Parallel badla and margin financing suggested

Analysts and traders at Karachi Stock Exchange (KSE) were of the view that to halt the declining trend in the market the Securities and Exchange Commission of Pakistan (SECP) should run badla and margin financing system parallel to each other to improve its image among investors and stockbrokers' community.
Yet another 'bloodbath' at KSE heralded last week, quite reminiscent of the goings-on of the last two weeks of March 2005. The KSE-100 Index had lost 2533 points (25 percent) during Mar 16-31, 2005 period, and during last week it lost 833 points, or 11.4 percent, to close at a four-and-a-half-month low of 6467.
In line with the heavy decline in the KSE-100 Index, the badla statistics also fell. Badla rates and investment levels decreased as leveraged buyers continued to either exit, or shied away from the market.
The KSE-100 Index finally broke out of its shackles on the downside, and breached the 6700-point barrier during the week. The current week would be the last full week of trading at KSE where badla would be available without any restriction. However, from June 8 onwards, a reduction of 8.25 percent per week in total badla exposure will have to be carried out. This could put further pressure on the dwindling KSE-100 Index.
Stock market is the barometer of an economy's performance. It provides an arena where investors can test their sentiment about the economy against the views of each other. The balancing act of sentiment in the stock market allows for gauging economy's performance, which is a very hard beast to measure otherwise.
To perform its function as an economy gauge, the stock market has to constantly check the edges of the trading range to explore the untraded price levels. Availability of financing/risk capital makes it easier for market players to test these trading range boundaries as they do not have to come up with 100 percent of the spot price of equity to test its range and their risk is limited. On the other hand, availability of excess financing and liquidity is also detrimental for a stock market as it allows market players to over-speculate and test trading ranges that they themselves are not convinced of. Availability of free money allows them to simply make huge bets on price levels thus increasing volatility and noise in price levels.
Following this logic, liquidity is a double-edged sword for the stock market. Just the right amount of financing should be available to the market so that trading range boundaries can be tested to avoid a lag between market and real business performance and not so much that testing of unrealistic trading ranges becomes cheap for speculators.
The recent crisis in KSE was partially the result of excess liquidity availability that allowed speculators to make super-unrealistic bets on price levels, sending stock prices in frenzy. It was quite obvious that liquidity had to be controlled to make the KSE work in a sane manner. However, SECP over-reacted and its decision to ban badla was more like throwing the baby out along with the water. What is needed is better management of risk capital available to the market.
Some of the potential alternatives to badla system could be functional futures exchange, options / derivatives, and a margin financing system. Currently, the Exchange has none of the above instruments available to the investors and this resulted in all speculation getting concentrated in cash equities market.
The futures being traded are actually just forward contracts and even the exposure on them is limited to a strangling 1 percent of the float.
So, this instrument cannot be used as a realistic source of risk capital for boundary testing of price levels. Options and derivatives are simply not available, and SECP has no plans to introduce them before complete phase-out of badla. Margin financing is being proposed as the 'be-all and end-all' replacement to badla system. However, even margin financing system is in very early stages of planning and investors will take some time to get accustomed to the new instrument.
The performance of margin financing in developing markets such as India has not been very promising mainly because of small retail trade sizes and aversion to documentation. Developing markets have had much better experience with derivative instruments and futures.
Traders and analysts proposed that SECP should take a realistic approach to the financing issue in the market. If KSE is to compete with international markets, SECP must give serious thought to launching derivatives and putting a futures exchange in place. And, most importantly, instead of wrecking havoc by pulling out badla and putting in an untested margin financing system, we propose that SECP should let badla and margin-financing systems work side-by-side, for the time being, as well as improve the functionality of the forward contracts already being traded. This way, investors will have access to a comfortable level of risk finances throughout the shifting process and the transition will be much smoother.