Carry-over market, also known as the Badla market, provides post-trade financing to speculators in our stock markets. Those who wish to speculate on borrowed money in the T+3 market obtain funds from those who are willing to lend.
Through a reverse repurchase, lenders pay the clearinghouse on behalf of speculators and take delivery of securities while speculators carry over their positions from one settlement to another. The speculators and lenders represent a mix of brokers, individual clients, and institutional investors. The motive for the speculators is capital gains and for the lenders, interest income.
Carry-over financing is well entrenched in our stock markets where, on the average, less than 10 per cent of the volume is settled at the clearinghouse, 40 per cent to 60 per cent is carried over and the rest is squared within the day. In 2003, average daily financing given in the Carry-over market was Rs 13 billion at the Karachi Stock Exchange (KSE) ranging from Rs 6 billion to 25 billion.
The average financing rate at KSE was 12 per cent per annum but ranged from as low as 6 per cent to as high as 50 per cent(pc). Currently, the rates have been caped at 18pc and the Carry-over facility has been confined to 30 securities. The clearinghouse guarantees the settlement of Carry-over transactions in these 30 securities. Carry-over financing is highly concentrated as half the financing is done in just four shares. Similarly, half the financing is routed through and a quarter of it is taken up by only a few brokerage houses.
Carry-over market has long been controversial. In every stock market crisis, it is held as a part, if not the cause, of the problem, and demands are made that it be eliminated. Such demands are vehemently resisted by some, particularly the few financiers who dominate the market. In 2002, a sub-committee of Consultative Group of the Capital Markets, consisting of known market practitioners, proposed phasing out this market by June 30, 2003.
That day has long passed but due to the influence of its proponents, the Carry-over market and its problems remain. The objective here is to explain the problems in the Carry-over financing and why it should be phased out.
There are three problems with the Carry-over financing. First, Carry-over financing is a source of systemic risk in our capital markets. This is the probability that some market participants would not be able to settle their obligations to the clearinghouse that would not let others do the same leading to the default of the clearinghouse, a catastrophic eventuality. Carry-over financing allows speculators to recklessly accumulate large unsettled positions.
Whenever prices tend to fall speculators try to exit their positions en-mass causing immense selling pressures. At the same time, lenders try to pull out their funds, as they fear that speculators would default due to the losses, increasing the probability of default of speculators.
In case of defaults, clearinghouse can end up with more losses than it has the capacity to bear. For instance, on May 20, 2002 when KSE-100 fell 133 points due to the Indo-Pak war threat, speculators tried to exit their positions while lenders pulled funds from the market creating a crisis. Similarly, in September 2001, a bank failed to settle its obligation to the clearinghouse when it suffered losses on its excessive exposure in the Carry-over market and was only saved due to intervention by regulators.
Second, Carry-over market has substantial room for market abuse (i) stock price manipulation usually requires trading and holding large amount of target securities and it is inevitable that those attempting to manipulate stock prices shall use the easily available Carry-over financing. No other credit market shall provide such large financing for equity investments so conveniently.
The most appropriate example of this is the May 2000 crisis which left the stock exchanges and the investors with large losses caused by manipulators who were using Carry-over financing (ii) Brokers who specialize as financier tend to have large quantities of financed shares available to them at all times. These large holdings can be abused in a number of ways. For instance, they may sell a part of these holdings and provide further financing based on the funds obtained! They can also sell a part of their holdings short depressing prices and then buying these shares back at a profit. (iii) Brokers can cover up their illegal blank sales in shares by providing financing in the same shares (iv) Financier brokers can direct the funds of their clients to provide relatively cheap financing in the shares in which they have taken proprietary positions to manipulate the prices to their advantage (v) Financier brokers can pull out funds from the speculators triggering a price fall and a hike in the financing rate as the financier themselves build short positions.
Third, Carryover financing is an improper deviation from international best practices. In international stock markets, a derivatives segment is developed particularly a Futures market for speculation and hedging. The derivatives segment is separate from the cash market and it attracts speculators because derivatives have built-in leverage. The prices of derivatives are derived from the prices in the cash market and the two move in tandem.
Instead of following the international best practice, we are providing Carry-over financing within the T+3 market, creating an open-ended Futures market within the cash market. Due to this hotchpotch, our Futures market is not developing and high level of speculative activity in the T+3 market is creating excessive volatility in stock prices shaking the investor confidence.
On September 12, 2003, when the KSE-100 reached its highest level of 4600, the Carry-over financing had exceeded Rs25 billion and financing rate had reached the ceiling of 18 pc. Market was overheated due to excessive use of Carry-over financing and once those with large outstanding positions started selling, KSE-100 slipped 16 pc to 3850 on October 23, 2003 as Carry-over financing halved at Rs12.6 billion.
Similarly, during the three days Jan 21-23 2003, KSE-100 fell 337 points. It is no coincidence that during these three days Carry-over financing at KSE fell by Rs 3.4 billion. The panic in the market in Jan 2003 was created by carried over positions exceeding Rs 14 billion and a financing rate soaring above 30 per cent.
Each time the stock markets gets into turbulence due to Carry-over financing, the investor confidence is shaken in the capital market.
Those who are against the phase-out say that by financing speculators, Carry-over market is helping create liquidity, which is the primary justification for a stock exchange. The proponents of Carry-over financing say that if it is discontinued, liquidity would dry up and investors, brokers, and listed companies all shall suffer. This argument has two flaws.
First, the problem in our market is not insufficient liquidity but its skewed distribution. There are about 700 companies listed at KSE but in the T+3 market only 10 stocks account for almost 70 pc of the traded value and 30 stocks account for more than 95 pc. Many companies are hardly traded at all through out the year.
More than half of the Carry-over financing is usually concentrated in Pakistan State Oil (PSO), Pakistan Telecommunication (PTC), Pakistan Oil Field (PAKO) and Hub Power Company (HUBCO). The cumulative turnover of PAKO from April to September 2003 is 1.5 billion shares whereas its total dematerialized shares in the Central Depository System (CDS) were 36 million. That is, in just 6 months, each dematerialized share of PAKO was traded 40 times! The ratios for PSO, PTC and HUBCO are 24, 13, and 10. This is not liquidity but excessive speculation in a few shares made possible due to Carry-over financing.
Second, it is wrong to assume that liquidity is solely a function of leveraged speculation. There are far more important determinants of liquidity, such as the size of a company, number of its shareholders, the quantity of share held in the hands of public, company's financial performance, its future prospects, and the number of investors that participate in the capital markets. Many companies listed on KSE are so tightly held that nothing can make them liquid. For others, liquidity can be best created by providing market access to more investors.
Currently KSE has only 775 trading terminals, most of them are located within the premises of KSE building and none outside Karachi. Similarly, Central Depository Company has less than 70,000 securities accounts in a country with a population of 150 million. Most of these accounts are also in Karachi.
The number of those investing through mutual funds is also small. Clearly, the overwhelming majority of Pakistanis is not participating in the country's capital markets. If we want to have wide and deep markets, the logical way is to provide market access to more genuine investors and improve corporate governance rather than encourage excessive speculation by satta players.
Carry-over financing provides an opportunity for leveraged speculation and so do derivatives and margin financing. Currently, derivatives in our market consist of Single-stock Futures that are the most suitable substitute for the Carry-over financing. Both Stock-Futures and margin financing are currently dominated by Carry-over financing due to market distortions in favour of the Carry-over financing even though both of these are largely free of the ills of the Carry-over financing.
In phasing-out Carryover financing we can learn from India that had a similar Carry-over market and similar problems. Due to market abuse through Carry-over financing, the derivative market was developed and the Carry-over financing was banned. After the end to Carry-over financing, the derivatives segments took off and now the notional turnover of equity-based derivatives exceeds the turnover of equities in the T+3 market. The Carry-over financing has become a thing of the past.
Carry-over market has more vices than virtues. If we continue with it, the interest of investors at large shall be compromised in favour of the vested interests of a few. To effectively manage systemic risk, protect investors from market abuse, and develop our markets in line with international best practices, we must phase-out the Carryover market.
We need not be daunted by the resistance to the phase-out. Remember that when in 2001, the internationally recognized T+3 system was replacing the archaic weekly settlement system at the KSE, the opponents of the change were making a big hue and cry that T+3 would dry up the liquidity. The thriving turnover in the T+3 system has proved them wrong and the opponents of the phase-out shall also be proven wrong.
( The writer is an official of the securities & exchange commission of Pakistan. The commission, however, does not necessarily agree to his views)