In such situations, stock broking companies enjoy high trading turnovers, and merchant and investment banking deals lead to high brokerage incomes.
On the contrary, during bear phases of capital markets, investors leave equity investing and companies shelve fundraising plans. In such situations, stock broking companies face a sharp decline in their brokerage and commission income.
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A conducive capital market environment, which is characterised by increasing industry broking turnover, rising indices levels, and a growing number of initial public offers (IPOs) and investment banking deals, is expected to help a broking firm improve its financial performance while keeping the associated risks low. On the other hand, an unfavourable capital market with declining broking turnover and volatile stock prices would impact the company’s performance.
For example, during 2008-09, in the aftermath of the global financial crisis, capital markets faced sharp and significant declines leading to huge losses for investors. Almost all fundraising activities came to a complete halt. During this period, stock broking companies faced a very tough time and many of them shut their businesses.
On the contrary, in FY2021-FY2022, in the post-Covid recovery period, during the work-from-home phase, numerous retail investors joined the equity markets and stock broking companies saw their business improve sharply.
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broking firms witnessed a challenging phase in FY2009, which exposed them to various business risks associated with equity broking. In a contrasting trend, domestic broking firms registered a healthy performance in FY2021 and FY2022, after a lull in FY2019 and FY2020, supported by favourable liquidity and the healthy participation of retail investors in equity markets.
Therefore, the business of stock broking companies depends significantly on the state of stock markets and a transition from a bull market to a bear market can have a sharp impact on their revenues and profitability.
Also read: How to do Business Analysis of a Company
2) Intense price-based competition among stock brokers:
The stock broking segment has numerous players competing with each other to gain customers’ market share. The market is highly fragmented.
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As the Indian equity broking industry is highly fragmented, investors have a large number of intermediaries at their disposal for transactions on exchange houses.
The presence of a large number of brokers and sub-brokers in Indian capital markets is due to low barriers to entry. It seems relatively easy to meet regulatory requirements to start broking operations.
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Low barriers to entry due to low regulatory capital requirements resulting in a large number of weak players.
As a result, during bull markets, numerous new players start broking operations. Moreover, in recent times, many online discount brokerage companies like Zerodha, Upstox, Groww, PhonePe, PayTM etc. have started operations.
These new-age online discount brokers have pushed the brokerage rates to extremely low (₹0 to ₹20 per order) when compared to the period before their entry when traditional bank brokers used to charge very high brokerage rates (0.75% of transaction value, ₹95/- per options lot).
This has led to intense price-based competition in the industry. As a result, the brokerage profit margins of almost all the brokers have come down.
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past decade has been the emergence of discount broking houses, which has caused a sharp contraction in broking yields and consequently impacted the profitability dynamics of the industry.
Due to intense price-based competition, the survival of players is very difficult. When capital markets face bear phases and the income of brokerages falls, then many players shut their shops. Therefore, even though the industry has low barriers to entry, it has very high barriers to success.
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The barriers to success (sustainable, profitable and long-term customer relationships) are high, however, and the ability to withstand shocks is low for most entities. This is evident in the exit of several equity brokers in the recent past.
As per ICRA, in 2010, India had about 37,000 brokers and sub-brokers, which declined to about 32,000 by 2018.
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With Indian equity broking industry being a highly fragmented industry having more than 37,000 brokers and sub-brokers active on various Exchange Houses
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As the Indian equity broking industry is highly fragmented—with more than 32,000 brokers and sub-brokers active on various exchange houses
Therefore, stock brokers face a very tough business environment where the operating environment is highly volatile and uncertain with unpredictable bull and bear markets and at the same time, feeling the pressure from intense price-based competition among players to gain a market share.
Also read: How to analyse New Companies in Unknown Industries?
3) Cost efficiency is the key to survival for stock brokers:
Stockbrokers have to face a highly uncertain, and volatile business environment with cyclical boom and bust phases. In addition, they do not have any pricing power over customers due to intense price-based competition.
As a result, during the bear phases of stock markets, when the revenue and profitability of stock brokers decline, many of them go out of business.
In such tough circumstances, it becomes essential that stock brokers make their operations as cost-efficient as possible so that they may survive through the downcycles.
Stock brokerage firms use the following strategies to minimize costs and bring resilience to their business model to survive downturns.
3.1) Economies of scale: increase the size of operations:
As the business/market size of a stock broker increases, then it is able to spread its fixed costs over a larger number of customers; thereby, reducing the per transaction/per customer cost of running the business. As a result, the company is able to relatively safeguard itself from declining profitability during downturns.
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Scaling of operations brings pricing advantages as costs are spread over a higher number of transactions
Moreover, as the market size of any stock broker increases, it becomes a well-known and established brand in the minds of consumers. This, in turn, attracts more new customers which helps the company survive the downturns as its business faces relatively lower reduction than other smaller peers.
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Broking houses with a strong market share and an established brand in the key segments are expected to be more likely to withstand a downturn in the industry.
Moreover, established players usually have lower costs because they do not need to advertise aggressively to gain new customers and on technology systems. On the contrary, new players need to spend significant money on customer acquisition and systems and technology, which makes them vulnerable during bear markets.
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profitability level is lower in a company during the expansion phase compared to one with a well-established and diversified earnings profile as it benefits from better economies of scale.
Also reading: Margin of Safety in Stock Investing: A Complete Guide
3.2) Asset light operations with lower fixed costs help stock brokers survive during downturns:
Brokerage companies can expand their operations via multiple modes like owning their retail network i.e. opening branches and offices where customers can walk in to trade and have their own sales force, which goes out in the field to sell its services, open new customer accounts etc. On the other hand, it can opt for a franchise model where it can outsource its branches and sales to other counterparties.
The former case of owning a retail network with a sales team will have a higher fixed cost and will be a significant burden during a capital market downturn when revenue and profits decline. Whereas, the latter route of franchise-based business will have a lower cost, which will help the company survive downturns better and may even enable it to stay profitable even during bear markets.
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A company that has a large, owned retail network/high lease rental, a captive employee base for business origination and servicing, and inefficient processes is expected to have lower pre-tax margins compared with other players who have a franchisee-operated retail network
Broking firms with a large proportion of variable costs would be more comfortable protecting their pre-tax margins during stressful times.
Also read: Asset Turnover Ratio: A Complete Guide for Investors
3.3) Excessive cost cutting is a double-edged sword for stock brokers:
Cost cutting is usually a good exercise for any business, which does not have pricing power and frequently faces periods of low profitability/losses. Therefore, in general, stock brokers also benefit from lower costs of business operations.
However, if any stock broker conserves cash by compromising on the investments required for maintaining and upgrading its technology and systems, then it may expose it to significant risks that it could have otherwise avoided by keeping up with technology upgrades, backup systems, risk management solutions etc.
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Although an abnormally high non-staff costs expense ratio or a rising trend may indicate a lack of management control over expense levels, low ratios may indicate insufficient reinvestment in systems technology and infrastructure to enhance productivity and sustain the firm’s competitiveness, or to maintain good oversight of risk development.
Therefore, stock brokers need to walk a fine line to strengthen their business model to survive during downturns and only focusing on cost-cutting may not prove beneficial in the long run.
Moreover, while estimating cost efficiencies, investors need to assess staff costs, which is one of the most critical costs for stock brokers, properly. This is because, if the compensation policies do not align the interests of shareholders (company) and its management, then at times, management prioritizes their short-term interests over the long-term interests of shareholders.
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established and consistent compensation policy that aims to align compensation with the medium-term interests of the company more than the short-term interests of the individuals.
In the past, there have been numerous occasions in the stock broking/securities firms across the globe where in the chase of short-term profits, rogue traders have brought down entire large corporations.
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4) Diversification of operations helps in reducing the cyclicity in stock brokers’ performance:
Stock brokers’ business faces high cyclicity, and uncertainty leading to a high volatility in revenue and profitability. In order to smoothen their earnings, stock broking firms attempt to diversify their business offerings and services across different parameters.
As high price-based competition has impacted the profitability of core brokerage operations; therefore, stock brokers add segments like investment banking, wealth management and distribution of financial products like mutual funds, portfolio management services (PMS), alternate investment funds (AIFs), insurance etc., which leads to an additional commission income.
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to shore up their profitability and to augment their portfolios, broking firms have been looking at the distribution of financial products and wealth management/investment banking over the past few years.
Many of these business segments are niche services, which face relatively lower competition than traditional equity broking services. Therefore, companies are able to earn relatively higher profit margins than core equity broking operations.
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While retail broking is highly fragmented, other activities such as institutional broking, investment banking, distribution and capital market-related funding are limited to a few established entities.
Apart from adding to revenue and profits, these additional business segments may also reduce the cyclicity in the business of stockbrokers.
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Given the volatility in the broking business, a higher proportion of relatively stable cash flows, which could be through financial product distribution or portfolio/wealth management services, would help mitigate earnings volatility during cyclical downturns.
Apart from diversification in business segments, brokerage firms also tend to diversify their customer base by focusing on retail, high net worth individuals (HNIs) as well as institutional clients with the expectation that during bear markets revenue from all these diverse customer segments will not decline at the same scale that might help some reduction in cyclicity.
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Client profile and diversification may also be assessed in terms of types of customers (i.e. retail, high-net-worth individuals, institutional), diversification in the clientele and stability of income from various client segments.
Broking firms also tend to diversify their client base by spreading operations across different platforms like traditional clients who walk into a brokers’ office to trade, customers who trade over the phone, online websites, mobile apps etc. These diverse sets of customers may behave differently during bear markets and therefore, may reduce the cyclicity in stock brokers’ business.
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Within the retail segment, ICRA may look at the diversification of revenues in terms of the broking channel, such as traditional broking, online broking and mobile platforms.
Even though a diversification in business segments, client profiles etc. brings stability to the business operations of a stockbroker; however, at the same time, an investor needs to keep in mind that during a downturn when a crisis like the global financial meltdown (2008-2009) or covid pandemic (2020) strike, then all the business segments decline together.
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Diversification may mitigate risks but it is important to differentiate the sources and dependence on diversification during extreme market events, when risks can become more correlated.
Or if despite diverse customer profiles across different trading channels, most of the customers end up being day-trading customers, then the revenue and profitability will fall sharply during bear markets.
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Similarly, a higher proportion of day trading clients increases the volatility in earnings.
Moreover, even though a stockbroker may venture into diverse business segments like asset management company (AMC), clearing corporations, financing of securities business etc., which seem to offer relatively more stable earnings than core equity broking businesses; however, these businesses are usually very low margin and do not contribute meaningful benefits unless these are grown at a large scale.
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more stable operating revenue, such as asset management, clearing operations, or securities financings and clearing…However, due to the narrow profit margins of these businesses, they often require sufficient scale to influence results meaningfully.
Also reading: Margin of Safety in Stock Investing: A Complete Guide
5) Risk management is the key to survival for stock broking companies:
Stock brokers act as intermediaries between investors/traders and stock exchanges and, in turn, have to guarantee the payment of money from their customers (investors/traders) to the clearing corporations for their purchases. In case, the customer refuses to make the payment, then the stockbrokers have to pay from their own pocket. Thus, the stock broking business comes with an inherent credit risk.
Similarly, stockbroking firms face numerous other risks like market risk, where changes in capital markets, interest rates, forex rates etc. impact the assets, investments, and business of stock brokers. In addition, stock brokers also face operations risk, regulatory risk, and litigation risk as well.
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Securities companies face numerous risks, including market, credit, operational, legal, regulatory, and business risks.
Managing each of these risks is essential for stock brokers because any failure on their part in risk management can drive them out of business.
Let us understand some of the key risks faced by stock brokers.
5.1) Credit risk faced by stock brokers:
Stock broking companies are exposed to credit risk because they provide financing to their customers under a margin trading facility, which helps customers trade for a higher sum of money than what they have deposited with the broker. If for any reason, when the settlement of money from the broker to the clearing corporation is due, the customer is unable to bring in the required money, then the broker has to pay to clearing corporation from its own pocket and then recover the money from the customer.
This settlement risk under the margin trading facility is the biggest credit risk faced by stockbrokers.
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Settlement risk is still often the largest credit risk for trading businesses
As a result, stockbrokers need to manage credit risk related to their customers very diligently. There must be reliable systems to control client-specific exposures/limits. Such systems should have efficient risk management practices to close customers’ trades when their risk/exposure increases beyond predetermined limits.
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risks related to the broking client in terms of setting up and monitoring the client-wise exposure limits in case of leveraged exposure taken by clients, the leverage provided by the broking firm through the margin trading facility (MTF), the margin policy (margin calculation, monitoring and call/set-off) and the margin cover maintained on margin funding clients.
In order to build a strong credit risk framework, stock brokers must have efficient processes for approval of margin trading limits for new customers, processes for approval of new franchisees as well as efficient policies for underwriting merchant banking transactions like IPOs.
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assessment of the credit appraisal procedures for approving new clients and new franchisee, portfolio characteristics etc. ICRA also evaluates the procedures for approving under-writing deals or merchant banking investments and concentration of business with any particular client.
Any lapses by stockbrokers in credit risk management can risk the survival of the company. As a result, investors need to examine the write-offs/bad debt, provisioning done by stock broking companies in their analysis.
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To capture the risk management track record, ICRA evaluates the quantum of write-off of bad debts, provisions on bad debts, and error trades on the broking business as a percentage of the company’s net worth and its operating income for the past several years.
Also read: Receivable Days: A Complete Guide
5.2) Market risk in the business of stock broking:
Stock brokers face market risk, which arises due to changing values of key parameters in capital markets like interest rates, forex rates, stock and commodity indices etc.
Market risk is especially prominent for those stock brokers who have a significant proprietary trading book i.e. they invest/trade with their personal money in capital markets.
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Furthermore, a high share of proprietary investment/trading operations can further increase the broker’s risk profile, given the exposure to market risks.
For such brokers, any change in capital market levels, interest rates etc. leads to a significant impact on their personal portfolio, and net worth, which, in turn, exposes them to further risks like the inability to meet the minimum net worth criteria stipulated by regulators, inability to meet higher margin requirements from stock exchanges etc.
Therefore, stock brokers, especially the ones who keep a large proprietary trading book, are exposed to significant market risk and must have good systems in place with hedging strategies to protect their business if capital markets, interest rates, forex levels etc. move against them.
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The analysis of a broking firm’s exposure to market risk encompasses assessing the mix of proprietary trading versus customer-oriented trading, variability of trading income/profits, risk appetite and hedging strategies, and the concentration of risk in the debt and equity trading portfolio.
Assessing market risk for stock brokers is crucial and tricky at the same time because the commonly accepted parameters of risk assessment like value-at-risk (VaR) do not prove helpful when real risks in capital markets arise like the global financial crisis (2008) or post-Covid meltdown.
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Reliance on VaR alone is insufficient to measure the complex positions and structures of many trading desks. VaR provides some information but is unreliable in abnormal market conditions – arguably the time it should become more relevant.
Moreover, for many investments done by stock brokers like private equity (PE), venture capital (VC) etc. there is no good method/benchmark for valuation, unlike stock market investments where the current market price of stocks acts as a very good benchmark for valuation. In the case of PE and VC investments, the valuations are highly inflated in times of easy liquidity whereas the valuations crash sharply when liquidity in the market is tight.
Therefore, an assessment of market risk becomes a challenging task for stock brokers.
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Market risk within investments such as merchant banking, private equity, and venture capital is heavily influenced by liquidity. Determining a fair value for these instruments can be difficult and vary widely based on internal assumptions, such as discount factors
Assessing market risk becomes essential for stock brokers who have a significant investment book as well as a large margin funding book for customers because during stressful times, increased market risk (fluctuations of market indices, interest rates, forex etc.) leads to payment defaults and in turn leads to a high credit risk.
During stressful times, counterparties to hedging contracts may not be able to make payments if they themselves are facing a liquidity crisis/are bankrupt.
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the grey area between market and credit risk for traded assets. …On the other hand, market risk can often morph into credit risk following stress events.
Also read: Credit Rating Reports: A Complete Guide for Stock Investors
5.3) Operations risk for stock brokers:
Stock brokers’ operations are critically dependent on technology systems for the execution of a large number of trades executed by customers. These systems have to be robust enough to move significantly large amounts of money and securities flawlessly. Otherwise, any problem in any of the multiple parts of the technology chain can disrupt stockbrokers’ operations and impact customers’ experience.
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As a routine business operation, brokerage firms are engaged in processing large number of transactions and transferring huge amount of cash and securities every day. For executing such large data based transactions, it is necessary to have efficient and smooth running internal control system.
In the past, customers have experienced numerous instances of systems of securities companies failing due to operational issues highlighting the importance of taking operations risk seriously.
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During such outages, it becomes essential that stock broking companies have recognized the importance of maintenance of backup systems, databases, and quick restoration in the event of disruptions as any prolonged outage can seriously impact the reputation and customer confidence in the stock brokers’ ability to handle customers’ money and securities.
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company’s policy and the systems available for business continuity planning such as availability of back-up systems, time taken to restore the connection failure, database maintained, policy on disaster house etc.
At the same time, the technology systems of the brokers are essential for monitoring risk in operations as well. The risk management systems have to work efficiently to monitor client-specific limits in trading, issue margin calls and close trades when the risk increases.
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Operational risks tend to emanate from sub-par internal control and information systems, among others. Instances of inability to liquidate client positions because of infrastructure breakdown and resultant claims from clients are viewed negatively.
In current times where securities trading has shifted from orders-over-phone to online systems and algorithms, new risks have surfaced like manual input error (fat finder trades) or bugs in the algorithms threatening the systems of stockbrokers as well as stock exchanges.
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algorithms run with minimal human intervention, operational risks arising due to improper input (fat finger error) or algorithm malfunctioning (runaway-loop situation) need to be addressed.
In the recent past, one of the stockbrokers, Emkay Global suffered significant losses when one of its traders made a serious error while entering an order in the system.
The panel feels gross negligence by a single member cannot be allowed to impact 60,000 trades executed by 14,000 clients of 665 exchange members
Moreover, a lack of strong and secure technological systems also exposes stock brokers to social risk because they control the very sensitive personal and financial data of a large number of customers. Any hacking of brokers’ systems could create a serious risk for the company as well as its customers.
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financial services sector faces risks from a social standpoint…The risk of data breaches and cyberattacks, affecting the large volume of customer data managed by such entities, also exists.
Therefore, stock brokers have to be very prompt in upgrading their systems and making them secure with the latest protocols so that the interests of both the company and the customers are safe.
5.3.1) Continuous requirement of investing in/upgrading technology infrastructure by stock brokers:
In order to ensure a smooth trading experience for customers as well as to safeguard the business from credit, market, and operational risks etc., stock brokers need to invest in the latest technology infrastructure with various security-related upgrades.
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The quality of a broking house’s infrastructure, systems and processes is important for ensuring uninterrupted operations while keeping the operational risks under control. Also, a broking house’s information technology (IT) infrastructure not only aids in efficient operations but is also critical for efficient real-time monitoring and to comply with the requirements of regulators/stock exchanges.
In order to run its operations efficiently and make the best use of its capital along with proper risk management, a stockbroker must have a strong management information system (MIS) and back office, which can monitor limits at the levels of dealers, sub-brokers, clients, and terminals.
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management information systems (MIS) also play a crucial role for monitoring branch efficiency, utilising the capital placed with the exchange houses, monitoring dealer and client limits besides ensuring the smooth running of normal business operations. Moreover, back office operations serve as the backbone of a broking firm for ensuring efficient servicing of the client while mitigating the risk by assigning dealer-wise, terminal-wise, sub-broker-wise and client-wise exposure limits.
Any bugs or inefficiencies in crucial technological functions may threaten the survival of a stock broker’s business besides impacting risk management and spoiling customers’ experience. Therefore, broking companies must upgrade their systems and do regular stress testing to ensure their proper functioning and relevance.
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Brokerage firms with poor back-office infrastructure are likely to compromise both on risk management as well as client servicing…companies doing regular stress testing and upgrading their systems accordingly are also viewed favourably
Also read: How to do Financial Analysis of a Company
5.4) Regulatory and compliance risk for stock brokers:
Securities business including stock broking is one of the highly regulated sectors. Moreover, market regulators continue to bring in more regulations to increase the stability of financial markets as well as to safeguard investors.
Therefore, the risk of new regulations that might impact stock brokers’ business, their revenue and profitability is a continuous threat.
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trading restrictions or high capital charges on certain products can curtail activities or profitability and make businesses less viable.
For example, in 2015, in order to safeguard small investors, the Indian market regulator, the Securities and Exchange Board of India (SEBI) increased the minimum contract size for derivatives trades (futures and options, F&O) from ₹2 lakh to ₹5 lakh. This increased the minimum capital requirements on the investor, which in turn led to a reduction in trading volumes, resulting in a lower revenue for stock brokers.
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In November 2015, in a bid to contain retail participation in the futures & options (F&O) or derivatives segment turnover, SEBI increased the minimum contract size for contracts to Rs. 5 lakh from Rs. 2 lakh, This resulted in a decline in trading volumes in the following months
At times, in order to make the securities firms more resilient, the market regulator has prohibited them from certain business activities e.g. giving financing/loans/margin funding to their clients from their own capital. The market regulator, instead, made it mandatory for institutions like NBFCs to enter the field for providing margin funding to brokers’ clients.
Such steps lead to shifting of a part of value-addition in the broking business from stock brokers to other entities leading to a loss of revenue and profitability for stockbrokers.
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Regulatory changes in the securities industry can also result in business shifting to new or different market participants. For example, new regulations now restrict margin funding to customers by brokerages
Recently, SEBI has come up with a consultation paper that intends to restrict stock brokers from engaging unregistered financial influencers (finfluencers) on social media to generate leads for new customers. As per Zerodha, one of the leading Indian stock brokers, this step might lead to a loss of about 10% of new client additions for the company.
In addition to limiting the unrestricted growth of stock brokers’ business, stringent regulations also put a significant financial burden on the companies to meet tight compliance norms. In the financial markets, the compliance burden is so stringent that it can seriously impact the profit margins of smaller players.
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a company with a small presence in retail broking and limited brand strength is expected to face stiff competition, besides having lower wherewithal to bear the rising compliance costs, which could put pressure on its broking margins
Moreover, the risk of regulations is also cyclical in nature where the probability of stringent regulations increases when markets and investors’ sentiment are at extremes, both at the peak of the bull market and the bear market. At such times, regulators are extra cautious to avoid any runaway risk from hurting the stability of financial markets.
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As with other risks faced by securities firms, litigation and regulatory risks can be cyclical and often rise following equity market declines, stress losses, or regulatory changes.
Therefore, investors should always be mindful of the continuous presence of regulatory risk while assessing stock market entities including stockbrokers and be more cautious about a heightened regulatory risk during good times/bull markets when stock brokers report peak earnings.
Moreover, investors should always assess the past record of the company in terms of compliance, litigations, regulatory actions, penalties etc.
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history of non-compliance and severity of regulatory sanctions and history of penal action (deactivation of terminal, etc) by regulators/exchanges for violation of norms.
6) Requirement of a significant amount of capital for smooth running of stockbrokers’ operations:
Stock broking companies are required to keep money with stock exchanges as a security/guarantee for meeting their payment obligations on behalf of their customers. This capital is to ensure that if a broker fails in its assessment of the customer’s ability to pay and as a result, any customer fails to pay for its obligations, then the stock exchange will deduct the required money from the capital placed by the broker with the exchange.
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Given the volatile nature of the broking industry, a broking house needs to have an adequate level of capital to be placed with the exchange houses for margin requirement. Also, strong capital levels provide the necessary cushion in terms of absorbing any losses if needed.
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strong capital levels provide the necessary cushion in terms of absorbing any delay in collections from clients and losses should there be a requirement.
Therefore, the availability of liquid capital is an essential requirement for stock brokers. Many times, stockbrokers face the sudden requirement of additional capital when stock exchanges increase margin during times of high volatility in capital markets. Usually, during the expiry week (the last week of the month), the capital requirement of brokers increases.
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Since sudden liquidity requirement is a possibility (for instance, through higher margin requirement by the exchange houses during a volatile market phase and also during the expiry week every month for futures and options), adequate liquidity to meet these short-term requirements along with the ability to raise funds quickly is a distinct positive for a broking firm.
Most of the established stockbrokers keep sufficient liquidity to tide over phases of higher margin requirements. Nevertheless, it is important to note that investors should only take comfort in that capital, which is invested in safe, liquid, and short-term investments. It is advised to exclude the capital invested in illiquid and long-term assets, which are not readily accessible at short notice.
Rating methodology – broking by ICRA, January 2018, page 7:
However, a brokerage firm may have deployed a part of its capital towards long-term and ill-liquid investments, which reduce the financial flexibility available with it. Thus ICRA evaluates a company on the basis of free net-worth, which refers to the net worth excluding the long-term, risky and /or ill-liquid investments.
Even though stock brokers do not use long-term loans in their business, they still use non-fund-based bank facilities like bank guarantees to meet margin requirements at stock exchanges as well as keep undisbursed bank lines as liquidity backups for urgent situations.
Rating methodology – broking by ICRA, August 2022, page 7:
Broking firms tend to have material non-fund based limits, as they normally place bank guarantees (BGs) with exchange houses for margin requirement.
However, an investor must note that in the financial services business including the stockbroking business, a slight hint of liquidity troubles or impacted reputation may lead to a credit squeeze on the company indicating that it may face difficulties in raising money from banks and the market.
Rating criteria for securities firms by CRISIL, July 2023, page 8:
Securities businesses are based on confidence―even a perception of trouble in the market can impact a company significantly.
Therefore, free net worth coverage i.e. the cover provided by liquid net worth over the risk of non-receipt of customer receivables/losses is an important parameter for assessing the financial strength of stock brokers.
Rating criteria for securities firms by CRISIL, July 2023, page 4:
For broking companies, networth coverage is a parameter to understand the adverse impact on net-worth due to credit risk (non-realization of receivables). Higher networth coverage reflects the resilience of the securities firm to continue its operations unabated during adverse conditions.
Also read: How to do Business Analysis of a Company
7) Annual reports and routine financial ratios are not sufficient to assess of business position and risk of stock brokers:
The year-end financials reported by stockbrokers in their annual reports do not reflect the true nature of risks faced by them in their businesses and investments. Therefore, investors need to be cautious before they rely on conventional ratio analysis in their assessment.
Rating criteria for securities firms by CRISIL, July 2023, page 1:
Unlike for commercial banks and financial institutions, analysis of the balance sheets and financial ratios of securities firms does not entirely capture their risk profile. That’s because the key risks these firms face are market and business risks, which are volatile and difficult to measure from year-end reports.
Rating methodology – broking by ICRA, July 2020, page 1:
It notes that analysis of financial ratios alone (based on annual reports) does not capture all risks associated with a brokerage firm.
It is difficult to assess the value of assets/investments owned by stockbrokers from their annual reports. For example, there is no standard regulatory credit provisioning policy stipulated for stock brokers. Therefore, each firm uses its own estimates. As a result, the assessment of credit quality and a comparison across peers becomes challenging.
Rating methodology – broking by ICRA, January 2018, page 7:
In the absence of any stringent regulatory credit provisioning policy, it is difficult to assess a company’s asset quality on the basis of the financial indicators alone
Similarly, the models used by securities firms to estimate market risk are also not standardised leading to uncertainties in analysis by investors.
Rating criteria for securities firms by CRISIL, July 2023, page 5:
models to evaluate market risks and the assumptions underlying the models are not standardised across Indian securities firms.
For the valuation of assets/investments like derivative contracts, private equity, venture capital investments etc., securities companies use pricing models developed by them in-house. As a result, assessment of many parameters like mark-to-market, and fair value-based gains or losses becomes challenging. Therefore, investors need to be diligent in assessing how much revenue and asset size is valued based on such in-house pricing models by the companies.
Rating methodology for securities firms by India Ratings, April 2022, page 6:
firm’s assessment and reliance on internally developed pricing models and the basis of accounting for product lines that are highly dependent on determining market prices from a model or haircut due to exclusivity or liquidity issues…ascertain the amount of revenue that depends on internal inputs and is model based.
Therefore, an investor should keep in mind that even if she has done an in-depth reading and analysis of the annual reports of any stock broking company, there would be many aspects of its risk profile and assets/investment assessment that will remain uncertain.
Also read: How to study Annual Report of a Company
Summary
The business of stock broking companies is very volatile, cyclical, and full of uncertainties coming from external factors like macro and microeconomic factors, investor sentiments, regulatory actions etc. The revenue and profitability of stockbrokers is highly correlated with the boom or bust phase of capital markets.
During the bull phase, numerous new investors come to capital markets and as a result, trading volumes increase, leading to higher income for stock brokers. On the contrary during bear phases, many investors suffer losses and therefore, leave stock markets and this leads to a decline in revenue and profits of stockbrokers. Therefore, the revenue and profits of stock brokers are highly cyclical.
The stock broking segment is highly fragmented because it does not have any major entry barriers. As a result, investors have options for numerous brokers to trade/invest their money in stocks. Nowadays, many online discount brokers operate in Indian markets, which have reduced brokerage charges significantly even to the extent of zero brokerage on equity delivery trades. This has led to severe pressure on the profit margins of all the stockbrokers in their core equity broking business.
Even though the stock broking industry has low entry barriers, it has very high success barriers. During downturns, many brokers/sub-brokers shut their shops.
In light of intense pricing pressure and cyclical declines in revenue and profits, stockbrokers need to be highly cost-efficient to survive through downturns. One of the ways to be cost-efficient is to increase the market share and benefit from economies of scale. Additionally, stockbrokers who keep their fixed costs low and run asset-light operations are in an advantageous position.
Nevertheless, stockbrokers need to continuously invest money in their technology systems and cannot avoid such capital investments. In case, a stockbroker cuts down on technological investments and system upgrades, then it leads to compromises in risk management as well as deterioration in customers’ experience because robust and secure technological systems are a must for any stockbroker to smoothly run its operations.
In order to reduce the cyclicity and improve profitability, stockbrokers diversify their business across different segments like asset management companies, wealth management, distribution of financial products, insurance, private equity, and venture capital etc. Even though, these businesses offer relatively stable cash flows than equity broking; still, companies still need to achieve a reasonable scale in these businesses to get a meaningful contribution to revenue and profits.
Management of risk is absolutely critical for stockbrokers, which comes in the form of credit, market, operations, and regulatory risk. Stockbrokers need to be very cautious in their risk management systems while offering margin/limits to customers and dealers. This is because if brokers’ customers default in making payments, then stock exchanges recover that money from the brokers.
Stock brokers who have proprietary trading face significant market risk because the fair value of their investments keeps fluctuating along with market indices levels, interest rates and forex rate levels. At the same time, managing operations risk is crucial for stockbrokers because any disruption in the technological infrastructure can lead to a halt of trading by customers and threaten the risk management in their businesses.
Stockbrokers are crucial for investors to access stock exchanges for trading/investment; therefore, market regulators keep stringent guidelines for their business. As a result, whenever markets are at an extreme, both bull and bear phases, then there is a high chance that regulators will come out with more stringent regulations to protect the stability of markets.
As a result, stock brokers face a very high regulatory risk when a single circular from the regulators can have a significant impact on their revenues and profits.
Stock exchanges require brokers to keep a significant amount of capital with them in order to let the brokers’ customers access the exchanges for trading. In addition, brokers also need to keep more liquid capital to meet sudden requirements like higher margins stipulated by exchanges in volatile periods as well as to cover for losses due to non-payment by customers. Therefore, all stockbrokers need to keep a significant amount of liquid investment, which can be accessed at short notice.
As the business of stock brokers is highly uncertain, volatile, and cyclical; therefore, their annual reports and routine financial ratios are not able to disclose all the risks inherent in their businesses. Analysis of broking companies also becomes challenging due to the absence of standard credit provisioning guidelines or models for assessing market risk. Stock broking companies use their own internally developed models for market risk assessment and pricing of investments like PE and VC funds. Therefore, investors need to be very cautious while assessing the financial and business position of stock brokers from their annual reports.
An investor should always keep in mind these multiple aspects of stock broking companies to understand their business position.
- Cyclical, very volatile, and uncertain business environment
- Intense price-based competition
- Cost efficiency is the key to survival
- Economies of scale bring a competitive advantage to stockbrokers
- Asset-light operations with lower fixed costs help stock brokers survive during downturns; however, excessive cost-cutting acts as a double-edged sword
- Diversification of operations helps in reducing the cyclicity in stock brokers’ performance
- Risk management is the key to survival for stock broking companies: credit risk, market risk, operations risk, and regulatory risk
- Continuous requirement of investing in/upgrading technology infrastructure by stock brokers
- Stockbrokers require a significant amount of capital for the smooth running of their operations
- Annual reports and routine financial ratios are not sufficient to assess the business position and risk of stock brokers
We believe that if an investor analyses any stock broking company by keeping the above factors in mind, then she would be able to assess its business properly.
Regards,
Dr Vijay Malik
P.S.
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Disclaimer
I, Vijay Malik, am a SEBI-registered Research Analyst (Regn. No. INH100008364). This article is for educational purposes only and does not constitute investment advice or a recommendation to buy or sell any securities. Investors should do their own research before making any investment decisions.
I, or my immediate relatives, do not have any financial interest in the companies discussed as on the date of publication of this article, nor do we hold one per cent or more of the securities of such companies at the end of the month immediately preceding it. I do not have any material conflict of interest and have not received any compensation or other benefits from the companies or any third party in relation to this article during the 12 months preceding its publication. I have not served as an officer, director, or employee of the subject companies, nor have I been engaged in market making activity for them.
