IN 2006, key issues in stock market reform process pertained to office of chairman of stock exchanges, UIN system, new netting and margining methodology, free-float based KSE-30 index, CFS MK-II, cash settled futures and a whole host of controversies about market abuse and cover-ups. So going forwards, what are the key issues that are likely to dominate stock market reform process in 2007? Based on past trend and current situation, four issues stand out.

First is demutualisation of stock exchanges. The Securities and Exchange Ordinance 1969 has been amended for the purpose and SECP has been given powers to specify how and under what conditions it would be done. We should see finalisation of the scheme in 2007. Many are hoping that after demutualization exchanges would get the human and financial capital to develop at a fast pace. However, the simple fact about demutualisation, which is often overlooked, is that it is not a panacea and whether and to what extent it would address the issues facing exchanges depends on how it is structured.

Second issue is making further progress on initiatives taken in 2006, most notably in management of settlement risk and development of new trading products. It is likely that when required margins would go up significantly under the current one percentage point per week phase-in programme and time would come for implementing client level netting, there would be a fresh round of resistance by market participants leading to more concessions and compromises. In product development single stock cash settled futures are likely to be introduced in 2007 but perhaps the year would be consumed before these contracts are fully absorbed by market participants. In CFS Mk-II progress appears difficult due to strong reservations of stock brokers and it may well be shelved.

Third issue is investor protection from market abuse through market surveillance, investigation and enforcement. Throughout the stock market reform process, this has been the most difficult area for regulators. Lingering controversies of March 2005 crisis and court cases triggered by May 2000 crisis only highlight this ground reality. On the brighter side, we may see installation of surveillance software in 2007, which would improve monitoring capacity of regulators. We may also see some enforcement action against wrongdoings and wrongdoers of manageable size because decision makers need to show some enforcement actions to the media to restore their credibility.

Fourth issue is of merger of exchanges or at least integration of order book. In the past KSE has rejected possibility of a merger with LSE and ISE. Merger plans of smaller exchanges have also not materialised; however, LSE and ISE are planning to start off their common trading platform in early 2007 in which ISE brokers would pay a market access fee to LSE brokers. Earlier it was expected that demutualisation would pave the way for unification of exchanges but if cap on trading rights is maintained, their different values across the three exchanges would continue to stand in the way of merger.

Those familiar with stock market reform process would notice that none of these four issues is new. Efforts towards demutualization and merger of exchanges are being made since 2003 but progress has been slow. In risk management, a lot remains to be done in areas other than margins including clearinghouse protection fund and securities borrowing and lending before exchanges can provide full settlement guarantee.

Similarly, plans to introduce cash settled futures date back to early 2005 and these are a new variant of a product already being traded since 2001. Clearly, exchanges have to go a long way in all functional areas before they can catch up with other markets like that of India, which not so long ago were in a similar stage of development but now have given us a big lead.

More importantly, the four issues listed earlier do not include the core issue of enabling capital market to raise capital and serve as an economic agent for the country. This issue may remain largely neglected in 2007 as was the case in the past because we are yet to see a clear sense of direction and a basic strategic plan in reform process. That raises the question why is reform process so haphazard and slow? To answer it, we need to look at the constraints on progress.

First constraint on reform is limited institutional capacity of SECP and exchanges, which essentially means not having the required experts in their ranks and an enabling environment in which their expertise can be meaningfully utilsed. It is easy to loose key professionals but it is hard to hire them. The task is made harder still because work done at exchanges and SECP is to a large extent unique in nature and there are few professionals in the market who have expertise in this area. Thus it remains an irony of stock market that while large brokerage houses and their associated companies are hiring top tier professionals for years, stock exchanges are still struggling to come up as a potential employer for the same.

Second constraint on reform is power wielded by elements that have a vested interest in obstructing development or are simply averse to change. A good example that illustrates this constraint is prevalence of ‘badla’ financing. This highly controversial financing system is flourishing even though it has contributed to every major crisis and it is clearly against international practices. It is only the high ups in government who can make vested interest yield to reform but no one is expecting that to happen.

Third constraint on reform is ongoing scandals and potential for another major crisis. Most of the high powered time at SECP and exchanges is lost in dealing with scandals that keep cropping up at an alarming frequency. After a crisis in March 2005 and another one in June 2006, it is also difficult to rule out the possibility of a crisis in 2007. If another crisis strikes, its controversies could result in development issues getting rolled over to the next year.

A number of factors show that external environment in 2007 is not going to be particularly helpful to reforms. Consider the following: (i) perception of stock market has worsened and news media would continue to pounce upon every controversy in stock market (ii) trading volumes have dropped substantially and research analysts are pointing out that bull run is fizzling out (iii) privatization through domestic offerings has slowed down and new listings are a trickle (iv) next finance bill has to decide upon imposition or exemption of capital gains tax on stock market dealings and (v) 2007 is set to be an election year which means heightened political uncertainty.

In sum, 2007 does not seem to be a favourable year for furthering reform and development in the stock market. Having said that, there is one source of hope, which is presence of some progressive people within exchanges, SECP, and stock brokers. These people may make a minority but they make the difference. In the absence of government’s commitment to stock market reforms and strong institutions to implement it, it is primarily the political acumen and technical knowledge of these progressive people that holds the promise for further reforms and developments in 2007.