OUR stock market frequently suffers from allegations of market abuse by resourceful participants and excessive use of leverage by financially weak speculators. Moreover, investors remain unsure whether their trades are given priority by the brokers over their own trading, as required by the law. Each market scandal causes losses to ordinary investors and affects their confidence in market integrity. Most recently, this was witnessed in the March crisis.
The responsibility for investor protection lies with the stock exchanges, as front line regulators of the capital market, and the SECP, as its apex regulator. There are a number of laws (such as Securities and Exchange Ordinance 1969, Securities and Exchange Rules 1971, Regulations Governing Short Selling, Regulations for Proprietary Trading etc) that empower regulators to act against market ills. However, an important obstacle in enforcing these laws is that required information is not readily available to regulators.
The recently proposed system of unique identification numbers (UIN), believed to be a major reform in the stock market, has been designed to readily provide the regulators critical information that they need to fulfil their responsibilities.
The UIN system has been developed by CDC on the directive of the SECP. Currently, it is undergoing a public consultation that would continue till November 5, following which implementation phase will begin. Let’s try to understand this system and the difference it can make for the investors.
When an investor places an order to buy or sell shares to his stock broker or a broker wants to trade on his own account, these orders are entered into the computerized trading systems of stock exchange. These trading systems provide the facility to enter an identification number along with order details so that brokers can keep systematic record of all trades. Most brokers enter identification numbers with the orders but these numbers are created by each broker as required by his own record keeping practices.
A stock exchange keeps record of every trade executed by each of its brokers but due to inconsistent use of identification numbers, it does not know whether a trade was executed by the broker or one of his employees on his own account or for a client. Similarly, records available with the stock exchanges do not have information about the identity of the person placing orders for the trades. The problem becomes more complex when investors trade through multiple brokers on more than one exchange.
Theoretically, it is possible to gather the required information about the identity of investors by collecting detailed trading data from each broker. Practically, this is too tedious an exercise to be meaningful. When investigators at the stock exchange or SECP identify suspicious trading and go about collecting client level data from brokers, it takes weeks to gather it. The data is provided in different formats and it takes further time before it can be compiled into a form where it can be analyzed. It can easily take a number of more weeks to analyze it because the trades that have to be looked into usually run into thousands.
Finding out those who were trading through multiple brokers is very difficult as it requires matching names, NIC numbers etc, which may have been recorded differently. Add to this that the data provided is not very reliable as back office programmes from which records are obtained usually have the option to overwrite past entries. Before the investigators are able to conclude an investigation, a few months are elapsed, a new scandal hits the market and there is another investigation to conduct. Clearly, at present the odds favour the wrong doers.
Under the proposed UIN system, each person trading in the stock market would be assigned a unique identification number by the Central Depository Company (CDC), after he meets the necessary documentation requirements. Through the National Clearing and Settlement System, each broker at the three exchanges would map the identification number assigned by the CDC to the identification numbers being used by him at present for back office record keeping. This information would be linked to the trading systems of the exchanges.
At the time of entering an order in the trading system, brokers would first specify whether the order is for proprietary trading, for a client, or for another broker from a different exchange. This would be done by checking a box which would require merely punching one key on the trading terminal.
While entering the order, the broker would enter the identification number being used by him. This number would be automatically converted into the UIN assigned by the CDC. Together with the check boxes and identification numbers, every trade would be readily traceable to the investor placing the order for that trade.
Due to mapping and automatic conversion of identification numbers, brokers and investors would be able to continue to trade as at present without any disruption. The confidentiality of trading information would not be affected as only surveillance personnel at the stock exchanges and SECP would have access to trades carrying UIN information.
To avoid loop holes, the proposed UIN system includes a number of checks and balances. For instance, UIN would be only assigned after proper documentation and a broker would be able to access the UIN of only those investors who would authorize its access for that broker. Manipulators would try to find new ways to beat the system but it would not be easy. They may try to trade through properly documented accounts of front men under their control, such as personal employees.
However, investigators looking into market abuse could find the payment trail from the banking system to trace the manipulator. Where a meticulous manipulator takes care to avoid that, say by getting a blank cheque book signed by his front man, it would still be possible to identify him. This is because whenever investigators would call upon the suspect for a hearing, it would not take them long to find out that he is a mere fall guy.
The impact made by the UIN system in enhancing the capacity of the regulators for managing settlement risk and countering market abuse would be substantial. After implementation of UIN system, a typical probe by regulators would start from the point where it currently ends. It would be possible to carry out live monitoring of exposure of each investor to assess settlement risk and enforce position limits. Within days, if not earlier, it would be possible to detect the person behind some abuses such as mala fide withdrawal of financing, wash sales, and blank selling.
Other more complex abuses such as front running and insider trading would take longer but their chances of success would be much greater. When complemented by other elements, such as resolve to punish abuse, effective surveillance wings and an updated legal framework, the UIN system would pose a threat so credible that even the shrewdest and most determined manipulator would have to take it seriously.
The primary beneficiary of the proposed UIN system would be ordinary investors as they are the ones who suffer the most in market manipulations and settlement problems. The proposed UIN system has been designed to use information technology in a way that it minimizes inconvenience for the investors. They would only have to undergo a once off documentation to come under the umbrella of this system.
They would control which broker would or would not have access to their UIN. In case of any dispute regarding their trades with a broker or an agent, stock exchanges would be able to readily trace the disputed trades through their UIN. In sum, implementation of the proposed UIN system would be a breakthrough in providing investors the much awaited protection that they deserve.
(The writer worked as a consultant in preparing the proposed UIN system. All opinions expressed here are his own.)