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The investor’s exchange

January 22, 2013

A SOMEWHAT underplayed, but certainly significant corollary of last week’s political turmoil was its impact on the Pakistani stock market.

On Jan 15, as stocks plummeted more than 500 points, there was an entirely reasonable fear amongst investors and observers alike, that the fall would spiral out of control.

Contrary to all dire predictions, however, stocks rallied the following day and analysts dubbed the fall as merely a correction, albeit a major one. Even though a crash had been averted, and the index steadily rose over the next few days, this major dip raised concerns, particularly in the mind of the uninitiated investor, of the wisdom of venturing into an arena as volatile and as vulnerable to external events, as the stock market.

The concerns of this would-be investor are not entirely unfounded. In the last decade, Pakistani stock exchanges have witnessed at least three major crashes and a potential investor is bound to have noted that although the precise circumstances of each crash were different, each one was characterised by extensive losses to the investing public and little or no perceptible damage to the brokers.

This disparity in the outcome for the average investor and the experienced broker, is likely to have given rise to two distinct thoughts in the investor’s mind: either that the market was the playground of experts, best avoided by the novice or, more worryingly, that the market was in fact controlled by these experts, and manipulated to their advantage at the expense of the investors.

Is there any merit in either of these thoughts? Before answering this, let’s establish certain basics of the stock exchange: a stock exchange is ultimately only a limited liability company, licensed by the Securities and Exchange Commission of Pakistan to undertake trading in stocks and shares.

However, unlike an ordinary limited liability company, a stock exchange has the legal mandate, under section 34 of the Securities and Exchange Ordinance, 1969, to make regulations (with the approval of the SECP) to regulate its business, its members and brokers. As a result, a stock exchange is not only a “self-regulatory organisation” but also the “front-line regulator” of the capital markets and by virtue of this status, enjoys a degree of prestige as well as autonomy in the conduct of its affairs.

Over the years, this very prestige and autonomy, conferred upon the stock exchanges, and particularly on the Karachi Stock Exchange, the oldest and most dynamic of the three exchanges presently operating in Pakistan, an aura of exclusivity, which the exchanges jealously guarded by restricting membership.

The primary hope someone had of acquiring a membership — or a seat on the exchange — was on the death or bankruptcy of an existing member and then too upon payment of an exorbitant price.

Consequently, not only did exchange memberships remain concentrated amongst a privileged few but also over time this small community developed a unique language for the conduct of its business, which rendered the workings of the exchange nearly unintelligible to an outsider.

As if this was not sufficient to lend credence to the worst fears of investors, the situation was further complicated by the “mutualised” structure of the exchange.

Simply put, this meant that the fortunate few who held a seat on the exchange were the very people who had the right to trade on it and a person wishing to invest in shares, had no choice but to utilise their services.

Whilst historically such a structure was the universal norm for exchanges, it gave rise to valid concerns about the loyalties of members of the exchange in times of crisis: would they safeguard the interests of brokers, and therefore their own? Or would they take tough measures that may become necessary for the protection of investors?

Given this environment, it is hardly surprising that the would-be investor maintained a distance from the exchange. And it would not even have mattered too much, had this distance not been an important factor in limiting the growth not only of the capital market but also of companies and by extension, the economy.

The real tragedy, however, does not lie in the investor’s hesitation, but in the fact that members of the stock exchange, who by virtue of their privileged status, had a duty to the exchanges and to the economy, who also had countless international examples of demutualisation of exchanges available to them and who were urged repeatedly by the SECP to demutualise, preferred to protect their own position rather than to take the initiative to modernise.

The good news is, however, that this bleak scenario is already a thing of the past. The SECP, tired of waiting for the exchanges to demutualise voluntarily, decided to proceed with demutualisation by legal fiat. It was a result of its concerted efforts that in May 2012, the legislature enacted the Stock Exchanges (Corporatisation, Demutualisation and Integration) Act, 2012. This law provided a time-bound plan for the segregation of the members’ ownership rights from their trading rights.

Despite threats of possible derailment, the process outlined in the act, was duly completed in December 2012. The management of the exchanges was vested in newly constituted boards of directors, and trading right holders, although represented on the boards, did not form the majority. Is our would-be investor now perfectly insulated against the vagaries of the market? Unfortunately, there can be no definitive answer to that question because given the circumstances, markets, even the best regulated ones, can crash.

Demutualisation is however a first step in the direction of introducing a corporate culture in the market and in breaking the barriers of exclusivity and language that have deterred investors in the past.

This, along with programmes for investor education, some of which are already under way, will provide the investor the only real safeguard available: to understand the market he is investing in and to have the assurance that this market is being governed and operated in accordance with the best, internationally accepted standards.

The writer is a barrister.