ON March 4, the Securities & Exchange Commission of Pakistan (SECP) issued a directive to the three stock exchanges, the Central Depository Company and the National Clearing Company asking them to strengthen the risk management system of share trading.
The directive included several amendments to the existing system including the downward revision of the quantum of profit distribution for the futures market, the application of three kinds of position limits on futures contracts, banning the netting of positions across the ready and futures market for exposure calculation and the collection of loss margins in the futures market on an hourly rather than daily basis. These new measures are directed to be in place by April/May.
In addition, the SECP also directed the exchanges to review the entire risk management system and submit to the apex regulator a plan of action by April 15. Included in this plan, the SECP expects to see provision for the introduction of unique/global client identification. “[This] is necessary for the effective monitoring and surveillance of the market and would facilitate the client-wise netting of positions for the purpose of exposure calculation,” the SECP directive reads.
This particular measure has significant implications for the future of share trading and has drawn sharp reactions from the stock market community.
What it is: Currently, when any transactions go through the stock exchanges’ trading systems, the deals are identified by a code which represents the broker. What goes unidentified by the system is the client on whose behalf the broker is trading, or indeed, whether the broker is trading on his own account. Therefore, if client A is buying 100,000 shares of company X and client B (through the same broker) is selling 100,000 shares of company X, the system will cross out the two transactions and show a net exposure of the broker as zero. That’s because individual clients are not separately identified. The introduction of global client identification will change this, ensuring each client is assigned a code to use when he trades at any of Pakistan’s stock markets.
The regulators hope this system will reduce the risk of a client defaulting (for example client A in the example above) since netting of brokers’ positions for exposure purposes would be done client-wise without the crossing-out effect explained above.
Background: The SECP had long been pressing the exchanges to introduce this system but the bourses have lingered the issue, largely on pressure from brokers and a lack of adequate understanding on the part of the risk management team. On February 7, a meeting was held between the three stock exchanges and the Central Depository Company in Lahore, on repeated requests of the SECP and a letter to the exchanges dated December 9, 2004. At the meeting, parameters were worked out to establish a global client ID system. A concept paper was then drawn up submitted to the SECP prior to its directive of March 4.
Now, the SECP plans to assign to the Central Depository to work out how this ID system can be implemented. Meantime, in a board meeting held on March 8, the KSE decided that the management would make a presentation to the board on March 16 detailing the concept and how it works. According to Yacoob Memon, acting managing director, KSE, some of the points raised need urgent decisions for which an emergent meeting could be called prior to the next board meeting on March 24. He declined to comment on the merits of the global ID system saying he was not familiar with the contents of the directive. How it would work: The plan is for a centralized database of client registration to be provided to brokers and clients through the Internet and through specialized outlets nationwide. A system-generated unique identification number would be issued to each investor and the identification of each traded order with this unique ID would be mandatory for all brokers. Separate system generated unique ID numbers would be assigned to brokers for proprietary trading.
Why it’s needed: According to the concept paper drawn up by the exchanges, unique client identification exists in the majority of developed exchanges and emerging markets including India where it was introduced in 2003.
The SECP claims a system of global identification of clients is essential to further improve risk management at the exchanges. “The world over, futures are riskier than ready markets and the risk profile of our market is higher anyway for so many reasons,” says Shahid Ghaffar, commissioner, securities markets at the SECP in Islamabad. “This [global client ID] system will help exchanges monitor the positions of brokers and clients since clients often trade through several brokers.”
The futures market has recently grown rapidly as the carry over transactions system is being phased out and this growth has raised concerns about risk management at the apex regulator. Volume in the futures market has risen more than six fold from 33.5 million shares in February 2004 to 220 million shares last month, according to data from Jahangir Siddiqui Capital Markets.
In addition to strengthening risk management, another reason for the introduction of the global client ID system is improving market monitoring and surveillance, principally to track front running and insider trading. Since post-transaction name changes, now a common phenomenon, will no longer be possible, the system will also discourage the internalization of trades by brokers.
“Internationally, the measure. …. is introduced in order to meaningfully curb unfair trade practices including price manipulation and short selling and to promote trade netting and risk management at the client level,” the concept paper says. “Moreover the practice is also used as a measure to segregate and identify proprietary trades from client trades for the purpose of transparency.”
Thirdly, the process will improve documentation, and help detect money laundering, part of the government’s overall effort in this direction, market experts say.
Prior to implementation, the exchanges plan to produce a detailed design document and seek feedback from market participants. Trading courses would also be held, hardware and network equipment would be procured, software developed and legislative protection for confidentiality of information sought. Possible pitfalls:
However, even before that stage is reached, the regulators will have to examine the possible fallout from the introduction of this system. As things now stand, brokers seem far from enthusiastic. “It is unrealistic in our scenario where the entire economy is not documented and you should not bother people who are law abiding tax payers,” says Yasin Lakhani, chairman of the KSE.
Some brokers say the system will cause a scare and push those investors away who are wary of revealing their identities.
“The market should be allowed to develop and other alternative tools should be discussed,” says one former chairman of the KSE.
Brokers also say the impact of the end of COT, the introduction of margin financing should be allowed to take root before new measures are introduced. “Risk management is fine right now,” says Aqeel Karim Dhedhi, chairman of AKD Securities. “Even if the market falls 50 per cent, there is no possibility of problems because exposure requirements are so high.”
Market experts say clients who are wary about obtaining unique IDs will find ways around the system. “Why make a system so difficult it becomes suffocating,” says Munir Ladha, CEO of Eastern Capital. “Those who don’t want to come into the net won’t.”
Some say clients will look for loopholes by using the IDs of relatives or friends. Brokers could also set up a certain number of client IDs and use those to trade on behalf of several clients. “Then separate books will just be kept for benami accounts,” says one broker. “That happens even now.”
Happily for brokers, market experts say the system may force clients into paying their margins themselves since individual IDs will exist. According to the rules, investors are required to deposit margin to brokers but since they do not, brokers deposit margins to the KSE on behalf of their clients, which often strains brokers’ finances. In a February futures contract, for example, a broker faced a liquidity crunch due to high volumes and price fluctuation which eased when the February contracts were settled on March 2.
But brokers are more worried that client confidentiality will be put at risk. The concept paper prepared by the stock exchanges says IDs must only be used for market related issues. “Under no circumstances such information should be utilized or provided to any authority for any other purpose whatsoever,” it says. “In order to ensure confidentiality of such information legislative protection should be obtained.”
That should give brokers the assurance they seek. And market experts say that if this system is effectively put in place, it could put a dampener, however limited, on brokers’ proprietary trading, curb grey market money which finds its way into the share market and help with the implementation of existing regulation which required clients to pay their own margins. To make it truly effective, however, the front line regulators will have to be far more aggressive in monitoring and implementation.
