It rains in the plains in Spain

It was an extraordinary Friday. It was taken up by the press releases of the SECP Chairman, the release by the board of the Karachi Stock Exchange and the notice to members by the management of KSE.
SECP is launching an enquiry into the recent market decline. They have said that there is prima evidence that some participants may have indulged in aggressive and illegal short selling to depress the market; there is preliminary evidence that market manipulation has taken place. The SECP is constrained to take action.
The board of directors of the Stock Exchange have stated that volatility is a function of a normal market and nothing extraordinary has occurred and indeed they are satisfied that with the risk management procedures in place there is no need for further actions.
The management has warned the members that whoever violates the rule & regulations with regard to short selling would be subject to penalties under the regulations.
The media was full of news and comments. Talk shows were buzzing with views.
I went home after the second session put on the air-conditioner in my bedroom. Lying in bed I was wondering about the day's events. The market had responded positively to the SECP action as short sellers covered their positions. The index, which had opened and closed at 260 minus closed at 74 plus. In between, we saw the index go positive by more than 200 points. It was pleasant to consider that aggressive short selling would stop and the market would be given some breathing space.
Lo and behold, the doorbell rang. It was the Bulbuls. An angry Bulbul wanted to know why they had not been invited to dinner that I had arranged for my bridge friends to celebrate the opening of the World Cup. Over my dead body, I wanted Bulbul mixed up with my bridge party. Those people are gentleman and do not want to get into nasty arguments and Bulbul is liable to do. Nevertheless, they were there.
I had to put a brave face on this and invite them to join the party.
"Listen my friend", I said to the Bulbul, "if you want to discuss the market do it now before my friends arrive". "When we are having dinner and watching the opening ceremonies of the world cup, talk football and do not get into any arguments please".
"Professor what is this about the SECP, the board of the Karachi Stock Exchange and the Management of the Karachi Stock Exchange are saying different things. Are they talking about the same stock exchange"? "Indeed it is", I said. "And when the SECP has dug out its can of worms, there will be no new faces. 2000, 2005 and 2006 is all the same.
The only question that should arise is whether we shall see any action on the findings of this new inquiry. I am an optimist perhaps against the expectations we will be lucky this third time. I can only thank the Chairman for having launched this inquiry. Knowing the expectations it will raise and the disappointment that will occur if nothing comes out of it. Good Luck to you Sir, God Bless".
"I wonder, as to why upto now the stock exchanges do not have an effective market surveillance system. The SECP Chairman is promising to have a surveillance system in place within the next quarter. Once again Sir, my heartfelt thanks."
As to the claim of the board of director of KSE that volatility is a normal phenomenon in any stock exchange, and that they are satisfied with their risk management procedures, and they feel that no further action is needed. Good Lord when men want to confuse issues they talk like sages. Volatility is not the issue.
I concede that volatility is part of the package. But should we not examine the nature of the volatility and its causes? If volatility is normal, it has to be within certain limits 600 points range is not normal. If volatility is excessive, the causes need to be investigated. It could be too much money chasing too few shares, which certainly is the case. But we must also be aware that excessive volatility could be caused by market manipulation. This is exactly what the SECP inquiry wants to investigate. Gentlemen please cooperate. Please do not confuse the issue. Only angels do not populate the stock exchange. It is your job to monitor market activity.
It is not your mandate to cover up cracks in the system. The earlier you put in a system of market surveillance that enables you to establish market abuse and take remedial measures the better off we will all be. It is often said that the day trader and the small investor are ignorant and greedy and deserve to be punished by the market. I agree you make a mistake you pay for it. Nothing wrong here.
However, no one should be allowed to cheat me. Can you ensure my safety? You cannot do this without a market surveillance system. Provide me safety and leave me to gain or lose by my own actions.
Now to the stand of the management that the members should refrain from illegal short selling or they will be penalised according to the regulations. And what are these penalties: -
1- For the first default 1% or Rs 25, 000 which ever is higher and a forfeiture of the gains made illegal.
2- For the second default 3% or Rs 50, 000, which ever is higher, and forfeiture of the illegal gains.
3- The honourable members of the exchange are not supposed to default on the regulations more than twice. The regulations are silent on what would happen after the default.
Consider the nature of the penalties and the potential for abuse of the market. Assume that I want to depress the market to and provide me an opportunity to re-purchase these shares and sell them subsequently again at high price. Take one example, early in the morning, the price of Pakistan Oil Field shares is Rs 375/- and I illegally short sell 13.33 million shares worth Rs 5 billion. The price falls to 356.25, which is the lower circuit breaker for that day. I repurchase these shares at a down lock. Moreover, the price rises back to around Rs 375.
I have cleared a profit of Rs 250 million. My fine at 3% would have been 150 million that is if I am caught. For me with my unimaginable large resources 150 million is loose change I will continue to take these risks because I own the stock exchange and no body can touch me. I urge the management to seriously consider a set of penalties that match the crime.
The existing regime is unsatisfactory and will provide no deterrent. Indeed so negligent has been the management that no case has been tried since the regulations were promulgated or else we should have seen evidence of forfeiture and of fines. There is a limit to protecting ones own.
But all this will be superfluous considering the nature of the defaults identified by the SECP in its notice. If manipulation is proven, the penalty will be under section 17 of the Securities and Exchange Ordinance 1969 and the penalties defined under Section 24 thereof describe a fine and three year term of imprisonment.
Of course, the SECP will have to follow the legal route of going through the courts. It may be time consuming and difficult but given the present mood of the courts the decision would be handed out within 90 days as required by Section 9 of the Companies Ordinance.
The Bulbul then wanted to know about my viewpoint on the privatisation of N.I.T. I had claimed that the market participants are depressing the market to achieve a lower price when the bidding begins. I gave him the following explanation. Let us assume that I am a bidder.
FIRST, LET US CONSIDER MY INCOME FROM THE ACQUISITION:
a) Currently NIT is charging 1% of NAV (net asset value) as a fee which means that for every 100 million NIT charges Rs 1million in fees. I too would be entitled to the same rate. But this is not true. The law permits me to charge 2%. The NIT being a public sector institution charges a lesser fee. Now assume that I am able to acquire the management rights. I would be making Rs 2 million where as the NIT is making only Rs 1 million.
b) Assume further that I want to make a 20% return on my investment. Therefore, for every Rs 100 million giving me a fee of Rs 2 million, I would pay a price of Rs 10 million.
c) Now consider that I want to acquire the asset for the lowest possible price. I would depress the price so that the NAV comes down to Rs 75 million. Quite obviously, I am loosing out. A higher NAV would have got me higher fees. So why do I lower the NAV. It is because I would be able to charge 2% instead of 1% and I make Rs 1.5 million, one and half times what I would have made had I retained the NIT scale of fees.
d) Now having acquired the management rights of a portion of NIT, I let the share prices rise to the level dictated by the earnings of the corporate sector. It is commonly argued that the real index would be 13,000 points by the end of this year or may be earlier. NAV of NIT would increase by the same percentage, which is 30% more.
I paid Rs 10 million for Rs 100 million in assets. I am now making 2% on Rs 130 million of assets, which yields me a fee of Rs 2.6 million. A return of Rs 2.6 million on an investment of Rs 10 million translates to a return of 26%. I receive 30% more return on my investment at this higher NAV.
It is a win-win situation. Depressed prices still come out ahead. The solution my friend would be not to privatise NIT before the index has achieved its real value. There is no way in which it can be equitable to reward market manipulators.
At this point, the Bulbul wanted to know what I would propose for the market. It is simple my friend it is simple. Install a market surveillance system. Then milk will be milk, water will be water and the fat lady will have sung, which will be the end of the opera. For the time being what the Exchange board is saying is volatility is an essential part of the market. Yes, I say. I agree. It rains in the plains in Spain.