Reducing systemic risk

The Securities and Exchange Commission of Pakistan issued directives to the management of bourses, at the end of last week, to undertake further measures in order to strengthen the risk management regime. Normally, SECP directives to bourses are publicised with a press release. However, this time they were quietly posted on the KSE website so as not to adversely impact the bullish fervour pushing the benchmark index to a new record level every day.
The latest SECP directive to stock exchanges to implement a series of measures within a stipulated timeframe is both timely and pertinent. However, there are some areas in which we feel it amounts to over-regulation and it may not be feasible or even practical to implement these measures by the deadline fixed, April 2005.
The SECP demand that the exchanges restrict profit distribution until settlement, in the present volatile market, is timely. It is rightly felt that 30 percent distribution at present is on the high side and could pose a systemic risk. Therefore, the exchanges should reduce the profit distribution before settlement to ten percent.
While SECP has the right to impose limits on the numbers of futures contracts equivalent to the free-float of the scrip, we believe it has overstepped the boundary when it wants to regulate a client's relationship with a brokerage firm. As a regulator, SECP has to watch the capital adequacy of a registered member/broker and limit his scope of activity. But limiting a broker's activity in a particular scrip or imposing an overall limit on a particular client of a broker in accordance with the total futures position reflects a thinking to treat a brokerage house as a commercial bank.
The Central Bank imposes single client exposure limits, varying from bank to bank, dependent on the bank's capital and free reserves. There are also sometimes caps on lending to a particular sector. Brokerage firms are not banks. It will not be easy for SECP to regulate the activities of investing clients, nor has it thus far spelled out the criteria for limiting a client's investment in a particular scrip.
According to existing rules, brokerage firms are required to segregate client assets from their own assets. It appears that this rule is not being implemented. Netting off one client's purchase position with the sales position of another client in the same scrip will be very difficult to check.
Since these directives are to the management and not to the boards of the bourses, they now have to come up with ways and means to satisfy the regulator. However, it would be a challenging exercise to frame any new proposals with which the trade is also agreeable.
The directive to delink the Ready Market from Futures Market by disallowing netting across the two is a sound move. The KSE will be adopting a pre-trade margin verification mechanism by April 2005. That will bring it in line with international norms. LSE and Islamabad Stock Exchanges are already using this mechanism. Collecting of mark-to-mark difference on hourly basis on Futures Market on the pattern of Ready Market is a correct step.
A major move, overdue since long, is to allow banks and Mutual Funds who are associate members of the clearing house to deposit exposure directly, with the clearing exchange, as they have become major players on the bourses.
The equity markets of Pakistan have witnessed unprecedented rise in recent months. The index surged to 9200 level on Tuesday. The volume at the exchanges has also multiplied and now it is averaging around 750 million shares daily. This rise in index and volumes is attributed to high liquidity in the market, but the paradox is that the carry-over Trade (COT) market of all the three exchanges is suffering from lack of funds and the COT rates have risen abnormally.
Presently the annualised COT rate in the KSE is more than 18 percent and COT value is at an all time high of Rs 33.21 billion. In the LSE, where there is no cap on the COT rates, the rate has risen to 171 percent and the COT value is at Rs 5.94 billion.
The SECP has chalked out a plan to phase out COT by July 2005 and introduce margin financing in its place. Now KSE has only 12 companies left on the COT counter. The current liquidity crunch on the COT counter can only be attributed to the rise in the rates of the companies still traded in the COT. For instance, PTC has risen by almost 80 percent in the last three months, which keeps the total COT value on the higher side.
This has increased the volumes on the Futures Counter but at the same time the Ready-Futures spread has gone up to nearly 50 percent. This is being exploited by cash rich institutions and investors, which buy on Ready Market, sell on the Futures and gain nearly 40 to 50 percent on their investment.
It is, therefore imperative for the State Bank of Pakistan to induce banks and DFIs to extended margin financing facility to brokerage houses so that the financing rates for carry-over transactions may come down.
Further, the government must speed up its off-loading of shares to give the market more depth as the bulls are running amok mainly on three weighty stocks in the Index, namely, OGDCL, PTCL and PSO. Induction of PPL into KSE-100 Index from April 1st in the current scenario will make KSE-100 more volatile.
The Privatisation process has become the key driver. Any hiccups will adversely affect the market. Fresh private sector listings in a big way are not in the pipeline. We need to ponder over this for sustainability of long term growth.