In an interesting development that would help retail investors, large brokerage houses are seeking a formal grading process, say media reports. As with everything else, the efficacy of the grading would depend on the methodology adopted and the scope of the process. From the brokers’ perspective, this will allow stock exchanges and banks to grant trading limits or finance, based on objective criteria and through an independent assessment. Grading will also help investors to choose brokerage firms with more confidence, especially since switching from one firm to another is an expensive and difficult process.
However, issues that will matter to financiers and bourses are different from those that concern investors. With stock exchanges taking care of counter-party risks, investors will be more concerned with service quality and ethical dealing by the staff rather than the firm’s net worth or its branch network. The biggest risk for an investor is not the fear of a financial collapse but several other issues arising out of electronic transactions. Becoming an investor involves significant costs for meeting account-opening formalities; investors are also expected to pay upfront for their purchase and even maintain balances with their brokers. Active investors are forced to trust brokers with a power of attorney for the efficient credit and transfer of shares and funds. The misuse of customers’ funds has been fairly rampant and comes to light only when there is a sharp market correction (see below).
Another problem is brokers’ staff; working on incentives and commissions, they often lure or hustle investors to ‘allow’ them to ‘manage’ their money. Losses arising from their reckless churning of stocks have been a big factor in driving retail investors away from equity trading, especially since stock exchanges rarely bother to work at informal dispute resolution and push investors into a tedious, often one-sided, arbitration process.
Then there is the issue of brokers who have been caught violating SEBI rules and filing consent terms – since there is no admission of guilt, will the rating agencies take such consent orders into account while grading brokerage firms? Grading of brokers is an excellent idea if the methodology is such that it has a value for investors, bourses as well as financiers. But even before we get into the issue of broker grading, one wonders what happened to the finance ministry’s exercise to tighten the regulation of rating agencies themselves, especially after the global financial crisis has raised serious questions about their independence.