AFTER some bitter and long drawn controversies, financing of speculation through Carry-over transactions (COT) in the stock market is being replaced with a modified version, named Continuous Funding System (CFS).
At present market is still using COT mechanism and it would take some time before transition from COT to CFS can be complete. However, given that CFS is all set to replace COT, here we discuss whether and to what extent CFS would be free of the problems of COT.
Let’s first remind ourselves of the three problems of COT that led to its phase-out. First, COT was a source of systemic risk. It encouraged reckless speculation and allowed sudden withdrawal of funding that could lead to an unmanageable chain of defaults.
Even when withdrawal of funding was not an issue, COT was problematic because it was post-trade. Speculators could take large positions expecting financing from COT that might not have been available.
Second, COT carried room for market abuse. The large broker-financiers, who dominated COT financing, could take advantage of others in a number of ways. For instance, they could direct and withdraw financing to suit their proprietary positions and to increase financing rates, do large scale short selling with the help of financed shares to bring down prices to their advantage, sell a part of financed shares and use the proceeds for further financing etc.
COT also provided an enabling environment for the financees wishing to manipulate prices. No other channel but the COT blindly provided large scale financing for manipulative trading, as was seen in the May 2000 crisis.
Third, COT was against international practices and obstructed development of derivatives. Developed markets use derivatives and to some extent margin financing for leverage speculation. Only the Indian stock market was known to have a system like COT, which was finally done away with by the Securities and Exchange Board of India in 2001.
CFS is attempting to address the problems of COT by a number of checks and balances concerning management of settlement risk and prevention of market abuse. (i) CFS session would run parallel to Ready market while COT session took place after Ready market, reducing the uncertainty about availability of funds;
(ii) CFS would allow financees to lock financing up to 30 days at compared to 10 days in COT, increasing the confidence of financees;
(iii) Maximum funding in CFS has been capped at Rs25 billion, thus limiting market wide exposure, whereas there was no limit on COT funding prior to the last leg of its phase-out; (iv) CFS would require linking margins rates on exposure in CFS to KSE-100 index while margins in COT were based on exposure slabs;
(v) Exposure of a brokerage house in CFS and futures has been reduced to a maximum of 15 times its net capital balance from 25 times in COT; (vi) CFS requires broker-financiers to keep financed securities in a designated depository account (on which they should not have any direct control) while financiers could take unfair advantage of financed securities in COT;
(vii) CFS would discontinue netting of trading and financing positions for financiers which was permissible in COT and which enhanced the ability of financiers to take greater exposure;
(viii) CFS financees would only be allowed to obtain financing against purchases, i.e. financees would not be able to directly raise cash from CFS which could be done in COT;
(ix) In case of a default, settlement obligations of T+3 market would be given priority over those of CFS, which used to be on parity in COT. These nine measures would be complemented by some other measures such as pre-trade verification and development of derivatives segment.
Some checks and balances built into CFS regulations are likely to be implemented in the near future as they may not require major changes in the systems. These would probably include capping financing, extending financing period, and limiting capital adequacy. Their implementation should help in addressing the problems faced in COT.
However, given the mixed track record of implementing similar COT reforms in the past, it would not be unreasonable to say that all elements of the new CFS regulations might not be implemented. For instance, after the May 2002 COT crisis, exchanges were advised to restrict the access of broker-financers to the COT financed securities but that was never implemented.
The new CFS regulations have been brought in haste and as one would expect they have ambiguities and technical shortcomings. Consider the following. (i) COT regulations have been repealed while CFS regulations are yet to be implemented. That is, at present we have a situation in which financing is taking place through COT but regulations are of CFS; (ii) Legally, owner of securities deposited in a sub-account in CDC is holder of that account. Keeping large quantities of financed securities that belong to many different investors in a single account for each financier may run contrary to the depository’s legal framework;
(iii) Speculators are used to trading through out the day and then determining their net financing requirements. A parallel financing session may create problems for clients and brokers that could cause a rush of orders in CFS by the expiry of parallel session;
(iv) Margin on exposure in a security ought to be based on its volatility and liquidity and it is not clear why and how margin rates applicable on exposure in CFS should be linked to the level or change in KSE-100 index. We also know that KSE-100 index is overly influenced by movements in prices of a few stocks and linking margin rates to this index could lead to distortions. Earlier KSE had discontinued margins on exposure in COT, therefore, a new margining system has to be worked out for CFS; (v) If financed shares in CFS are retained by the CDC, there need not be any margin on exposure of financiers in CFS. If financiers are still required to deposit margins on exposure in CFS, they might charge higher interest rates; (vi) Some elements of CFS regulations are inconsistent with other regulations of exchanges, such as those governing members’ exposure, default recovery, and associate members. What these ambiguities and technical shortcomings mean is that there would have to be more rounds of regulatory and operational changes in CFS before it can take a final shape.
The bottom line is that the regulations and nomenclature for financing may be changing but the fact remains that CFS, like COT, would only serve to sustain excessive speculation and trading concentration in a few companies that has long been an undesirable characteristic of our stock market. CFS, like COT, is inherently problematic because it amounts to operating a quasi futures market within the cash market.
At best, CFS would be a lesser evil than COT and at worst it would be COT with a new tail. For the capital market, hope is not in the checks and balances that CFS might bring but in CFS regulation seven according to which phase-out of CFS would be reviewed by February 28, 2006.
Indeed, CFS too would have to be phased-out if our market is ever to develop in line with developed market where leveraged speculation takes place through derivatives and not through any COT or CFS. There is no point reinventing the wheel and nurturing a lesser evil against all reason and evidence.
