Three issues were raised by Chairman Karachi Stock Exchange Zubyr Soomro, subsequent to the approval given for the proposed Margin Financing System. They related to (a) letting the broker off-the-hook on default of a client; (b) allowing individuals to lend money (ie Badla) through the screen-based system; and (c) enforcement of know-your-client mechanism as required under anti-money laundering law.
All three have been answered in a communication to SECP by the KSE. Under the proposed system, in case of mark to market default the UIN holder will be blocked and his broker suspended. In case of settlement default, the broker will be blocked. Individual lenders cannot walk away from a deal as they have to lend through broker to enter the system.
And, KYC mechanism as envisaged in law will be strictly adhered to. The following are some legitimate and profound concerns/questions in relation to explanations/answers to Margin Financing System (MFS): Screening of eligible parties: Broker Financee and Authorised Financier (both broker and financial institutions) are mandatorily required to be Participant Accountholder of CDC and Clearing Member of NCCPL as per stringent eligibility criteria laid down in their respective regulations duly approved by the Commission. An annual NCSS audit by an external auditor reviews compliance of NCCPL, systems including all regulatory compliances.
Automated settlement of securities to ensure proper controls on the use of sub accounts: It is agreed. The Automation of Securities Movement project will be launched in parallel with MTS, whereby system will ensure proper control on the usage of sub-accounts by synchronising UINs used by the brokers while executing trades on KATS. Accordingly, system will automatically move-out and move-in securities from respective sub-accounts on the basis of particular UINs. The system is ready to be implemented shortly. This automation will restrict movement of securities into CDS sub-accounts to the trades/transactions executed/ recorded at the Exchange which will result into almost no brokers' intervention in changing beneficial ownerships of securities, and will also prevent misuse of client's securities at large.
NO COUNTER PARTY RISK ASSESSMENT AS NO PRE TRADE DISCLOSURE: It may be noted that even in the case of Margin Financing System (MFS), which is based on Counter-Party Risk Assessment as per the International Best Practices, Authorised Financiers will not be able to assess the risk to actual financees, ie, clients of a broker and they have to rely upon. the requesting brokers as intermediaries for arranging financing for their clients. Moreover, collateral moving to financiers' blocked accounts in CDS may also belong to those clients which will not be known to such financiers.
Both MTS and MFS should be launched in parallel for enabling those who are comfortable with Credit Assessment of intermediaries to choose MFS and for those who are comfortable with Credit Assessment of underlying Securities, to chose MTS. A rough analogy is issuance of warehouse receipts in the case of commodity financing; whereby bank is doing commodity financing purely on the basis of commodity as collateral under management of a collateral mgmt company.
MTS to be restricted to institutions only, which should use the IDS platform at NCCPL: IDS platform of NCCPL is used for disclosed transactions whereby affirming non-broker clearing member (financial institution) only knows the initiator (broker clearing member) who executes particular trade/transaction on behalf of such institution as its client. Even in such IDS transactions, counterparty (financee) is not disclosed to the institutions.
Secondly, an MTS institution will be able to directly participate in the capacity of financier without involving any intermediary broker and will take direct exposure on the particular security to be financed. Accordingly, all financed securities will be parked in the institution's CDS blocked account till the settlement by financee. Therefore, in MTS, there will be no need of IDS functionality.
TO CONFIRM THAT NCCPL'S CRITERIA FOR IDS PARTICIPANTS IS SUFFICIENTLY ROBUST: In the proposed MTS, all non-broker financiers will be the direct participants of MTS transactions in the capacity of Non-Broker Financiers and will be admitted on the basis of robust and stringent criteria laid down in the Regulations duly approved by the Commission. A similar contract existed for CFS MK II system.
In case of broker participation, a higher limit of capital adequacy to be prescribed in addition to minimum net capital balance. It needs to be ensured that MTS financing by broker financier is limited to his own funds or funds borrowed from financial institutions: Minimum Capital Balance for a member of KSE is required to be Rs 2.5 million which makes him eligible to participate in all markets, whereas, Capital Adequacy Requirement for broker as MTS participant is proposed to be minimum of Rs 10 million either in the capacity of financee or financier. So capital adequacy and minimum net capital balance are two terminologies for the same requirement.
Moreover, high net-worth and sophisticated clients having Rs 5 million available for financing will also be allowed to provide financing through brokers, Such restriction was not available in CFSMk II. The following options may be considered:
(a) Eligibility of a financier client to be declared based on the Standard Agreement between Broker acting as an intermediary and its relevant client which will clearly specify terms and conditions along with proper KYC disclosure, of
(b) Otherwise brokers shall be restricted to provide financing through its own funds or funds borrowed from financial institutions. However, in this case, system will record such financing from proprietary account of broker financier.
Having a wider range of financier pool, it ensures that no joint action can take place such as 'removal of funding from the market.' Also the margins being taken from financier will limit the incentive for lender default which has not been witnessed to date in any financing product.
In the absence of counter party disclosure, it is equally important that the requirement for a higher limit of capital adequacy in addition to minimum net capital balance should be prescribed for broker financees. Also, it should be made mandatory for all broker financees to carry out credit risk assessment of relevant UIN financees in line with a proper KYC procedure and enter into written agreements clearly specifying the terms and coijditions in accordance with the rules/regulations: It is agreed. Such aspect has already been addressed in the proposed MTS whereby minimum net capital balance for broker financee and financier is Rs 10 million. However, as financee, capital adequacy has been limited to only 5 time of his net capital balance (this is one third of the limit set in CFS Mk II thereby significantly reducing the amount of leverage possible).
In order to make it mandatory for broker financees to carry out credit risk assessment of their client (UIN) financees in line with a proper KYC procedures, a separate Standard Margin Trading Account Opening Form with KYC Procedures clearly specifying the terms and conditions should be signed by respective clients and brokers in accordance with the rules and regulations of KSE and NCCPL to be designed and drafted. In order to ensure compliance of such requirement by the broker, a random audit may also be exercised.
At the same time an external audit must be done for all UINs to ensure that these are current and adequate KYC screening has been done: It is agreed. NCCPL Board has already advised NCCPL Management to develop ToR for external auditors to conduct audit of UINs opened by the brokers.
Also, it is a standard practice of all three entities involved in MTS ie, KSE, NCCPL and CDC, to perform a stress test on all their systems, being utilised, before their formal launching and same will also be followed in the case of MTS.
USE OF SHARES IN BLOCKED ACCOUNT Given that reliance for credit extended is entirely on the pledged securities, contrary to the proposal, the use of blocked accounts shares for exposure margins even in case of proprietary positions only should not be permitted. This may lead to over-trading by broker financiers and defeat the very purpose of blocked accounts: It is agreed. It is pertinent to note that a 50% haircut is sufficient from risk management perspective; however, in the spirit of keeping the Ready Market separate from MTS, this suggestion is appropriate.
RISK MANAGEMENT (a) While reviewing some of the risk management areas of the product, it is felt that in order to reduce the speculative aspect and the easy access to liquidity which may lead to overleveraging and ultimately systemic a risk to the market, the position limits and concentration margins for brokers need to be tightened: Position Limits have already been proposed to be significantly lower relative to other futures markets and Concentration Margin are proposed to be double of those applicable in Deliverable and Cash-Settled futures in addition to minimum 25% Financing Participation Ratio (FPR). The risk management of any product is subject to change as markets change; however, initial parameters need to be robust which are appropriate as currently envisaged.
(b) The scrips in which margin financing is to be allowed need to be selected based on more carefully prescribed criteria which limit financing in scrips which can be easily manipulated: Criteria proposed by the committee for MTS eligible securities may allow not more than 20 more liquid and larger free float market capital securities as are tested on existing data history by us (this is fewer than what is allowed in other derivative markets currently). Moreover, Financiers and Financee are forbidden to acquire and provide financing in the securities in which they may have privilege to be insiders or any other interest such as subsidiary and associated undertakings, which was not applicable in CFS Mk-Il and other futures markets.
(c) In the earlier crises, the weak enforcement of regulations at NCCPL was mentioned and the effectiveness of their processes! Oversight should be assessed by external auditors and addressed right away as they play a central role in the MTS product: It may be noted that whatever action taken by the NCCPL in 2008 was duly consulted with all stakeholders and duly approved by the Commission. Moreover, the NCCPL regulations have stood the test of court action in 2008 and found to be valid/enforceable. However, the Committee proposed robust default procedures based on the lessons learned from those crises including but not limited to separating risk managements of MTS from underlying Ready Market and allocation of underlying securities instead of final loss to the financiers if could not be squared-up by NCCPL due to any unavoidable circumstances.
THE DEFAULT PROCESS
(a) The proposed product differentiates between types of defaults and who bears the responsibility thereof. This distinction was not there in earlier versions of this system based product and puts the onus for MTS defaults essentially on the UIN involved and leaves the broker out of it until there is a settlement default. The broker handling and driving the underlying transactions should necessarily be involved responsible for all the legs of the transaction as the party bringing the business to the table.
A default should be treated as a default with all the resulting actions included in prior products and with no distinction between mark-to-market and settlement default as both constitute a failure to pay as committed. The brokers should thus be responsible not only for proprietary defaults but also for the UINs that they bring into the system and do transactions for which, as referred to earlier, should not distinguish between the nature of defaults ie, mark-to-market or settlement of principal amount: If broker is defaulted in MTM default then the current Product will be exactly like CFS II and trigger sale of Brokers assets that leads to systemic volatility. Current concept is that financier is taking risk on security but broker should also face significant 'penalty' so that he has no incentive to wilfully default.
A comparative table highlighting disciplinary action on daily MtM failure by Financee as recommended by the Committee and management is available. In view of this, margins relating to transactions should be kept discrete and under effective relevant control as the underlying securities are the only recourse available upon default ie, they should not be used in anyway against other exposures: It is agreed that underlying securities in the blocked account should not be used by MIS Participants against other markets.
Keeping discrete and under effective relevant control on Margin relating to MTS transactions have already been addressed in the concept paper and NCCPL Regulations (under preparation). There needs to be more clarity in terms of the legal aspect, ie financing in MTS is proposed through an undisclosed system whereas in a default situation the default proceedings are being pursued on UIN level with the blocking/suspension of the relevant UIN on counterparty basis:
It is agreed. However, such treatment of default envisaged in order to avoid systemic risk due to default of a bad client and its impact on those clients who are properly managing their margins. In the event of default of non-payment of' mark-to-market losses by a particular UIN, financed shares will ultimately be allocated proportionately to all those financiers who provide financing in such security.
Legal Framework and Contractual Obligations there-under as transactions are via the system and at execution the parties are unknown to each other it is important that contractual arrangements/obligations are clear, in line with the relevant contract law and are accordingly documented. It would be appropriate that a concise one page agreement with specified terms should be executed between the parties so there are no ambiguities: It is agreed. NCCPL Regulations are being prepared with due consultation of the legal advisor which will appropriately cover all legal aspects including agreements with clearly defined terms and conditions. This exercise was also done in CFS Mk II (in fact NCCPL regulations have stood the test of legal dispute).
ANTI MONEY LAUNDERING (AML) RELATED ISSUES Given the international focus on anti money laundering issues and our own recent legislation on this we should ensure that the proposed product is in compliance with the letter and spirit of these requirements. The fact is that counterparties will not be known at the time that credit is extended to them. How then can AML due diligence be done on them before execution of the transactions? Some of the suggestions given on strengthening the KYC process may help to mitigate such concerns but this must be duly cleared by the relevant authorities: It is agreed that concept paper on MTS based on undisclosed parameter should be cleared by the relevant authorities. The proposed Margin Trading System (MTS) has safeguards and checks and balances to avoid money earned through crimes channelled through the system. Though the overall securities trading, including proposed MTS, carried out at the Stock Exchange is undisclosed, whereby the buyers and sellers of securities are not identified to the market participants/investors in order to discourage speculation, compromise confidentiality of transactions and avoid front-running, however, the overall market mechanism has been devised in such a way that market entities have all the necessary information, about the investors, which can be retrieved at any time whenever required.
IN ADDITION TO ABOVE, THE MANAGEMENT IS OF THE FOLLOWING VIEWS ON MTS, MFS 'AND OTHER LEVERAGE PRODUCTS: Having minimum requirement of 25% as Equity Participation by a leverage buyer, it is not expected high leverage in the market as compared to CFS Mk-II due to the following reasons:
a. Based on last two years' average value outstanding in the Ready Market, at any time it was around Rs 15 billion which included at least 50% positions belonged to local and foreign investors who were Cash Market's players. It means that leverage demand would not be more than Rs 28 billion in the current liquidity situation.
b. Prices of underlying leverage securities will be Marked-to-Market daily if move downward, it means that during the bearish trend in the market, committed finance will be reduced gradually by collecting from leverage buyers and returning to the financiers by the system.
c. Banks' Margin Financing to the brokers will be limited to the Collateral bought through Ready Market in contravention to their existing mechanism of Shares Financing where they may accept land, building and shares other than those required to be financed in the Ready market.
d. Existing cash requirement in Deliverable Futures Contracts (DFC) and CashSettled Futures (CSF) are around 15% and 12% respectively which are considerably lesser than 25% FPR requirement in the MTS.
e. Overleveraging in MIS is also tightly controlled by placing very low position limits in term of FF %ages and Rupee Values as are flexible in DFC and CSF markets.
2. It would be economically not viable for a broker if he wilfully defaults to pay Mark-to-Market losses or Settlement amounts on account of MIS because defaulting UIN's shares will be sold out to financiers at minimum 16.7% discounted prices, as a last resort if such shares could not be squared-up by NCCPL till 2nd day of payment due date. For example if FPR is 75:25 on Rs 100/- ie, Financing Price, security will be sold out to Financier at Rs 75 at the close of 2nd day on which price will maximum go down to Rs 90 due to continuous circuit breakers (5%+5%10%).
3. It would enhance investors' confidence in the capital market, if their open positions will be safe even in case of their brokers' default due to a delinquent client.
4. Very stringent concentration margins over and above FPR will minimise chance of concentration in a security by overall Market, a Broker or a Client.
5. Restriction on MTS participants to finance or borrow to or on any security in which they supposed to be insider will reduce the chance of their manipulation through leverage market.