February 19, 2007	Monday	Safar 1, 1428

THESE days a lot of debate is taking place in stock market about KSE regulations pertaining to investigations into March 2005 futures trading as well as lack of regulatory cover for new risk management measures introduced by SECP. This debate has brought to light the larger issue of inadequacy of regulations.

Many argue that in Pakistan problem lies not in the laws but in their enforcement. Without belittling the truth in this statement, it must be said that weak rules make enforcement ever more difficult. Their weaknesses are exploited by wrong doers who like to usurp other people’s money without breaking any law. Take for instance the March 2005 crisis. A key reason the task force was unable to prove market manipulation because there was no clear piece of regulation dealing with withdrawal of ‘badla’ financing and profiting from its consequences.

Exchanges can make regulations for both listed companies and their members or brokers. These regulations are made under Sec 34 of the Securities and Exchanges Ordinance 1969. Typically, these are first approved by the board of directors of exchange and then by SECP and come into effect when they are published in the official gazette. In most cases, regulations are made by or for KSE which are adopted by LSE and ISE. Since the SEC Ordinance only deals with major issues, it is regulations that provide the detailed do’s and don’ts for conducting the business of dealing in securities.

Exchange regulations are considered to be the most efficient and flexible means of regulating the market place. That’s because these are not made by distant law makers who have little interest in and understanding of a highly dynamic industry but by concerned professionals and stakeholders. Thanks to a simple approval process, they can also be made and amended in a matter of weeks, if not days. Thus it is hard to justify why so many weaknesses persist in regulations of exchanges. Let’s look at some of these.

First, structure of KSE’s regulations is highly fragmented spanning about 20 different sets. Each set of regulations is an independent piece, with its own set of definitions and scope. While it makes sense to have separate set of regulations for different functional areas, such as one for listing and another one for trading, the degree of fragmentation in KSE’s regulations is not supported by functional considerations. This fragmented structure is not just against common sense, it is also against other local precedents as both the CDC and NCCPL have a consolidated structure of regulations.

Second, there is lack of consistency within different pieces of regulations. For instance, CFS Regulations 2006 state that Members’ Default and Procedure for Recovery of Losses Regulations shall also apply to CFS segment. member’ default regulations, however, refer only to COT, the regulations of which have been repealed and which itself has been “abolished.”

This implies that CFS is out of the scope of members’ default regulations. Add to it that the general rules and regulations specify a hammer price rule which overrides all other regulations of KSE in case there is a default of “high magnitude.” Clearly, once there is a default, these internal inconsistencies would make default management highly subjective and controversial.

Third, a number of important areas that should have been covered are left out while certain things are built into systems without the cover of regulations. A good example of former are surveillance and investigations into market abuse which do not have any specific regulations despite their overwhelming importance while a recent example of the latter is the new netting methodology which has been built into the software without changing concerned regulations.

Fourth, regulations are not consistent with other laws and regulations of related entities. For instance, according to Companies Ordinance 1984, a “listed company” is defined as a company whose securities are listed on a stock exchange and a similar definition of listed company is used in listing regulations, however, exchange does not apply listing regulations to companies which only have a TFC listed at the exchange.

Similarly, member’s default regulations of KSE are not the same as money default regulations of NCCPL nor do exchange regulations give due recognition to the non-exchange transactions executed through the NCSS.

Fifth, quality of regulations is less than satisfactory. For example (i) some elements of the general rules and regulations and those for regular segment still pertain to open outcry trading which was replaced with automated trading in the late nineties; (ii) regulations do not provide definitions of key terms, such as futures contract, cross trade, continuous funding system etc; and (iii) undefined terms, such as “scrip,” are liberally used instead of defined terms such as “security.”

These five points do not make an exhaustive list of weaknesses in exchange regulations. One can add on without much difficulty, for instance (a) regulations are often mixed up with decisions of the board and exchange notices, (b) regulations often do not specify the action that may be taken in case of a violation, (c) there is no separate set of procedures backing the regulations, and so on.

Weaknesses in regulations reflect weaknesses in governance of stock exchanges. There is a lack of systematic approach in dealing with regulatory issues as decision makers remain busy with “fire fighting” all year long. Some also have the tendency to brush aside these weaknesses as “academic” because in times of stress, regulations are changed overnight to achieve the desired outcome or they are simply put aside as big players emerge from behind the scene and take charge of the situation, as seen in June 2006 and March 2005.

Unfortunately, this point of view is strengthened by regulatory bodies and government high ups as they eagerly join in to put down controversies and rescue potential defaulters through any ad hoc measures necessary.

Many market participants consider this way of regulating the market “practical” and in line with the way things are run in Pakistan whereas making a proper set of comprehensive regulations is considered relevant only for markets in countries like USA and UK.

This phoney reasoning is then backed up by the popular sophistry used to justify all forms of economic lawlessness, that is, this is an emerging economy and we should give things time to grow before regulating them. Some also go further than that. All this talk about regulation, they say, is a joke that is not even funny any more because the sole purpose of the market is to let the speculators make a killing or be killed.

Changing such retrogressive mindsets and breaking from the past is never easy but maintaining the status quo cannot be an option either. To play their due economic role, exchanges first have to improve their perception which would not happen until they put an end to the informal way of dealing with their regulations.

As the apex regulator of the capital market, SECP bears the ultimate responsibility for fixing regulations of the exchanges. It would do well to bring together stakeholders and legal experts and develop a comprehensive and consolidated set of regulations for all three exchanges, which can provide a sound basis for regulating the stock market.