APPROXIMATELY 300 stock brokers are registered at KSE, LSE, and ISE. Their number has grown by 15 per cent from 261 in 2002. But how many brokers does our stock market really need?

The question needs to be examined from the point of view of investors, taking into account both the local peculiarities and international practices.

We take the position that protecting investors from abuse in broker-client relationship, expanding market access, and delivering services at competitive rates is not consistent with having such a large number of brokers. The industry should be consolidated through regulatory intervention and a favourable environment should be created for reputable financial institutions to enter this business.

First, the criteria for becoming a member as set out in the articles of association of stock exchanges and the criteria for registering as a broker with SECP as specified in the Brokers and Agents Registration Rules fall short of the stringent capital requirements and fit and proper standards that are used in relatively developed markets.

There are no licensing examinations and the few conditions pertaining to education and experience are subject to discretionary exemptions. These criteria cannot be relied upon to filter out unscrupulous elements or those who do not have the capacity to run a modern day brokerage business.

Practically, anyone possessing the necessary millions to buy membership of a stock exchange can enter into brokerage business. Lack of appropriate criteria is a reason why our market has so many brokers but so few investors. There are a number of brokerage houses which are being run in obsolete ways. They would rather not hire professionally qualified staff nor would professionals like to join them.

Second, it is very difficult, if not impossible, to effectively regulate hundreds of stock brokers to offer investors necessary protection from abuse. Brokerage houses, like banks, deal in public money and safeguarding public interest requires a strong regulatory regime.

While there are a plethora of laws that aim at protecting investors, the stock exchanges, as front line regulators, and the SECP, as the apex regulator of capital market, have not demonstrated the capacity to enforce them.

The March crisis and report of the task force are evidence that brokerage industry is weakly regulated to the detriment of investors. For instance, it has been identified that a fundamental conflict of interest in broker-client relationship is trading done by brokers on their own account. There are regulations governing proprietary trading but there is no system in place to distinguish the same from that done for clients, so one cannot even begin to regulate it.

Third, international trend shows that it is consolidation and not expansion that is taking place in brokers. Information technology, used extensively in the business, is continuously evolving and reshaping the market structure. Due to automation, the marginal cost of executing one more trade is often insignificant. Excess capacity and potential for large economies of scale has caused mergers and acquisitions among brokers.

The number of brokerage houses is shrinking even when trading volumes and transactions are growing. Moreover, regulators are increasing the standards for entering and staying in brokerage business. Cost of compliance with regulatory requirements is not easily borne by smaller brokers and this is also promoting consolidation.

In Bursa Malaysia which has a market capitalization more than four times that of the KSE, there are only 32 stock brokers and all of them are corporate entities. The Securities Commission in Malaysia has been aggressively pursuing consolidation in brokerage industry. Their number has been reduced from 63 in 2000 and it is likely to be reduced further.

Consolidation is also taking place in India where the number of registered brokers is close to 10,000. In his personal publication titled “Broking Industry: 10 Years Hence”, published in March 2004, M.S. Sahoo, Chief General Manager of Securities and Exchange Board of India and a known writer on Indian securities market, has forecast that in coming years the number of brokers in India could at best be 100! If Indian stock market may have only 100 stock brokers and Malaysian stock market has only 32, then one can argue that we could do with even fewer.

Consolidation in the broking industry could be brought by enhancing capital requirements and fit and proper standards, which should prompt mergers and acquisitions. But consolidation alone might not lead to the desired results.

Many brokerage houses have been run as a conventional proprietorship for a long time and they would be slow in changing their way of doing business even after undergoing corporatization and consolidation.

Some would find out means to meet the new requirements on paper, comprising the underlying spirit. Therefore, consolidation would need to be complemented by encouraging some financially sound and well governed financial institutions, particularly banks, to enter the business. These institutions would enjoy the trust of an average Pakistani and using their resources, they should be able to put together the human and technological capital required to run a large scale brokerage business.

It would be critical that banks entering brokerage business are allowed and encouraged to use their existing network of branches to generate business for their broking subsidiaries. Together consolidation of existing brokers and entry of more financial institutions could raise the standards in the industry at the desired pace, expand investor base, and dilute the power of “big brokers” who are frequently accused of manipulating the market and blocking reforms.

Perhaps demutualization of exchanges would be the right time to sow the seeds of consolidation and arrival of better players. The SECP should consider preparing a policy paper on the broking industry and initiating a consultative but firm process of consolidation, as done in Malaysia.

Those who are against bringing consolidation in brokerage industry through regulatory intervention would argue that the right number of brokers for our market should be decided by market forces. They would add that it is because of a large number of brokers that commission rates in our market are competitive and market access is expanding. These arguments may be catchy but they do not stand the test of logic.

Economic theory tells us that market forces could be relied on to deliver the optimal outcome when market is free of distortions, which clearly is not the situation here. Whatever little has been done for protecting investors in broker-client relationship, be it abolishing group accounts or introducing standardized account opening forms, is not the work of “market forces” but that of the SECP.

Market can be intensely competitive with much fewer players and it is technological developments that are keeping commission rates low. Despite having 300 brokers, most of the country does not have direct access to the market as majority of brokerage houses remain confined to three cities and within them in narrow pockets in and around the buildings of stock exchanges. The case against consolidating broking industry and raising its standards stands on very weak grounds.

Reducing the number of brokers would be anything but easy. Those brokers who are unwilling or incapable of keeping up with the changing times are bound to offer stiff resistance. But if policy makers are committed to serving investor interest, they would have to consolidate the industry one way or the other.

They need not be reminded that bringing reforms is perhaps only as difficult in our capital market as it was in markets of those developing countries that have taken a long lead over us. Investors in Pakistan do not need a large number of small brokers but a small number of large brokers who are well regulated, enjoy the trust of ordinary citizens and have the capacity to serve investors across the country.