The US experts’ report (conducted by a firm called Diligence) containing the findings into the alleged causes of the stock market crash in March 2005 contains some glaring contradictions and omissions for it to assert categorically that “under the existing circumstances, and on the basis of the evidence examined to date, we render findings and conclusions that greatly differ, in many r respects, with the findings and conclusions rendered by the Taskforce [of Justice Saleem Akhtar].
“Most significantly, we do not find sufficient evidence to support the paramount scheme of manipulation in the manner put forth by the Taskforce for the period in question. Nor do we find sufficient evidence to support the alleged scheme’s primary element (withdrawal of COT) that was ostensibly responsible for the fall of market prices. We find no patterns of activity or credible evidence to support a theory that, during March 2005, certain influential brokers systematically and manipulatively inflated and then deflated market prices, reaping substantial profits in the process.”
The report should have stated that it did not find sufficient evidence to support or refute the findings of the task force. Here are the reasons why?
The report admits that trading information on unregulated Badla (“in-house Badla”) is not readily available from exchanges or the public domain, but only from individual brokers engaging in such activities. It goes on to state that the data, if any, provided by individual brokers could not be reasonably or easily independently verified or tested for completeness or accuracy with a sufficient degree of certainty.
Given these and additional time constraints, reliable and verifiable data related to potential trading levels of in-house Badla was not obtainable. Therefore, Diligence is "unable to provide any conclusive findings in this area.” Given the critical importance of the role of Badla in financing highly speculative trading and its contributory role in the volatility of trading on the Karachi Stock Exchange, no investigation can draw any definite conclusions unless it can find its way through the often murky operations of the Badla market.
Some insiders believe that its size was as large as $1.5 to $2 billion at the height of the stock market peak during the first quarter of 2005. This unregulated and undocumented activity probably represented almost 33-45 per cent of the entire stock market capitalisation on a free-float basis.
The report acknowledges that the US experts found abundant indirect evidence (e.g., press reports) of the existence of this form of unregulated Badla which, “to the extent it exists, is in violation of Section 16 of the Securities and Exchange Ordinance, 1969.” This honest admission raises serious questions about the whole regulatory regime and its efficacy.
Free markets do not work well and are open to abuse without proper supervision and regulation. There can be little or no accountability in absence of transparent trading practices because it is simply not possible to track such transactions.
The US experts also attempted to analyze whether one or more brokers conducted illicit blank Ready Market sales. This scheme involves selling shares on the Ready Market that the investor does not own and cannot deliver at the settlement date. This is a key technique that can be used to bring down prices in an artificial manner.
The report (page 10) concedes that ready positions cannot be quantified on the basis of KSE activity alone. It adds that “reliable and detailed investor-level share balance information is required in order to determine whether a client has transacted a blank sale on the Ready Market. The use of group accounts at the CDC precluded such an analysis for the period at issue.” It adds, “without additional verifiable and complete information from individual brokers, it is not possible to determine whether or not this type of illicit activity was perpetrated on the market during March 2005.”
Now, if the experts were not able to investigate into the in-house Badla transactions nor they could lay their hands on blank short-selling, supposedly two principal causes of the stock market crash, the whole rationale for hiring forensic experts becomes seriously questionable and their findings suspect at worst and academic at best. The June 2005 report of the task force headed by Justice Saleem Akhtar had held that the withdrawal of the regulated carry-over-transaction (COT) financing facility by some large brokers was a deliberate tactic to push down prices in the ready market. The Diligence report (on page 7) however disagrees with this allegation and found no evidence that regulated COT was restricted or withdrawn from the market in the weeks prior to the market’s fall as a result of voluntary and manipulative actions of any influential broker.
Instead it contends that although there was, in fact, a withdrawal of certain regulated COT during February and March of 2005, this activity was attributable to two independent factors: (a) the execution of the SECP’s previously planned and announced phase out of COT funding for certain scrips, which had begun in October 2004; and (b) the temporary suspension of “New COT” availability for two heavily-traded scrips, the Pakistan State Oil (PSO) and the Pakistan Telecommunications Company Limited (PTCL), in connection with their respective moves to spot trading to execute announced dividend payments – a necessary trading practice and “normal course of business” event.
Was it normal course of business event? An IMF report on Pakistan (November 2005 IMF Country Report No. 05/408) graphically depicted the total level of COT financing from July 2002 to end-March 2005. The IMF reported that the total COT financing peaked at Rs40 billion in mid-February 2005 before falling to Rs27 billion, that is by 33 per cent, at end-March 2005. As can be seen from the graph (reproduced here from the IMF report), it was the steepest fall during the shortest period of time in the recent history.
It is therefore rather contentious to say that the drop in the COT financing was a normal business event specially when even the IMF report acknowledged that the concentration of lenders, most of whom were also trading on their account, allowed manipulation of market liquidity and “abuses also reportedly took place, with some brokers raising financing for themselves by posting shares deposited with them by their investors.”
According to the Diligence report, due to the move to the spot trading in scrips of the PSO and the PTCL, the COT outstanding dropped by Rs7 billion during the period from March 10, 2005 to March 22, 2005. The report absolves the market players of any deliberate attempt to manipulate the market through the withdrawal of the COT and attributes it to the execution of the SECP’s previously planned and announced phase out of COT funding for certain scrips, which had begun in October 2004.
While this appears to be plausible, it is pertinent to note that the level of total COT outstanding continued to rise till February 18, 2005 notwithstanding the phase-out plan. It should also be noted that while the COT lending rates were capped at 18 per cent per annum at the Karachi Stock Exchange (KSE) , they were not capped at the Lahore Stock Exchange (LSE) and rose to 24 per cent at the KSE and as high as 100 per cent at the LSE during the peak of the stock market boom in February-March 2005. Investors, big or small, indulging in highly speculative trading by borrowing money at such high rates, should not just blame the brokers or the government. This is as good or bad as gambling in a Casino.
Having said that, one can not help but note that the manner in which the phase-out was managed does raise questions about the wisdom of removing a source of liquidity from the market without providing an alternative system and about the competence level and expertise of the regulators and key decision makers within the government.
The report however does a good job in documenting and illustrating the lack of transparency that has characterized trading practices at our stock markets. But in the absence of transparency and auditable records, it is difficult to prove that market was manipulated or not. The regulators and investing community have been working to improve the workings of the market and reform antiquated practices.
Hopefully, they have learnt that periodic crashes and high volatility can not inspire the confidence of local and foreign investors. If the investors, brokers, companies and the regulators want to develop the stock market on sound lines, they must work together to reform the system to bring it at par with the international standards for margin trading and compliance and adopt best practices for fair and transparent trading.
(The writer is a former Citigroup’s Head of Emerging Markets Equity Investments during 2001-2005 and managed its proprietary equity portfolio across Asia, Central Europe and Latin America)