Management of settlement risk is a critically important regulatory function performed in stock market. Every day, market participants trade hundreds of millions of securities worth billions of rupees assuming that every trade executed on exchanges shall be settled without fail and there would be no chain reaction because of default by one or more market participants.

Importance of effectively managing settlement risk is rapidly growing with average daily settlement exceeding Rs5 billion, linkages between capital market and banking sector becoming stronger, and market crisis recurring at an alarming frequency.

Risk management systems being used by stock exchanges carry many weaknesses. Local practice of passing defaulter broker’s obligations to non-defaulting brokers is in sharp contrast to international practice of providing full settlement guarantee.

Progress has been rather slow in coming because brokers tend to think that improving risk management would reduce turnover and therefore brokerage commissions.

Because of high political stakes in market, defaulters are not liquidated but bailed out through public and private money coupled with overnight changes in regulations. Thus, it was an uncanny situation both in March 2005 and in June 2006 when investors witnessed major market crisis and heard news about broker defaults but never saw any default on paper. But policy makers are able to see what investors cannot and know the dangers inherent in local practices.

It was perhaps in this context that on June 19, 2006, SECP has put forth a proposal to stock exchanges to improve risk management. The proposal covers three areas: (i) definition of exposure or how exchanges calculate net unsettled obligations of stock brokers, (ii) capital adequacy, which deals with maximum exposure a broker is allowed to take based on his net capital balance, and (iii) rate and form (cash versus securities) of initial margin, trading losses, and mark- to- market differences that brokers have to deposit to exchanges against their exposure.

This is the first time SECP has dug so deep into risk management issues. On the whole, proposal demonstrates good understanding of some elements of present risk management system. This is no mean achievement because in this market most stakeholders, including many stock brokers, do not understand these issues with this level of clarity. There are, however, more weaknesses than strengths in this proposal.

First, the underlying approach is flawed. Such micro-level proposals are devised by experts, approved by board of directors of stock exchanges, and then brought to SECP and not the other way round.

Logically, this proposal should not have come from SECP but a committee of experts which could have been appointed by SECP. By putting forth its home made (and therefore pre-approved) proposal to its regulatees for their approval, SECP has quite unwisely reversed institutional roles, which, in the very least, is a recipe for embarrassment.

Take the example of CFS Mk-II, another home made proposal launched by SECP in the same manner. Soon after its arrival, CFS Mk-II was categorically rejected by KSE’s trading affairs committee. Unable to make any headway, SECP has handed over CFS Mk-II to a large committee which is likely to hammer it considerably.

In putting forth this proposal on risk management, SECP has once again defied the established and internationally recognised institutional arrangement for regulation and landed itself in an unenviable situation.

Second, the proposal is too narrow in scope to be meaningful. It is confined to first tier of risk management, which pertains to exchanges and brokers. Within the first tier, it ignores important issues such as intra-day price limits and clearing house protection fund.

The other tier of risk management, pertaining to brokers and their clients, is left out. The different elements in the two tiers are inter-linked and as in case of first tier, a lot has to be done in second tier, including disclosure of brokers’ proprietary dealings, enforcement of specified minimum client-level margins, and increasing size of investor protection funds. Other issues which have a direct bearing on risk management have also not been covered, such as weak criteria used for registering brokers, controversial system of CFS, and lack of development of derivatives.

Instead of micro managing a few tactical risk issues, SECP should target the core structural issue of transferring risk management function from exchanges to national clearing company (NCC). Management of settlement risk by the settlement intermediary, which in this case is the NCC, is local need as well as international practice and something that had been agreed in principle between SECP and exchanges.

Once risk management is transferred to NCC, professionals, rather than stakeholders, would deal with risk issues, which would make it easier to improve things.

Third, it is not clear how this proposal would be implemented when in the past softer regulations already in place could not be implemented.

Take for instance, CFS regulation 4(1), according to which positions of financier-brokers in CFS (or Badla) are not be netted with their purchases in regular market. Apparent intent behind CFS regulation 4(1) was to reduce ability of CFS financiers to take large exposures and camouflage their blank sales.

CFS regulations were approved in August 2005 but regulation 4(1) has not been implemented to date. Still, the proposal ambitiously desires elimination of netting across (i) market segments, (ii) settlement days and (iii) different clients of a broker, which would increase exposures.

It is a misperception that value at risk (VAR) based initial margins would offset the impact of elimination of netting. Proposed VAR margin range (15-28 per cent) for active securities is not less than current margin range in slab based system for ready (5-25 per cent) and futures (10-30 per cent).

Moreover, proposal talks about reduced netting in mark to market differences and a “special margin” payable by buyers on sky rocketing securities. Net effect of these measures can only be a drastic increase in margins and straining of capital adequacy, which means that it is going to be a non-starter for brokers who are demanding lower margins.

Fourth, the proposal has been poorly timed for a number of reasons: (i) On June 14, 2006, as part of a bail out package to end market crisis, SECP has approved weakening of risk management by replacing cash with securities as acceptable margin deposits in futures segment. By launching this new proposal for strengthening risk management, SECP seems to be pushing forwards and backwards at the same time. (ii) SECP is in the middle of high profile investigations against market abuse by stock brokers.

It is likely issue of penalizing manipulators, which has become a test of regulator’s credibility, would easily distract attention from this proposal. (iii) It has been barely a month that SECP’s flagship proposal of CFS Mk-II, which was made public on May 19, 2006, was rejected. Putting forth another proposal so soon does not make sense.

In sum, SECP’s proposal to improve risk management may be well intended but does not seem to be heading for any success. Instead of putting forth micro-level proposals which are prone to outright rejection by regulatees, SECP would be better off first restoring its credibility through enforcement of existing regulations and then focusing on structural improvements and supervision.