Given the presence of heavy weights in KSE’s delegation that visited SECP’s head office in Islamabad, market was expecting that substantial last minute concessions would be made by regulator as in November 2006. But this time, in a show of strength, SECP held its ground, dashing the hopes of market participants and thereby also quashing the rumors about any change in its top management.
Market participants did get some concessions on other agenda items but these were largely issues that were not so divisive and important. These include implementation of direct margining by financial institutions against their exposure, adjustments in CFS financed shares due to corporate actions, and provision of comprehensive client-level trading data pertaining to first half of 2006.
Direct margining by institutions was SECP’s own idea and there was no reason to believe that regulator would withdraw its support from it. Therefore, it is only natural that all three sides - brokers, institutions, and SECP - are in agreement on direct margining and regulations are being drafted for implementation.
Off-system adjustments in ‘badla’ financed shares due to corporate actions had to be accommodated because these didn’t affect interest of investors and disallowing them could have triggered fresh controversies about withdrawal of financing and in-house ‘badla.’ That a new mechanism for on-system adjustments has been devised is a positive thing although it is an irony that it has been conceptualised by SECP whereas it should have been developed by the exchanges, on their own initiative, a long ago.
The mass scale gathering of client-level trading data for first half of 2006 had to be scrapped sooner or later because it was always an exercise in futility. Five market crises have taken place in the last seven years but investors have not seen the political will or the operational capacity to detect and punish market abuse. Any data collection is not going to change this ground reality.
In sum, the concessions market participants have secured are not significant but implementation of CLN is going to be remembered as a milestone in capital market reform process. Market participants have also gotten the message that CLN is here to stay and it would now be implemented in futures segment in April as scheduled. They would be better off accepting and adjusting to CLN rather than complaining about it.
Due to CLN, security-wise purchases made by a person, broker or his client, shall only be offset against his own sales, therefore, margin would have to be deposited to the exchange against exposure of each person. This would reduce room for reckless leveraged speculation of the kind seen in March 2005.
CLN would affect speculative activity but that’s understandable. No economic purpose is being achieved by churning shares of just about 30 companies over and over again. The extreme turnover velocity at local exchanges has not brought depth and price discovery to the market but caused a “satta” perception. It is a sad anomaly that compared to markets in other parts of the world, local market ranks at the bottom when it comes to capital formation and investor participation and at the top when it comes to generating turnover and crises.
There is much that remains to be done to achieve the objectives of CLN. Comprehensive regulations, system audit of exchanges and brokers, and continuous monitoring are just three elements that have to be put into place. It is hoped that the concerned IT professionals, who have turned the idea of CLN into reality, would be able to overcome any teething problems.
In addition to strengthening risk management, CLN is also likely to provide other advantages. Direct institutional margining, which was triggered by CLN, would allow relatively less resourceful brokers to compete for institutional business. Earlier, they could not target institutional business because of large working capital required to meet margins against institutional exposure.
Once exchanges start providing real time client-level margin requirements reports to their brokers, these would serve as a fair and transparent basis for brokers to collect margins from their clients.
The eventual vision of CLN should be to integrate depository and trading systems such that the exchange can use UIN of investors to collect and release margin from and to the sub-account of the concerned investor. With proprietary trading differentiated from trading on account of clients, in case of a broker default, it should be possible not to liquidate the positions and margins of non-defaulting clients. That would provide true protection to investors from broker-defaults.
Having said that, we should not overlook that management of settlement risk is about much more than margining. For instance, you need adequate settlement protection fund to make up for money default and an efficient securities borrowing and lending system to cover delivery defaults. Due to lack of sustainable depth in order book of exchanges, it may not be possible to liquidate a defaulter’s large outstanding positions and margin securities during a crisis, therefore, non-cash margins have limited ex-post value. In other words, CLN is good but it alone is not good enough.
Since the beginning of new risk management initiative in mid-2006, regulator has demonstrated the ability to deal with details at the tactical level, but it is the strategic perspective that is yet to be seen. There is a need to turn attention to shifting the function of risk management from the stock exchanges to the settlement intermediary which is the National Clearing Company (NCC). This was agreed between the SECP and exchanges a few years ago but has not been followed up.
Implementation of CLN should provide the regulator with the breather to form a strategic road map for ultimately achieving full settlement guarantee through the NCC. There is now limited value of spending high-powered time on operational details of management of settlement risk and the job should be given to the NCC and its capacity be strengthened for this purpose.
The regulator should be turning its attention on more pressing needs of investor protection from market abuse and capital formation. It is after a long time that the regulator has gained some momentum in the reform process and it ought to be put to good use for the investing public.