TO become a broker in Karachi, Lahore or Islamabad stock exchanges, one has to first become a member of that exchange. The maximum number of memberships at each of the three exchanges is capped at 200. One may buy a membership directly from an exchange, where it has less than 200 members, or from another member. While some buy memberships to earn their living as brokers, others buy memberships for capital gains. These members are generally referred to as inactive members.
Technically, inactive members can be distinguished from active members in a number of ways. To use a simple but effective distinction, let us classify those as “inactive” who have membership of an exchange but have not registered with the Securities and Exchange Commission (SECP) as brokers. Based on this classification, close to 40 per cent of total members are inactive, as shown in the table. Their proportion differs significantly across exchanges, with ISE having the most inactive members.
The policy question involved here is this: should stock exchanges have inactive members? There are five reasons why the answer to this question is No.
First, having inactive members is inconsistent with the purpose of a stock exchange, which is to provide price discovery and liquidity in listed securities. This is because inactive members do not participate in trading at all nor do they facilitate trading in any other way. The object clause in the memoranda of association of KSE, LSE, and ISE clearly states that these exchanges are established for the business of buying and selling securities whereas this is not the business of inactive members.
Second, inactive members have turned memberships of exchanges into an instrument of speculation. People buy them expecting that their values would rise as the stock market expands and trading volumes grow. The speculative nature of inactive memberships was most evident when in the recent past a relatively large number of memberships of LSE and ISE was purchased in anticipation of a merger of the three exchanges. Memberships are not meant for speculators but for those who want to earn a living through brokerage business and are fit to be trusted with client assets and orders. Our stock exchanges are often criticized for excessive speculation in listed securities and speculation in memberships of exchanges is adding to this perception problem.
Third, inactive members are free riders. They do not contribute to resources of the exchange but benefit from contributions made by others, investors, active members, and listed companies. The value of membership of a stock exchange is closely linked to its level of turnover. To increase turnover, active members and exchanges have to make significant investments, in terms of money and effort, in their businesses whereas no such investment is made by inactive members. But when the value of membership increases, inactive members gain as much as active members.
Fourth, inactive members are a long-term governance problem in stock exchanges. Inactive members enjoy the same one-member one-vote in the affairs of exchanges even though they are essentially speculators and not a genuine stakeholder. Interests of inactive members can often differ from the interests of other stakeholders, as explained earlier in the free riding problem. It is not difficult to think of situations in which this voting power can become problematic when general bodies of exchanges have to vote on critical proposals such as demutualization and merger.
Fifth, it is hard to justify so many inactive members when there are large parts of the country that do not have direct access to the market. What investors need is brokerage houses located in their cities and towns. Decrease in number of inactive members and increase in number of active members would intensify competition and increase incentives for active members to open up branch offices beyond major cities. Increase in market access would expand the market to the advantage of stakeholders.
Exchanges can use a simple set of economic carrots and sticks to phase-out these members. For instance, they can impose a fee on inactive members linked to the average contribution made by active members. Exchange can also facilitate sale of inactive memberships by providing an informal market where potential brokers and inactive members can communicate. But there are a number of difficulties that the exchanges face in acting against inactive memberships. These include (i) voting power of inactive members in general meetings (ii) a natural inertia in changing a structure which has been there for so long (iii) auctioning of new memberships by LSE and ISE to finance capital expenditure (iv) concern by active members that increase in number of active members would increase competition (v) list of inactive members would necessarily include people of power and influence.
Given the difficulties in acting against inactive memberships, the exchanges and the apex regulator of capital market, the SECP, should consider addressing this issue in the upcoming demutualization of exchanges. For instance, after demutualization, only those persons should be allowed to hold trading rights who are committed to brokerage business. Those who are not trading on behalf of clients should automatically cease to hold trading rights. Action by the SECP with the help of the exchanges can do away with inactive memberships in the best interest of our capital market.
