THE March 2005 stock market crisis has raised many issues that are being extensively debated in the media. One of the core issues that has emerged out of this crisis is that regulatory regime for the single stock futures segment was not ready for the shift of large speculative volumes from the carry-over segment.

The Karachi Stock Exchange (KSE), as the front line regulator of capital market, and Securities and Exchange Commission of Pakistan (SECP), as the apex regulator, both have drawn criticism for the weaknesses in the design and implementation of futures regulations.

As expected, futures regulations have undergone a series of amendments since the March crisis. Some other regulatory measures have also been introduced which cover both the regular segment (which includes carry-over segment) and the futures segment.

Some of these measures would be implemented in May while others are expected to be implemented gradually in the rest of 2005. Let’s analyze these measures to assess their potential impact on their target areas: management of settlement risk and protection of investors from market abuse.

First, eligibility criteria for a security to be traded in the futures market have been changed. Now, a company has to have a free float of at least 50 million shares before it can qualify for futures trading.

Generally, companies having relatively large free float are considered less vulnerable to price manipulation and excessive volatility caused by technical factors such as a relatively large buy or sell order. Mutual funds have also been excluded from the futures segment due to lack of supporting international precedents.

Second, the nature of futures settlement is being changed and multiple contracts of varying lengths are to be offered. At present, an outstanding position in futures at the time of contract expiry can be settled by delivery of underlying shares but soon settlement would only be in the form of cash. Open positions at expiry would be squared based on a formula based settlement price with no delivery of underlying shares. This change has probably been initiated because in March 2005, speculators were stuck with outstanding positions that they could not settle through payment of principal or delivery of shares but could settle through payment of losses.

Instead of just a 30-day contract, 60 and 90-day contracts would also be introduced to meet relatively longer term demands for speculating and hedging without the need to rollover positions from one contract to the other. International precedents show that both types of final settlements, cash and delivery, and multiple contracts are offered in single stock futures.

In National Stock Exchange of India, which is the largest market, in terms of notional traded value, for single stock futures, settlement is only in cash whereas in Euronext, the second largest market single stock futures, and Sydney Futures Exchange, a known futures exchange, specified contracts can be settled through delivery of underlying shares. These three exchanges offer multiple contracts of varying length on the same underlying shares.

Third, limits in futures have been put into place so that outstanding positions by brokers and their clients do not exceed their financial capacity or become a threat to smooth settlement for the exchange a market wide limit so that total open interest in a security does not exceed the free float of the company. That is, if the total outstanding shares of a company are 100 million shares out of which only 50 million are actually available for purchase, then the sum of long or short positions in that security is not to exceed 50 million shares(ii) a broker-wise limit where the open interest by a broker does not exceed one per cent of the free float. If the free float is 50 million shares, then each broker can have a maximum outstanding position of 0.5 million iii) Another broker-wise limit so that outstanding positions of a broker can be a maximum of 10 times of his net capital balance and (iv) client- wise limits, which are to be designed and implemented by brokers on similar lines.

Fourth, margins have been tightened (i) initial margin rates are being raised so that brokers would now have to deposit more margins to the exchange against their exposure. Margin deposits are used to make up for losses incurred on liquidation of positions of a defaulter broker, therefore, more margins means more protection for the exchange. Higher initial margin rates would also reduce the capacity of a broker to take large positions (ii) only select listed securities shall be eligible for deposit to the exchange as margin. Since margin securities have to be quickly converted into cash in case of a default, taking out relatively illiquid fixed income securities would reduce liquidity risk for the exchange (iii) all of the initial margin against exposure exceeding Rs200 million would have to be deposited in cash, unlike the present 50:50 split between cash and approved securities.

This measure would also reduce liquidity risk for the exchange and lower the ability of brokers to take large positions (iv) Netting of trading losses with retained profits has been discontinued reducing the leverage for brokers (v) Mark to market difference, or technical losses on outstanding positions, would be collected twice a day instead of only at the end of the day.

These losses occur when you take a long (or buy) position in a security and its price falls and vice versa. An additional collection during the day is expected to reduce risk for the exchange by reducing day end obligations of brokers.

Fifth, some other regulatory measures are also being introduced which cover both the regular and futures segments (i) a new system is being planned in which unique identification numbers would have to be entered at the time of punching orders in the trading system, establishing a trail from every order to the person placing (ii) Price limits (which are incorrectly called ‘circuit breakers’) have been made uniform at 5 per cent or Rs1, whichever is higher in absolute terms (iii) netting of positions across different segments for determining capital adequacy could be discontinued reducing the effective trading limits of brokers (iv) group accounts are being discontinued which would improve transparency in keeping book entry securities (v) assets of brokers and their clients are being segregated (vi) Initial margins would be based on volatility and liquidity of the securities on which exposure is taken and collected before the execution of a trade.

In addition concentration margins would be taken to cover the exchange against the risk of a disproportionately large position in any one security (vii) netting of trades and margining would eventually be moved from the broker level to the client level, a fundamental shift from the present system.

Let’s now look at the strengths of these measures: (a) they are likely to reduce settlement risk, so that in case of a default by a broker, there is no adverse chain reaction of defaults or systemic threat. Banks, other financial institutions, and large players who operate in multiple markets including real estate, are all trading in the stock market.

Despite being small in size relative to country’s GDP, stock market now has the potential to create a crisis which can easily spill into other markets. The importance of effective management of settlement risk is hard to exaggerate (b) surveillance and investigation capacity for dealing with stock market abuse is likely to improve significantly with the new measures aimed at enhancing transparency in trading and keeping securities. At present, this capacity is very limited and the odds are in favour of wrong doers.

There are also weaknesses in these measures (a) they appear reactionary in nature and not part of a well thought out plan. For instance, after completion of phase-out of carry-over financing, brokers would need most of their capital adequacy limits for trading in futures. Therefore it does not seem appropriate to reduce capital adequacy limit for futures down from a multiple of 25 to 10.

Similarly capping security-wise open positions to one per cent of free float for all brokers, regardless of their financial soundness, is likely to run into difficulties. These measures may create distortions in the market, say by forcing both brokers and clients to trade through multiple brokerage houses and increasing day trading in the regular segment.

Similarly, when price limits have been reduced to five per cent, need for collecting mark to market differences twice a day can be questioned. Restricting settlement to cash reduces settlement risk but also increase room for manipulation, as serious concern in our narrow market.

Manipulators may take large long positions in stock futures near contract expiry and then jack up the formula based settlement price in last minutes of trading in regular segment, thus making large gains on their future positions (b) Some of these measures have been tried in the past but could not be successfully implemented.

For instance, since 2001 it was mandatory for a broker, under the futures regulations, to use client identification numbers and take appropriate margins from the clients, but this was not implemented. It was also directed in March 2003 that unique identification numbers be entered at the time of trade for all segments, including futures, but that directive was not implemented.

Effective market surveillance and client level netting of trades cannot happen without the implementation of unique identification numbers. Two month contract was also introduced in futures segment in 2001 but discontinued due to lack of market interest (c) within weeks of their introduction, some of these amendments have been revised. For instance, free float eligibility criterion for futures was brought down from 100 millions shares to 50 million shares. News reports suggest that more revisions could be in pipeline, which has added to the confusion about the eventual design and implementation of these measures.

We have discussed the recent regulatory measures in the futures segment and their strengths and weaknesses. Now that the dust of March crisis has started settling, its time to go beyond quick fixes and plan medium to long term measures.

Markets have a short memory and once the sentiment turns slightly bullish, lessons learnt from a crisis are soon forgotten. What is required to improve risk management and investor protection on a sustainable basis is a well thought out and publicly disclosed strategic plan for an effective regulatory regime and the will to implement it.

Let’s hope the KSE and the SECP, in public interest, would deliver such a plan and the regulatees, in their own commercial interest, would support it through compliance.