The proposal is quite significant because it is likely to determine how and how much trading activity would take place in different market segments in coming years.
Salient proposed modifications regarding CFS are as follows: (i) ban on undocumented financing done by brokers off the trading system, also known as in-house ‘badla’ (ii) reduction in number of eligible securities to 14 from 32, thus confining ‘badla’ to less risky securities (iii) increase in financing cap at KSE to Rs40 billion from present Rs25 billion, perhaps to make room for in-house ‘badla’ (iv) placement of financed securities in blocked form so that they cannot be used for further pledging or illegal selling by financiers (v) reduction in netting of purchase and sales by both financiers and financees which would reduce their ability to take exposure (vi) restriction on availing financing without a net purchase in regular segment, which would not allow financees to raise cash by delivering securities and (vii) imposition of segment wide, broker-wise, and client-wise position limits to reduce settlement risk.
The proposal has a number of positive elements. It shows that SECP is aware of various issues facing CFS and it is trying to change things for the better. Hopefully, implementation of this proposal would improve transparency and strengthen risk management in ‘badla’ but it has a number of weaknesses.
First, history of ‘badla’ tells us that the more SECP has tried to modify it, the more entrenched and problematic it has become. Take the example of ‘badla’ modifications after May 2002 crisis.
It was thought that ‘badla’ had been reformed by modifications such as giving financees an option to hold on to financing for 10 calendar days. To the contrary, it allowed Badla to grow to unprecedented levels without reducing room for manipulation, which was a key reason behind March 2005 crisis. (Blocking financed shares was also a part of 2002 modifications but it was not implemented.)
In August 2005, ‘badla’ was again modified and renamed CFS, apparently addressing its various weaknesses, but in June 2006 crisis, outstanding positions in ‘badla’ threatened to create a chain reaction of defaults which was avoided by overnight changes in regulation.
‘Badla’, be it called COT, CFS, or CFS Mk-II, is an inherently flawed system because it turns equity market into a distorted futures-cum-lending market in which, more often than not, on one side is going to be a reckless speculator and on the other a usurer.
Second, neither CFS nor CFS MK-II is supported by international practices. In fact, no developed market is known to have a system like Badla financing.
International markets meet demand for leveraged trading through derivatives, which are used for hedging and not just for speculation, and to some extent by off-exchange margin financing.
In Indian capital market, where ‘badla’ was also deeply rooted and led to major crises, the securities regulator, Securities and Exchange Board of India, kept fighting ‘badla’ lobby and finally eliminated it in 2001, which paved way for development of a thriving derivatives segment.
Most of the measures in SECP’s proposal are also going to discourage ‘badla’ except (i) upsizing of CFS cap, (ii) continuation of relatively liberal and cash-free margins in CFS compared to futures and (iii) introduction of CFS Mk-II. These three pro-‘badla’ measures would outweigh impact of other measures and further obstruct development of futures market. If the aim is to develop Pakistan’s stock market in line with international practices, as we are so often told, then SECP should withdraw these three measures and develop futures and other derivatives to phase out ‘badla’.
Third, proposed modifications have technical deficiencies. (a) ban on in-house ‘badla’ has been proposed in SECP’s covering letter but not built into proposed amendments to CFS regulations. (b) The old controversial issue of whether brokers can take money from individual clients for lending in Badla has been left unaddressed. (c) Position limits for all members of LSE and ISE have been kept smaller than those for members of KSE even though some members from smaller exchanges could be larger, in terms of their turnover, than a number of members of KSE. (d) Some basic mistakes have been made in proposed amendments to CFS regulations, such as not giving any definition of CFS financing, use of term “CDC” instead of “CDS account” and use of possessive adjective “his” for stock brokers that include many corporate entities. Given the scrutiny that SECP’s proposal was bound to receive, greater care should have been exercised in its drafting.
Fourth, deadline for implementing proposed modifications - September 30, 2006 - is unrealistic. Due to delays caused by brokers’ objections and insufficient implementation capacity of stock exchanges, such deadlines in the past have been missed by several months and at times by years. It is unlikely that the outcome would be any different in this case. It would also take time to develop some of the complex modifications in concerned software.
For instance, restricting investor-level financing to net purchases would require development of pre-trade UIN based position verifications in both regular and CFS segment. SECP is in the middle of developing framework for cash settled future contracts - a burden it is bearing due to inability of KSE to do the same - and rushing these proposed modifications may further delay those efforts. It would have been better if instead of announcing a deadline for the entire proposal, SECP first negotiated implementation date for each modification with the stock exchanges.
We should remind ourselves that it is through Badla that naïve investors are facilitated in carrying out their economic destruction by speculating in the riskiest of assets through borrowed money and it is not a coincidence that all those who top the list of perceived manipulators of stock market have been and still are large ‘badla’ financiers. ‘Badla’ has not survived and prospered in this market because it is the “best financing system” as some would like us to believe.
Instead it has been growing because of other factors, such as a powerful ‘badla’ lobby which has connections in higher echelons of power, inability of exchanges to develop derivatives as alternative to Badla, and a failed Badla phase-out in 2005 due to flawed strategy used by the then SECP management.
The reality of Pakistan’s capital market is that secondary market is not facilitating primary market in raising capital for real economy, which creates output and employment, but merely encouraging “satta” through ‘badla’ financing under the guise of providing liquidity and price discovery.
If capital market is going to make any significant contribution to the country’s economy and improve its troubled perception, it would have to go beyond ‘badla’ and ‘satta’ and focus on raising capital for the real economy.