January 16, 2006	Monday	Zilhaj 15, 1426

Stock market reforms have had unforeseen outcomes, quite different to, even opposite of, what was intended. At times, instead of fixing a problematic structure or practice, reforms ended up establishing it on sounder footings and weakened the moral cause for changing things for the better.

Let’s look at three cases where reforms have led to unintended outcomes and the relevance of the lessons learnt for the upcoming demutualization of stock exchanges.

The first case is of Badla. When T+3 settlement cycle was introduced in 2001, the intention was to bring the settlement system in line with international practices. That was never achieved because using Badla speculators could defer settlements endlessly.

Given the many problems caused by Badla, a six month long road map for phasing it out was made public by SECP in end 2002. Little progress was made on the issue till 2004 when another road map was put into implementation.

However, a strategic mistake was made: instead of derivatives, particularly single stock futures, margin financing was portrayed as the main substitute of Badla.

Inability of margin financing to substitute Badla played into the hands of stock brokers. Taking advantage of the attention that some new electronic channels had started to give to stock market, brokers unleashed a propaganda campaign against the Badla phase-out and SECP, which quite unwisely did not present its point of view in the media.

Government high-ups intervened and in August 2005 it was agreed that Badla would be replaced by CFS, which like Badla is a quasi futures market within the cash market, against all international practices.

It appears likely that now CFS would only be phased-out by market forces, when derivatives, particularly, single stock futures, are sufficiently developed to make CFS redundant. That is, efforts spread over four years to phase-out Badla have produced the unintended outcome of entrenching a Badla-like system.

The second case of reforms having unintended consequences is restructuring of the board of directors of stock exchanges in 2002, which included appointment of four nominee directors by SECP. This move was brought about amid high hopes that in future decisions in the board room of exchanges would give due weight to the interest of investors. Those hopes did not materialize.

Nominee directors could not play an effective role in strengthening any area, including management of settlement risk and surveillance against market abuse, weaknesses which contributed to the March crisis.

While broker-directors are seen as conflicted, nominee-directors are criticized for lacking in required expertise in affairs of exchanges. Some of them seem to accept the position to enhance their personal profile and not to serve investors. They also remain fearful of potentially grave consequences of opposing stock brokers.

Decision-making powers at exchanges continue to be in the hands of stock brokers for a number of reasons, including their majority in the board of directors, their greater knowledge of issues facing the exchanges, board’s involvement in operational decisions which should be taken by the management, and a web of broker committees and “loyal” exchange employees.

Since the final selection of nominee-directors is done by SECP, the regulator remains ill-placed to criticize them and shares the blame when exchanges take controversial decisions.

Appointment of nominee-directors has not furthered the cause of investors much, but it has weakened the ability of regulator to question the decision-making at the exchanges.

Judging from the past, it is possible that after appointment of a non-broker chairman, governance at the exchanges may not show the desired improvements and the SECP could be in an even weaker position to intervene in the affairs of the exchanges.

The third case of unintended outcomes is stock market reforms as a whole. The objective of the reforms was to convert stock exchanges from mere clubs of speculators run by stock brokers in their own interest into meaningful economic agents that were run in the best interest of the investing public.

Of course, reforms have had success and exchanges have shown some improvements due to them but their cumulative result is quite different from what was intended.

Reforms have not led to enhancing capital formation in any significant degree or broadening of investor base or protecting investors from market abuse.

Despite economic growth and registration of many new companies, few are seeking listing to raise capital; less than one percent of country’s adult population directly or indirectly owns listed securities; and in March 2005 investors suffered a major market crisis.

On the other hand, when it comes to generating speculative volumes, KSE’s turnover velocity beats that of all the leading exchanges of the world, from USA to Australia.

In reality, primary beneficiary of reform process is not the investing public but the stock brokers. Reforms gave stock exchanges the legitimacy they needed in the eyes of the government and public and paved the way for channelling massive flows of liquidity into listed equities.

A four-year long market boom has brought an astronomical increase in the net worth of stock brokers. Some of the leading stock brokers are now busy building financial services and even industrial empires and are perceived to have joined ranks of the richest men in the country.

With all this wealth have come power, prestige, and influence. Things have already reached the point where those occupying the highest offices are always willing to lend a sympathetic ear to leading stock brokers in every petty controversy that hits the market.

Recently, a powerful stock broker, while talking on a television talk show, which is sponsored by his brokerage house, warned SECP of dire consequences on the current controversy surrounding the office of bourses’ chairman.

Following their leaders, brokers at KSE are now openly defying the SECP on this issue. This is not the kind of outcome in the beginning of 2006 that SECP leadership could have had in mind in 2000 when reform process was put onto the fast track.

Clearly, had they known the outcomes of the reform process, the policy makers would not have taken the course they took.

We should be willing to learn from the past, from the Badla phase-out, appointment of nominee directors, and capital market reforms as a whole. There is a fear that demutualization would be done in form rather than substance because controversies on core issues, such as shareholding ratios of new investors versus stock brokers, would lead to a CFS-style compromise due to intervention by government high-ups.

The costs of a half-hearted demutualization are likely to outweigh its benefits as it would substantially weaken SECP’s moral authority to bring further reforms. It may also compromise the ultimate power in the hands of regulators – the ability to license another exchange.

Indeed, there is no power in the hands of SECP more potent than the power to license another exchange and there is nothing that KSE fears more than genuine competition.

It was the fear of competition that stock brokers went to the court when PEX was licensed in early 2003. A new demutualized exchange backed by financial institutions and managed by top professionals could quickly change the stock market landscape in favour of the investors, as has been the Indian experience with the National Stock Exchange of India.

Indeed, it would be a great misfortune for the investors if demutualization, like some of the other reforms in the past, ended up producing unintended outcomes and blocked the path of licensing another exchange, which appears to be the best policy option for the future.