A US team of forensic investigators, who came to probe the March 2005 stock market crash, were baffled by the ‘badla’ system of share financing and took more than two months to understand it.

Badla, also termed Carry-over Transaction (COT), was a unique system of stock markets found only in the sub-continent.

It played a role in most market turmoil since 2001 and was one of the major causes of the market crash of 2008 that inflicted over $13bn losses on small investors. The crash led to the ban of ‘badla’.

Earlier, the Indian corporate sector regulator banned ‘badla’ which was also prevalent in the Bombay share bazaar. Fighting against broker backlash, it took quite a while for the heads of the Securities and Exchange Commission of Pakistan (SECP), after the crash of 2008, to introduce Margin Financing (MFS) — a system that is in operation in most global markets.

But the age old ‘badla’ did not quite disappear and the modified form of the old system — the ‘in-house badla’, though banned a decade ago, remains to date, in one form or the other. “Effectively it is like old wine in a new bottle”, says a market participant.

Investors dealing with such a brokerage house are at risk, for, in case of the broker facing financial distress, those dealing in cash would also have to part with their investment due to no fault of their own.

Such a situation occurred only a fortnight ago when a broker quietly sold off unsuspecting clients’ shares and took flight carrying with him billions in cash.

Investors dealing through badla are at risk, for, in case of the broker facing financial distress, those dealing in cash may lose their investment owing to no fault of their own

Hence, for the past week the SECP has come down with a heavy hand on brokers to crush the practice of ‘in-house’ badla. Show-cause notices were issued to 27 suspected errant brokers in January this year.

A market participant said that one of the reasons for putting a ban on ‘In-house’ badla was that the actual leveraged position in each scrip was not transparent.

Leverage was given in unapproved securities and, as opposed to Margin Trading System (MTS) where the financer institution remains undisclosed, in in-house badla the client is aware of the party which lends funds — mostly at exorbitant rates of up to over 18pc against the MTS margin rates of around 8pc.

A stock market expert made it simple. He stated that currently, available legal leverage products were Margin Trading System (MTS); Margin Financing System (MFS) and Future contracts.

He claimed that although in ‘in-house’ badla, the risk perspective was against the broker, the apex regulator was opposed to the product due to several factors: there was no margin requirement; stock exchange charges were not paid in this form of transactions and most importantly, being undocumented, the amount of ‘in-house’ financing in the market was unknown, which exposed the market to incalculable risk.

Although the PSX estimates the current volume of ‘in-house badla’ financing in the stock market at around Rs10bn, most market experts insist that it is almost impossible to arrive at an accurate figure because of the various forms and faces of the illegal product.

But small investors, unaware of the risks involved, seek ‘in-house’ badla as small brokers are even willing to provide financing on second and third tier stocks.

On the other hand, there is a detailed eligibility criteria for Margin Eligible Securities (MES), laid down in terms of free-float, market capitalisation and turnover.

MES acceptable to the National Clearing Company of Pakistan Limited (NCCPL) as collateral are notified. Those currently stand at 79 stocks and have been reduced to 60 from Feb 15.

An SECP official last week admitted: “The main reason that badla financing remains in practice is that margin trading and margin financing have remained limited to first-tier stocks, and even the second-tier stocks have not been able to get financial support from the banking sector”.

Brokers lament that the SECP’s action against ‘in-house’ financing has suffocated financing as a whole, leading to a steep decline in volumes of trade.

To find a solution to fill the financing gap, the SECP has formed a committee headed by the Commissioner, Securities Markets Division, which is expected to submit a report soon.

But to many others at the market, liquidity does not seem to be an issue.

Currently mutual funds and other institutional investors are providing funds to the market.

Most market participants have set their eyes on Pakistan’s inclusion in MSCI Emerging markets in May this year, which, they hope, would result in massive inflows from bigger international funds.

The Chinese consortium having bought 40pc equity in the PSX, four of their directors would be entitled to a seat on the Exchange’s board.

Regulators worry that illegal activities such as ‘in-house’ badla, if left unattended, would hardly cut a pretty picture of the Pakistan capital market.

Published in Dawn, Economic & Business, March 13th, 2017