SINCE the stock market meltdown in March this year, SECP has intensified its efforts to prevent excess liquidity from flowing into stock markets because it allows shares being traded at artificial prices, and big punters make enormous profits.

It is being resisted tooth and nail by some brokerage houses who (along with their powerful speculator customers) are believed to have been the main beneficiaries of the stock market meltdown.

Delay in publication of the report of the task force on stock market meltdown, is giving some brokerage houses the opportunity to level allegations against, and even openly defy SECP. What brokerage houses don’t realize is that this bitterness is damaging the image of Pakistan’s stock markets. It is not the route to attracting foreign investment. It would eventually hurt brokers, not the SECP. As it is, brokers carry a heavy burden of explaining the causes of the recent market meltdown.

On every TV channel, brokerage houses spokesmen have been condemning SECP for capping ‘badla’ financing and depriving ‘vitally’ needed liquidity. Undoubtedly, inadequate liquidity can drain life out of any market but the unanswered question is “what is the appropriate level of liquidity for Pakistan’s stock markets?” Shaukat Tarin Committee is trying to answer this question. Until the committee releases its findings, brokerage houses must hold their horses.

Badla financing – sanctified by brokers – is, in fact, a mechanism that allows share buyers and sellers to buy and sell shares without paying for the shares bought or delivering the shares sold, on transaction settlement dates. The fact is that badla financing sustains speculators who make wrong investment decisions without having requisite financial resources represented by the shares sold by them or the money to pay for the shares bought by them.

Besides being bad speculators, their serious disqualification is that either they can’t (because they don’t have the requisite financial standing), or won’t (because they don’t want to fall in the tax net) borrow from banks. Instead, they look to badla financiers to fulfil their commitments. Knowing these weaknesses, badla financiers charge them lending rates that far exceed the cost of bank borrowing.

Escalating cost of unsettled transactions forces these investors to indulge in even higher levels of speculative trading to drive share prices closer to levels at which they can settle their unfulfilled commitments along with the cost incurred on borrowing through the badla mechanism. This distorts the market even more. Bigger the size of these speculators greater is the distortion they introduce in the market and thus inflate stock market balloons.

To keep fulfilling the commitments of these speculators, badla financiers need ever larger volumes of money which they borrow from the banking sector. Given this background, it is not difficult to understand the reasons for the present bickering between SECP and stock brokers because, in many cases, badla financiers are powerful brokers who act on behalf of these investors because badla financing earns for them huge financing charges.

Thus, badla financing has been distorting Pakistan’s stock markets for half a century, and by lending to badla financiers, banks have unwittingly helped to aggravated market distortions. SECP is now under severe IMF and ADB pressure to stop it because it amounts to institutional support for creating and sustaining market distortions. IMF and ADB want badla financing to be replaced by ‘margin financing’ by banks, which may not be as efficient but won’t allow market distortions to develop nor permit tax evaders to reap the benefits they presently enjoy.

What SECP has done is largely correct. There was, though, a serious error on the part of both SECP and SBP. As early as 2002, SECP issued instructions on how margin financing may be undertaken by financial institutions. In July 2004 SBP also issued instructions to the banking sector on the same subject. But after issuing these instructions, neither investigated the level of preparedness achieved by the financial services sector to credibly deliver on the benefits that margin financing is supposed to offer.

There is visible hesitation on the part of banks about extending margin finance. Many have yet to commence even policy-making on the subject, let alone assembling the sophisticated infrastructure necessary to monitor the overall volatile risk under margin finance represented by investment in a variety of shares bought on behalf of the investors, minute-to-minute changing fortunes of the investors, and taking instant corrective action thereon by asking investors to either pay additional margins or off-load their escalating negative positions.

This system doesn’t need to be re-invented. India, with similar market profile and share trading culture, shifted from badla to margin financing eight years ago. Pakistan could study the Indian model and adopt it with changes to suiting its financial system. But this will require time and substantial effort by banks in installing the system and running and managing it without serious hiccups.

Successful margin financing requires a host of arrangements. Firstly, margin finance agreements between banks and investor customers must equitably secure the interests of both. Secondly, banks should specify acceptable profiles of investors and a basis for determining the exposure limit on individual investors based on their loss sustaining capacities.

Thirdly, banks must lay down bases (e.g. external credit rating) for short-listing companies, investment in whose shares they would finance. It is inappropriate for regulators to specify scrips for which banks can extend margin finance; it betrays a partisan attitude and unfair intervention in the market.

Fourthly, banks should require varying margins that investors must furnish for investing in shares of different companies. These could be based on external credit rating or a combination of credit rating and share volume traded in the market over a period.

Equally important is the share clearing system wherein delivery of shares bought by banks (on behalf of their customers) can be verified in real time, and direct receipt of the proceeds of shares sold by banks’ customers. But far more demanding is the installation of computer-based risk monitoring systems that inter-face with stock markets, for real-time risk management. Above all, it calls for expertise in anticipating price movements based on changes all around, and the volumes being traded.

A big stumbling block is that the SBP circular requires banks to finance brokers. Firstly, if banks continue to lend to brokers, how will margin financing eliminate the evil that is supposed to? Secondly, the circular requires banks to eliminate collusion on the one hand between bank directors, banks’ major shareholders (and their family members), and the banks’ investor customers on the other. To comply with this condition, brokers must disclose to their bankers details of their investor customers and the transactions being conducted on their behalf.

Brokers don’t like this although, legally and morally, they should. Brokers’ logic is that disclosing these details will be a breach of confidentiality but, more importantly, it will provide banks vitally important data on the basis of which they could trap the brokers and their investor customers. Given the fact that banks are allowed to trade in stock markets, the brokers’ argument has merit. Banks, on the other hand have the same misgivings because they believe that knowing the volume of their investment in various scrips, powerful brokerage houses could manoeuvre share prices against the banks.

Given the will and determination of both bankers and brokers, a way can be found to resolve every operational difficulty but the thorny issue that poses the real dilemma is the confidentiality of databases of both banks and brokers. It defies a solution because even independent depositories of data and documents have been founding wanting in maintenance of confidentiality.

Unless regulators find a solution to this problem, markets will continue to be exploited. This challenge calls for a determined combined effort by regulators, software developers and independent custodians of confidential data. In this context too, systems in developed other countries could be of great help. Given the size of the stakes involved, no amount spent on remedying this shortcoming could be too high.



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