Regulating the corporate affairs of companies listed on the Karachi Stock Exchange (KSE) is different from regulating the trading activities in the shares of those companies.
Whilst corporate affairs is the domain of the Securities and Exchange Commission of Pakistan (SECP), managing the trading of shares at any stock exchange is the responsibility of the respective stock exchange. The SECP ensures that uniform rules for trading are enforced at all stock exchanges.
During the last few years, the SECP has announced several measures towards improving the transparency and governance in listed companies. These are aimed at the ultimate advantage of shareholders of the company. The KSE has, on its part, announced several measures for making the trading activities more safe and transparent, while discouraging excessive speculation at the same time.
However, the recent crisis at the KSE following the bomb blasts and Indo-Pak situation, has raised several questions regarding the application of certain regulations and trading rules. Herein an analysis and evaluation has been made about the history, purposes and effects of the various developments and regulations at the KSE. Some suggestions and alternatives for a better working of the stock market have been also made.
T+3 and daily settlement: Preventive and safety measures to contain sudden changes and wide fluctuations in the share prices have been in place since several years. However, these rules have consistently been made more stringent. Before the T+3 trading system, the T+5 clearing system was in force. There was no requirement of daily squaring up/settlement of positions. Purchases could be squared off against sales made any time during the week-long trading period.
Likewise, blank selling could be offset against a corresponding buying at any time during the week. If there was a sudden surge or decline in the share values, there was a mechanism for controlling such declines. The rule at that time was that if there was a change of more than 25 per cent from the previous day’s closing rate or a change of Rs 5 per share (whichever was higher), the share would be traded only in spot deliveries. Under spot delivery rules, payment for purchases had to be made within a day. Likewise delivery of shares against a sale had to be given within a day. Badla, or carryover transactions, were not allowed for spot transactions. Such a share then continued in spot trading for that trading week.
Replacing the spot settlements: The system of trading a share in spot after a sudden change in the value was replaced by the rules of enforcing upper and lower price caps. According to this rule, the maximum allowable change was set at 5 per cent (also referred to as upper and lower price caps). The share was not traded beyond the cap limits on any given day. The concept of an upper and lower cap was brought about in May 2000 when there was a severe clearing and settlement crisis that also caused the default of a broker. It was then that blank selling was also banned and exposure limits were changed.
Changing the price caps in May: The price cap rules have been changed several times since they were introduced. The upper and lower cap remained at 5 per cent for quite some time until they were revised when the market started improving from the beginning of the present year. From 5 per cent, both the upper and lower price change limits were increased to 7.5 per cent.
Recently the KSE underwent a crisis situation. It started from 8th May when there was a bomb blast in the city. The crisis accelerated when the Indo-Pak crisis emerged. Between 17th and 22nd May, the KSE 100 Index fell by 290.18 points. On 23’d May the KSE had to be closed down due to the emergence of some problems in the settlement and badla processes. This volatility compelled the KSE management to reduce the lower cap for price changes twice. From 7.5 per cent it was reduced first to 5 per cent and then to 2.5 per cent to prevent rapid erosion in share values. The upper cap was retained at 7.5 per cent. The lower cap is again being raised to 5 per cent from 1st July 2002.
Futures trading: Futures’ trading (also called forward market) has been allowed since October 2001 in the shares of the most active and liquid companies. This was done largely as a compensatory measure after shifting to the T+3 clearing system in order to allow investors to take up long positions in a script without actually committing the full amount of funds required for the transaction.
In futures trading, the KSE rules require of the brokers to deposit a minimum of 20 percent of the value of the transaction amount with the KSE till such time that the transaction is squared off or settled. This requirement of 20 per cent has been placed as a safety margin and also to avoid excessive speculation. The deposit could take the form of cash as well as shares of listed companies. The losses or gains from the position on the futures counter had to be settled on a weekly basis in the form of cash.
Shortly after the shifting of the market to a T+3 trading system, a ban was imposed on blank selling i.e no shares could be sold unless the seller was in possession of those shares. Likewise there could be no badla in the case of blank selling. However blank selling is allowed in futures trading. The position has to be squared up before the settlement period, which is usually for a period of one month. If there is an outstanding sale or purchase in a futures trade, it can be settled against giving the delivery of the shares or otherwise making payment.
The prices of shares traded in futures were also reflective of the ready board prices. A cap couldn’t be imposed on the regular market while ignoring the futures market. The price caps were therefore imposed on both the regular ready broad market and the futures market.
Stringent requirements: Exposure is the value of purchases and sales from the brokerage house. The exposure requirements set by the stock exchanges have become so strict that now brokers have to ask their clients to provide them with the exposure amount, in case a client has done so much business that the exposure limit of the broker has exceeded the amount set by the KSE. Previously members of the KSE were allowed an exposure of up to Rs 50 million without providing any deposit to the KSE. Now there are no exposures allowed to the members without providing any deposit. These stringent exposure rules have reduced the overall business volumes of the brokers.
Suggestions: It is seen that all these changes during the last several months have the primary aim of reducing speculation and rogue trading while the former is an essential ingredient for provision of liquidity and volumes in the stock markets. It can be argued that due to all these checks, the enthusiasm associated with trading has melted down owing to interference with the ‘free market’ movements of share prices. Particularly, shares of illiquid companies tend to become further illiquid due to price caps. A lower price limit of 2.5 per cent or even 5 per cent is simply too low for several companies. Hence the upper and lower price caps should be made comparable, or done away with altogether.
The most noticeable disadvantage of a price cap is to the investors who had acquired shares through badla financing. In a rapidly declining market where the lower price cap is enforced, an investor simply cannot sell the shares financed through badla. The heavy financing cost has to be paid on the one hand while the losses have to be paid on the other. In fact it can be seen that when the lower price limit of 2.5 per cent was enforced on 19th May, the market continued to decline, cap or no cap. Rather such a low cap accelerates selling by the ‘weak holders’ and those with shares purchased through badla. Such investors, fearing an inability to sell in a declining market, start selling their stock at the slightest of negative development.
Several steps have been introduced to prevent blank selling and taking short positions. In addition to outrightly banning blank selling, the T+3 and daily settlement system was introduced. We feel it would be prudent if a new practice were introduced whereby blank selling would be allowed provided the seller could provide the shares after borrowing it from someone having possession of such shares.
This would be similar to badla with the difference that instead of funds, shares would be borrowed. Some ‘rent’ could be paid on those borrowed shares on a daily basis. The lending of shares could be done by only those who have possession of shares. This would benefit the existing shareholders of those companies immensely. Take the example of institutions like the ICP and the NIT that have large holdings of different shares that they haven’t sold or traded since a long time. They could have earned significant amount by renting out those shares.
Besides, if blank selling were to be made only against actual shares borrowed, there would be a limit to how much blank selling could actually take place in the market. At a very limited scale this blank selling against borrowed shares is taking place, however there needs to be discovered ways in which an organized market for this mode of renting/borrowing of shares could be developed. It would not only increase the volumes but would also benefit the exiting shareholders as they could gain by renting out their shares.
Futures trading should be made more lenient. If this area of trading is to be encouraged then the scope has to be increased by adding more companies on the futures counter on the one hand and reducing the exposure requirements on the other. At present several brokers are reluctant to let their clients engage themselves in futures trading due to the reason that the 20 per cent margin required by the KSE is too high and results in blockage of liquid assets of the brokers and their clients.
If a badla financing rate in excess of 24 per cent per annum is charged by a financier, such excess amount would have to be deposited by the investor in the KSE accounts. However the purchaser of shares has to pay the full amount as charged by the financier. This disparity doesn’t benefit the purchaser or the financier but only the stock exchange. If the purchaser is desperate for financing and no financiers are available at rates below the upper limit of 24 per cent then the financiers would simply exit the market, causing badla rates to hike up further. The purchaser would then have to go for other unofficial channels of financing. Thus the forces of demand and supply are distorted. This defeats the underlying objective of imposing ceilings on badla rates.
Measures like bringing the trading online through the Karachi Automated Trading System, (KATS) computerization of badla and electronic transfer of shares through the Central Depository Company, (CDC) have proven to be immensely useful, while other changes like excessive curbs on speculation and trading and unreasonable price caps are in fact an example of over regulation. The KSE is still going through a transition phase in which new rules and different ideas are being experimented with. The workability of alternatives, as suggested here, can be further researched and discussed by the stakeholders so as to arrive at a working system that satisfies all parties.