Adopt margin trading system with caution

A ten-member committee is now examining the Margin Trading System proposal sent by Karachi Stock Exchange to the Securities and Exchange Commission of Pakistan, for approval, a year ago. The internal in-fighting within the Commission is blamed for the delay in taking up the proposal. One legalistic view was to seek an amendment in the existing charter of the National Clearing Company for the introduction of the MTS.
Under the Margin Trading System, the contract, once signed between borrower and lender, will be assumed by the NCCL for settlement and the assumption of the risk involved in the transaction against a fee.
The MTS is primarily a more refined and risk-mitigated version of the screen-based Continuous Funding System (CFS) Mark-II. The difference between the two systems is, that under the CFS, the defaulting borrower (client) roped in his broker as well as other clients of the broker - under the MTS, the counterparty risk is on the scrip and the defaulting client is identifiable through the Unique Identification Number (UIN). In case of margin default, shares of a particular client will be sold off with no recourse to the lender on the assets of the brokers or his other clients. Still, however, one needs to properly assess the product in light of the bad experience of the CFS-MKII. The screen-based funding product does provide enhanced liquidity. But due to the poor enforcement of rules and regulations by the regulatory body, the capital market suffered a crisis in 2008 and as a result the CFS-Mark-II was discontinued in 2009.
The proposed MTS is a deferred settlement product with a potential to create significant liquidity in the equity market. However, it has an inherent risk of creating artificial bubbles by taking share prices to such inflated levels, not substantiated by the fundamentals of the underlying shares, thereby causing the market to overheat - possibly leading to an ultimate crash. Such a scenario is to the detriment of genuine investors, who trade in the ready or cash market but are forced to pay the speculative prices of shares due to over-leveraging.
The scrip eligibility criteria in the CFS-MKII was also faulty. While listed mutual funds were debarred - broker owned/managed entities were not. Owning banks, as well as mutual funds, and at the same time, some brokers enjoying credit lines in billions of rupees, managed to pump up the volume traded and the impact cost of certain scrips to make them eligible under the CFS-II. And, later dump the same, causing a settlement crisis between lenders and borrowers, in 2008. The movement of the share value of some known scrips reflects a clear pattern. Despite probes by the SECP, nothing actionable has come about, primarily due to weak enforcement and possible political pressure on the apex regulator. Another issue facing the regulators is the determination of the free float of scrips. KSE does not have a correct assessment due to cross-holdings within a group. Empirical evidence requires that the eligibility criteria for borrowing and lending in shares, qualifying for margin trading, be much more stringent and restrictive. All associated companies, as defined in law, having substantial shares owned by brokers, directly or indirectly, need to be debarred from the MTS.
The proposed MTS is a derivative product. It needs to have a separate distinct identity. It is needed because margin financing in the country has just not taken-off. Banks neither have the risk management capacity nor the will to create a proper back office mechanism to monitor and run equity financing products. Banks are willing to establish credit lines for big brokers as well as wealthy clients. However, at the retail level, they insist that the brokers must carry the counterparty risk of their clients. MTS offers a financing platform, where lenders can provide a credit line to the system, whereby the NCCL will assume the counterparty risk on the scrip and guarantee settlement against a fee. With a Unique Identification Number (UIN), it would be possible to handle default at the client level, with no significant repercussions for the brokers. This could, however, increase the risk for lenders as brokers will be less vigilant in evaluating their clients who wish to leverage their purchases in the cash market. As such, MTS needs to be a distinct product, away from the ready market, with no interaction between the two. Monitoring, vigilance and rules enforcement governing risk at the NCCL, as well as at the Central Depository Company (CDC), needs to be much more enhanced - than was done in case of the CFS MK-II, wherein the sub-accounts of clients were misused by some brokers.
At present, both the SECP and KSE lack the ability to monitor and enforce their rules and regulations over their regulatees. Demutualization of the exchanges needs to be expedited. The SECP also needs to be shielded from undue political interference. Its policy board must be placed under the Chairman SECP and the Finance Secretary should be only an ex-officio member. The relationship between the SECP and Ministry of Finance must be kept at an arm's length. The SECP must enjoy both financial and administrative autonomy and be manned with requisite expertise. The ground reality requires that the SECP's operational head office be shifted to where the needed talent is easily available and also, where most of its regulatees operate, ie the commercial hub of the country - Karachi.