This article suggests reforms with a view to improving the functioning of capital markets of Pakistan. It is in two Parts. Part one discusses the Role of SECP and part Two discusses other operational issues affecting the capital markets.
PART 1 The market floor was imposed on August 28th 2008, which was lifted on 15th of December 2008 through a directive from the Chairman of Securities and Exchange Commission of Pakistan. The lifting of the frozen lower circuit breaker without the resolution of CFS MARK 11 issues and the unavailability or delayed injection of the promised 20 billion rupees fund into the system has highlighted several operational, structural and risk management issues within the capital markets.
The current situation should be viewed as a challenge for the stakeholders and especially the regulators of the capital markets. It is generally realised that the activities at the capital markets would be affected due to lack of interest, shaken confidence, default of investors and more importantly the possible default of some of the brokerage houses. All these issues needed to be resolved before confidence is restored in the capital markets.
The regulators and the Ministry of Finance have to do lot of home work to restore investors' confidence. The government has to re-assure the local and foreign investors that it is serious in the development of capital markets and is ready to make structural reforms that are needed to strengthen these markets.
There is a need to study the weaknesses of capital markets rules and regulations and remove those anomalies that are thought to prove irritants in the development of capital markets. This may be the right time to suggest structural reforms and implement these in the best interest of the capital markets.
STRUCTURAL REFORMS SECP, as a regulating institutions, has been severely criticised in the past. It has been alleged that SECP has not been an effective regulator as it has not formulated long term policies to improve and develop capital markets. Quite often it has acted in haste under the influence of big brokerage houses to change rules and regulations without adhering to the consultation process with the stakeholders.
The policies, rules and regulations have not been as transparent as these should be. Thus it has made possible to take undue advantage by some of the stakeholders. This provided an uneven playing field for others. The most severe criticism levelled against this institution is that the Chairman of this institution has always been hand picked by the government without taking care of selecting the position on merit basis.
The method of appointment does not ensure that the Chairman has the capabilities and expertise that are required for this position. This is a position that requires innovative personality to handle abnormal situations in ever changing environment. The best example that could be cited is that recently the capital markets have been capped at the lower circuit breakers for over 100 days. There were serious problems within the systems, including the issues relating to CFS MARK 11. It is being alleged that no concerted efforts were made to resolve these issues before announcing the lifting of the floor.
Soon after the opening of the markets, several stakeholders resorted to litigation to solve their unresolved issues pertaining to CFS MARK 11 as these parties were not taken into confidence in the resolution of their mutual disputes. In fact, it is evident that SECP under its Chairman and the KSE management were unable to resolve these disputes.
These institutions lack the basic techniques of Dispute Resolution techniques that are needed in this field. There are so many other examples where SECP in fact did not concentrate on those issues that were important for capital markets.
Instead it devoted its attention to few areas like risk management that too was one sided and the rules relating to Risk Management ignored the legitimate rights of investors and traders to protect their securities and margins deposited with the brokerage houses.
It concentrated its efforts more on the day to day running of the bourses instead of concentrating to strengthen the capital markets through improvement in their working. "The institution has proved friendlier towards the Members and Brokerage community rather than protecting the overall interests of the capital markets and that includes the other stakeholders."
The Chairman has also been criticised when he appeared on electronic media to assure the market participants relating to the possible formation of the 20 billion rupees support fund for soft landing of the capital markets once the floor is lifted. It is being alleged that it was not at all the task of the Regulator to assure the participants of the capital market for support fund. This aspect should have been left for the Ministry of Finance to deal with that issue.
The role of SECP could he assessed from the Report of Task Force that was appointed soon after the stock exchange crash of 2005; the Taskforce was appointed to investigate the causes of collapse. It gave its recommendations in a Report.
The Report recommended (Para 7) that there was a need for structural reforms and the steps that are needed to be taken by the Stock exchanges and the SECP to check the recurrence of such events because of policy, procedural, systemic and institutional capacity weaknesses.
SECP should have given top most priority to protect public interest by ensuring that the financial might that has been accumulated by the stock brokerage and Badla financing institutions should be effectively checked and brought to a reasonable size to ensure that they are unable to manipulate the market and adhere to international practices. We are still awaiting some work on these issues.
"SECP has also been criticised for inadequate surveillance and weak implementation of policy reforms. Recently during the period "floor rule" was imposed, parallel secondary market was seen functioning and shares were being bought and sold at substantial discounted prices." This practice negated the concept of capping the lower floor as in practice the floor was open for big brokerage houses that were successful in exploiting the market by purchasing shares from distressed sellers on heavily discounted prices.
It being alleged that SECP intentionally allowed this to happen and took no steps to stop this practice. SECP has so far not given any justification for this practice. SECP must explain the justification of frozen floor in the light of the existence of secondary market where underlined trades were allowed.
To a reasonable person, it amounts to conspiracy to lower the market intentionally by some of the influential brokerage houses who were able to accumulate stock at 40-50 percent discounted prices presumably with SECP's implied consent. We see brokerage houses still providing in-house financing facilities to their clients. We still see conflict of interest issues in the areas where Brokerage houses are involved in the management of Open and close ended funds.
We also see the management of the brokerage house controlling and managing other financial institutions directly or indirectly that may affect the operations of capital markets. No serious efforts so far have been made to curtail these monopolies. We believe the Competition Commission of Pakistan should review these areas to ensure that their conduct or behaviour is not against public interest.
It is an irony that SECP, while promoting the development of capital markets ignored this important element and encouraged only a few players by permitting them to float, manage and operate several mutual funds in the same hand and placed them in such a monopolistic position where it started affecting public interest. One of the directors of Policy Board acknowledged publicly that this practice has developed serious conflict of interest issues that were ignored by SECP.
CHANGE OF RULES The tendency to change rules and regulations without proper consultation with the stakeholders is not regarded as transparent practice. In the past, several rules were changed without providing adequate notice to the stakeholders. Some of the changes in rules were not even consulted with the other two bourses of the country.
These decisions always remain disputed on the basis that these are one-sided and provide benefits to a special class of persons and not to the market participants at large. The rules of the game should be clear, understandable and remain enforced for a longer period of time so that there is no fear that the rules will be changed overnight. These weaknesses are visible from the following few examples. This is not an exhaustive list.
The Board of Directors of KSE and the Chairman of SECP held an emergency meeting on Monday, 23rd June 2008 to change and alter trading rules of the bourses by reducing the lower circuit breaker from 5% to 1%, increasing the upper circuit breaker from 5% to 10%. It also banned blank selling in Future Deliverable Contracts with immediate effect.
In order to overcome the crisis relating to margins, the brokerage houses were allowed to give bank guarantees as margin instead of cash and shares. These decisions were criticised by the stakeholders due to the manner the decisions were taken. It was alleged that the decisions were taken in haste without involving all the concerned stakeholders.
It was surprising to note that the other two bourses were also not consulted in the decision making process, even though these decisions very much affected their operations. Rules and Regulations once implemented should not be changed overnight to meet minor adjustments for the conveniences of the parties involved. We have seen too many changes in haste that have eroded the confidence of small and big investors alike.
One of the important task of the SECP, the Regulator is to ensure that an rules that are changed affecting the stakeholders must be taken in a transparent manner, providing a level playing field to all the stakeholders and must be publicised and announced by giving sufficient time for its implementation so that the stakeholders should be able to adjust their positions accordingly.
It become a routine practice that rules relating to bourses are changed abruptly on the pretext that it was in the best "interest of the market" to save the capital market from collapsing.
BOURSES DIRECTORS SECP will have to resolve the difficult issue of appointing independent directors on the board of directors of all the three bourses by following the already defined policy for selection of these individuals. So far these guidelines have been violated. Adopting a policy that ensures the way the directors will be nominated in future should further strengthen the independence of the KSE Board.
This is essential for the sake of transparency and independence. SECP should come out with a very positive statement declaring that its nominated directors would henceforth be independent in real sense. Once these directors are nominated, SECP should not in any way influence the nominated directors in the performance of their duties.
Their fiduciary role should be the same as the elected member directors and they should be equally held responsible for any negligence on their part and SECP should not provide any protection to their nominated directors in case they are negligent in their role as independent directors under the Companies Act.
This would put sufficient pressure on the nominated directors to take the appointment seriously and become participative and productive in the board meetings. They should be able to disagree on any issue to safeguard the interest of the general investors without being even influenced by the big brokerage houses or the Regulators. Board of Directors meetings should be held in a manner that reflects their independence.
Their true independence can only guarantee that decisions are made without haste and in the best interest of the stakeholders. The director's decision taken during the last four months when the lower floor was capped is a reflection how directors were influenced by the Regulator and did not make independent decisions based upon facts and circumstances.
OTHER TWO BOURSES During the current market crisis, another important weakness of capital markets has come to light. The total dependence of capital markets on KSE is not justified. Currently KSE regulates almost 95 percent of the trading volumes throughout the country.
The other two bourses remain spectators and act as middlemen between the buyer/seller and the brokerage house of KSE. Besides adding additional cost to the trader/investor, the development of regional exchanges was hampered defeating the very objectives for which these were established.
SECP has so far given a step motherly treatment to the other two bourses, Lahore and Islamabad Stock Exchanges. While taking important decisions, the other two bourses are either excluded or not consulted. Thus it seems that KSE is the only exchange in Pakistan that matters.
If this is the official policy of the Policy Board, then it is suggested that either the other two bourses should be wound up or should become subsidiaries of KSE, as SECP's current prejudice against the other two bourses has been the main factor in their poor performance to uplift the capital markets in the other parts of the country.
There is a need to review other options like allowing the other two bourses to share the business through the same floor or to establish a national stock exchange that is represented by all the three bourses to evenly distribute the business and remove the monopolistic positions of KSE members. Things have changed with the establishment of Competition Commission in Pakistan. The previous old structure must be dismantled to allow a fair competition in the interest of general investors. (To be concluded)