The directive from the Securities and Exchange Commission of Pakistan to suspend further phase-out of Carry Over Transactions (COT) and to cap it at the Friday (July 8th) level is a half-hearted decision. Half-hearted because it is admission of the unforeseen fact that margin financing availability has not kept pace with the weekly amount of phase-out.
And also because of embarrassment cum disappointment as banks are not ready to fully take over the needs of the bourses despite commitments to the regulator.
However, the SECP has erred in capping the amount instead of volume of each scrip at the Friday level. This will further accentuate the uncertainty. It was precisely why the weekly reduction of 8.25% was in the volume of each scrip and not in the value of transactions.
There is no dispute that margin financing at the retail level, directly to clients or through brokerage firms from the financial institutions, is the norm in the developed markets. The decision to replace COT (Badla) financing with margin financing is indeed a key element in the stock market reforms, besides demutualisation of the exchanges.
We have always supported this objective. However, the methodology adopted for achieving it has been faulty. Somehow the regulators seem to have formed an impression that the key market players want the reform process to fail. The market players, on the other, hand feel that the SECP is tying down their hands and feet because it has a poor understanding of the market mechanism.
Further, they say that the non-elected directors and the management of the exchanges remain at the beck and call of the regulator and when all else fails SECP shows its legal teeth to brow-beat them. It is precisely for this reason that bourses' representatives have directly approached the Government to take cognisance of the prevailing situation; after all, the government has the largest stake as the value of its assets goes up or down with the market movements.
Opposition to 'Badla' system - a home grown product - is largely due to the perception that the market at all times is at the mercy of Badla providers. In the past, whenever the market has gone into a nose-dive, with no logical explanation, the reason given has been sudden withdrawal of financing in the leveraged market by the Badla providers.
In order to address this problem, various steps were taken to minimise the risk. T+3 settlement system was initiated and COT effectively used for its successful implementation. It served as an effective system for providing easy and reasonably priced financing, under strict safeguards. Risk on each stock was priced into the rates and amount of financing publicly disclosed, bringing transparency. Switching between investment and financing is permitted to all participants.
The exchange management now regulates it comprehensively and borrowers are protected through a 10 days ban on withdrawal of funding.
Despite a good track record, the perception of market manipulation through Badla has persisted. Presently, a purchase done during the trading hours and financing arranged after the trading is over weakens the borrowers' ability to negotiate a rate with the lender. It does not mitigate the risk either. A way out is clearly available. There is no earthly reason not to allow a parallel run (ie from 10 am to 5 pm) on the KSE net for COT.
The common refrain of criticism is that SECP is micro-managing the exchange. Therefore, SECP should take the credit as well as the blame for the happenings in the market. Who determines the amount of liquidity needed in the market? Not the SECP nor the exchange. It is the State Bank of Pakistan which determines the overall liquidity needed in the system and the bourses' claim to a portion in the total liquidity for leveraging purposes is dependent on the rates offered by the borrowers for trading in shares.
The era of directed credit is over. Therefore, neither SBP nor SECP can ensure that the Rs 20 billion committed by banks for margin financing will really be available at all times. On the other hand, the market is in need of liquidity for leveraging without which the necessary volume cannot be generated. It is absurd to say that margin financing as an alternative mode of financing is available for 154 scrips while COT is restricted to seven only.
Furthermore, SECP feels brokers should tap into other liquidity channels for leveraged financing such as the futures market, running finance and financing against shares. Big brokers are already availing of all these avenues.
Difficulty is faced only by the smaller buyers who generate the daily volume. That is because banks, while lending, not only take into account the quality of security but also ascertain the borrowers' profile.
While in COT it is purely 'blind' lending against shares irrespective of who the borrower is. Secondly, the market will always react to a negative news or development. In a falling market, margin calls and sell-offs will take place inevitably, when margins are not maintained in leveraged positions. And, at the same time buyers also shy away from offered deals.
It will take time for banks to lend strictly against shares without taking into account the credibility of the borrower. This requires know-how, technology and trained manpower. Only when handsome returns are seen will banks move into margin financing at retail level; until then their treasuries will continue to lend in the COT market.
The other alternative is to give Central Depository Company a financial status where its own treasury raises funding from the banking system. And, CDC in turn would lend the market men on a small transaction fee to cover operational cost.
This would require not only changes in trading rules in the exchange but also in settlement regulations, the National Automated Clearing System (NACS), besides requiring associate members of the exchange to provide exposure margins directly to CDC. Until all this happens, COT and margin finance will need to be continued side by side.
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