Stock market brokers: SECP set to enforce new regulatory regime

The Securities and Exchange Commission of Pakistan (SECP) is all set to enforce a new regulatory regime to move towards consolidation of financial resource requirements of stock market brokers, reduce custody risks and set qualitative benchmarks.

Officials told Business Recorder Friday at the SECP headquarters that proposed regime divides the industry into three categories, ie, small-sized brokers (trading only brokers), trading and clearing broker, and trading and self-clearing brokers. The SECP has initiated public consultation on the proposed new broker regime that primarily aims to strengthen the capital markets and restore investor's confidence.

As per the proposed model, three categories of brokers will be created. Trading Only (TO) brokers will only execute proprietary trades/trades by clients and will not keep custody of proprietary or client assets and will not settle trades. Trading and Self Clearing Brokers (TSC) can execute and settle trades of their clients and also keep custody of clients' assets. Trading and Clearing Brokers (TC) can execute and settle proprietary and client trades, keep custody of clients' assets and also offer custodial and clearing services to the TO brokers and their clients, they stated.

As per the proposed regime, the TO brokers will have multiple options to transfer their custody to CDC/NCCPL through DSS/NCS, or to banks in the form of PCM or to other brokers which fulfill stringent criteria of Trading and Clearing brokers.

In the past, custody defaults by brokers have severely damaged investor's confidence and adversely affected the growth of capital markets in Pakistan as evident by the lowest number of investors in Pakistan. As per international practices, the custody and clearing functions are only performed by financially sound entities, which have adequate financial resources and infrastructure.

In case of Pakistan, all brokers are allowed to keep custody of client shares and money irrespective of their financial standing, corporate governance structure or capacity.

The aim of the new regime is to ensure that custody of customer assets is only allowed to brokers with sufficient capacity to meet the requisite level of compliance, particularly related to AML/CFT in the light of FATF requirements, keeping in view the placement of Pakistan in the grey list. The SECP is, therefore, seeking to create a structure in line with best international practices which will improve governance standards and transparency, and also enhance investor's protection.

The SECP officials informed that before issuing draft amendments to the regulations, the SECP circulated a concept note and consultations were done with all stakeholders. Currently well capitalized brokers have market share exceeding 90% both in terms of client custody and trading quantum. In order to avoid concentration risk, appropriate controls have been envisaged in the shape of stringent credit rating, limit on asset custody, auditor quality, high equity, strong corporate governance structure and more frequent inspection.

They specified that the small brokers have very low market share and maintain custody around 6 percent of total custody while they contribute not more than 10 percent in terms of total number of customers and a low trading quantum. On the other hand, the new regime provides the brokers with small capital to reduce compliance burden, transfer their custody function to institutes with adequate capacity and focus on their core competence of trading and investment advice.

The SECP officials further explained that most of small-sized brokers have capacity issues in ensuring compliance with the AML/CFT requirements. Experts say that implementation of the regime would improve compliance standards in the industry; thus, leading to enhanced compliance with the AML regime. Further, custody would only be retained by other financially sound brokers or professional clearing members, which have enhanced compliance with corporate governance standards; thus, further strengthening AML/CFT regime in the industry and improved compliance with FATF requirements for Pakistan.

Commenting on SECP's broker regime, an Islamabad-based stock investor opined that brokers make good profits but are unwilling to comply with laws and do not invest in systems, infrastructure and compliance. The concept of TO broker and categorization of brokers according to their net worth is practiced globally and is in line with international best practices in countries such as India, Malaysia, Hong Kong, Singapore, US and Canada, etc.

New broker regime:

Existing scenario:

Analysis of existing data reflects that major proportion of market share in terms of quantum of custody and number of customers is concentrated among few large brokers whereas the brokers with low net worth cater to a very small market segment. Further, majority of customers of small brokers are retail clients as shown in table below:

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Net worth (PKR million)               No. of Brokers        Custody as %        Trading as %      No. of Clients      % of Total     Individual     Corporate
                                                        of Total Custody    of Total Trading                                            Clients       Clients
=============================================================================================================================================================
Less than 100                                     98                  6%                  7%              23,040          10.70%         98.90%         1.10%
Greater than 100 & less than 500                 109                 36%                 43%             109,704          50.70%         97.80%         2.20%
Greater than 500                                  18                 58%                 50%              83,491          38.60%         97.30%         2.70%
=============================================================================================================================================================

Past defaults by brokerage houses, as exhibited below, has led to deterioration in investor confidence which also affects the development of capital markets and investor outreach:

It is also noted that the brokerage houses have failed to act as intermediaries leading to the lowest number of customers as compared to the number of brokers in Pakistan as reflected in below analysis:

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Sr.  Jurisdiction            GDP      Population   Market Capitalization     No. of Brokers   Investor Base     Investors/Broker
                         ($ billion)   (million)        (% of GDP)
================================================================================================================================
1.  Malaysia               314.5        31.62             135                        28         2.5 million               89,000
2.  Thailand               455.2        69.04             116                        39        1.46 million               37,500
3.  India                  2.597         1339              90                     1,464          32 million               22,000
4.  Indonesia               1016          264              52                       141        1.12 million                8,000
5.  Bangladesh             249.7        164.7              35                       250         2.7 million               10,800
6.  Pakistan                 305          197              30                       250         0.2 million                  800
7.  Sri Lanka              87.17        21.44              22                        27        0.63 million               23,500
================================================================================================================================

* The new regime aims to ensure that custody of customer assets is only allowed to brokers with sufficient capacity to meet the requisite level of compliance, particularly related to AML CFT.

* SECP is therefore seeking to create a structure in line with best international practices which will improve governance standards, transparency and also enhance investor protection.

* The new regime will allow the brokers with small capital to reduce compliance burden, transfer their custody function to institutes with adequate capacity n focus on their core competence of trading and investment advice.

* Before issuing concept note was circulated and consultations were done with all stakeholders.

* Currently well capitalized brokers who have higher governance standards have market share exceeding 90 percent and they are fully supportive of these regulations.

* In order to avoid concentration risk, appropriate controls have been envisaged in the shape of stringent credit rating, limit on asset custody, auditor quality, high equity, strong corporate governance structure, more frequent inspection.

* These brokers are unable to comply with the requisite compliance obligations of AML/CFT which is now more crucial then ever due to placement of Pakistan in the grey list.

* It is also important to mention that these brokers add little value to market, still they act as a pressure group and create obstacles in the way of each and every reform sought to be introduced in the market.