HAVE you ever wondered: Why short selling is usually banned in a very bearish market, and speculative trading using CFS is always welcomed in a bull run?

Why short sales in cash market require prior borrowing arrangements, whereas, a weak buyer is allowed to purchase in the cash market without obtaining prior funding?

Why a short seller is always considered to be speculative, whereas “speculative trading using CFS market” is considered to be adding to the liquidity in the market.

These examples of discrimination are the realities which we fail to accept, and therefore, take pride in being the only country in the world, where a deferred product like CFS (now known as CFS Mk-II) still exists.

In 2006, when CFS Mk-II was in its early days of evolution, the think tanks considered that this product will be able to eliminate systemic risks in the capital market. In April 2007, CFS financing came close to its cap of Rs55 billion at Karachi Stock Exchange, and the stock exchange requested SECP to enhance the limit, so that additional liquidity could be available in the market.

Now, the market participants think that the main obstacle in removal of “floor” from the stock exchanges is the Rs11 billion financing in the CFS Mk-II market. According to them, removal of floor without resolving this issue could result in brokers’ default, which in turn could poses a systemic risk to the exchanges and the NCCPL, and also have a domino effect on the financial institutions including the banks and mutual funds.

Now the people are talking about the same systemic risk, which the new improved CFS Mk-II claimed to have eliminated. And that was precisely the reason, why the cap of Rs55 billion was removed when CFS Mk-II was introduced.

For the last four months, efforts have been made to introduce a market support fund, to provide an exit opportunity to the weak holders in CFS Mk-II market, amounting to Rs11 billion, which pose a systemic risk to the market. Had the quantum of this CFS financing been around Rs55 billion or more at present, this would have created an unimaginable crisis. The maximum financing that can be accommodated in CFS Mk-II is Rs213 billion, based on market values as of August 27, 2008.

In the last two years, the apex regulator has introduced significant reforms in the risk management of CFS market, which was eventually replaced by CFS Mk-II market in July 2008. These risk management measures included the following:

1. Introduction of special margins on CFS financees, to discourage weak holders from jacking up share prices

2. Netting regime, whereby netting of different clients’ positions was not allowed. This measure was very important to introduce risk management at client level.

3. Imposition of position limits at the level of client, broker and overall market.

4. Collection of mark-to-market (MtM) losses in cash on daily basis

The financial institutions directly providing funds in the CFS Mk-II market, together with the above risk management measures, especially the collection of MtM losses in cash, have made this product, structurally, very sound. However, these risk management measures have only made this product a “lesser” evil. The flaw no more lies in the structure; it lies in the concept.

CFS Mk-II (previously known as CFS or COT or badla) allows a buyer in the Ready Market (hereinafter called as financee) to finance his purchase. The Financier, on behalf of the financee, makes the payment to the seller, and eventually the financee pays the amount of financing together with interest accrued thereon to the financier.

In my view, there are three inherent deficiencies in the CFS Mk-II product and its earlier versions from a strictly conceptual perspective:

1. Badla is a very efficient form of providing credit to the buyers who do not have money to pay for their purchases. This is the efficiency of this product which makes it so dangerous and also irreplaceable by alternative financing methods such as margin financing. A weak buyer can have access to billions of rupees of credit, just at the click of a button. This easy credit encourages the speculators to participate in the cash market. The demand-supply imbalance (speculator creating artificial demand) created as a result takes the shares prices to such inflated levels, which are neither sustainable, nor can be supported by the fundamentals of underlying shares.

2. The CFS Mk-II market is very closely coupled with the cash market, which means that the ‘leveraging’ and ‘de-leveraging’ directly affects the prices in the cash market. The effects of excessive leveraging using the CFS Mk-II market on share prices in the cash market is easier to understand, given the fact that the CFS Mk-II market is being used by the speculative buyers to create excessive demand. Fortunately, or rather unfortunately, the present market condition is a classic example of how the de-leveraging phenomenon works. In the present situation, where the market is expected to be bearish in the short run, the weak buyers, stuck in the CFS Mk-II market, are desperate to liquidate their positions, and make an exit. This de-leveraging by the financees will put excessive selling pressure in the cash market, thereby driving the share prices lower than their true fundamental values.

3. One of the basic principles followed by lending institutions in the credit granting process is the assessment of counter-party risk, which is known as determining the Probability of Default (PD) of the borrower. Other factors are also considered, but these are secondary in nature, such as the collateral, which is used in determining the Loss Given Default (LGD). CFS Mk-II, a financing market, does not follow the most fundamental principle of lending i.e., credit risk assessment of the borrower.

CFS Mk-II market provides an automated platform, where lenders and borrowers place their offers and bids, which are matched on undisclosed basis. It means that the lenders do not evaluate the creditworthiness of the financees to whom they are offering funds.

In the absence of a credit screening process, it is very likely that the financiers are in fact providing funds to sub-prime borrowers, whom they would not have entertained at all, had these borrowers come directly to the financiers. This lesson has finally been learnt by the financiers in the present market fiasco.

The present netting regime is more beneficial for a CFS financee, as compared to a person who only deals in the cash market.

To illustrate, consider Mr X who buys in the cash market, gets the same financed in the CFS Mk-II market, and sells off the shares the next day. Mr X will have to pay margins on his purchase on the first day, and from second day onwards, no margins will be collected from Mr X. On the other hand, there is Mr Y, who has enough money to purchase shares. He purchases shares on the first day, and sells them the next day. Mr Y will pay margins on both on his purchase and sale transactions till their respective settlement dates.

This discrimination means that Mr X who leveraged his position has a significant advantage over Mr Y. So, if a person has a short-term investment horizon, he will always leverage his purchase position, even if he has money to pay it himself. If the CFS Mk-II market is to be discouraged, this discrimination needs to be eliminated on an immediate basis.

The CFS Mk-II allows a leveraged buyer to defer its settlement at a future date, similar to a long position taken by an investor in a futures contract. The Indian experience shows that their derivatives markets took off after Securities and Exchange Board of India banned badla in May 2001. In our market, the derivatives have not yet become popular, despite the fact that deliverable futures contracts were introduced way back in 2002. The reason that futures have not been able to take off, is that badla provides many advantages over futures for a person who intends to speculate on the upside potential of a share, such as:

a. The Badla market provides an opportunity for a person to speculate in the cash market, which is far more liquid as compared to the present futures market. This is the single most important reason why the speculator does not need to come to the futures market.

b. The initial margins in the Deliverable Futures Market are currently required to be deposited 20 per cent in cash, rest in other forms of collateral. Presently, in the CFS Mk-II market, 100 per cent initial margins can be deposited in collateral other than cash. This disparity clearly gives CFS Mk-II a significant competitive advantage.

c. A CFS Mk-II contract can be rolled-over at any time before the expiry of the 22 working days. Long position in Deliverable Futures Contract can be rolled over only during the last week of the month. Historically, the roll-over in the Deliverable Futures Market has been problematic for two reasons: lack of liquidity and compulsory delivery settlement, which may create issues if most of the sellers want to deliver the shares.

The regulators are coming up with out-of-the-box solutions to alleviate the crisis which the Badla market has created; modifying the regulatory framework, allowing special sessions to provide exit opportunities to CFS financees, forced extension in the maturity of CFS contracts, and making efforts to introduce the market support fund.

Given that the overall sentiment is against this Badla market nowadays, it provides an excellent opportunity for the regulators to take the first step towards phasing out this market. The elimination of badla will help our cash market become more stable and our derivatives markets become more liquid, and not to forget, that in future we will be saved from a crisis which currently surrounds our equity market.

The writer is head of Research and Cooperate Advisory, Crosby Securities Pakistan (Pvt) Ltd