Capital market reforms propose some risky returns

LAHORE: The Security Exchange Commission of Pakistan (SECP) after long deliberations has come up with half cooked reforms on the working and operations of brokers that were against the spirit of demutualisation, as it would reduce the number of brokers.

Small brokers have reservation on increase in minimum capital requirements. They are also surprised that the new draft has set no provision for a professional clearing member or direct payment system as these two measures were proposed by SECP in its Concept Note on these reforms. It was expected that after demutualisation, the number of active players in the stock market would increase and professionals like doctors, engineers, lawyers and architects would be allowed to trade directly from their terminals at home with low security.

Instead, under the proposed setup, brokers have been divided in three categories, starting with “Trading only” for those with minimum net worth of Rs15 million. Category II is for brokers with “Trading and Self Clearing” rights with minimum net worth of Rs100 million, while the Category III brokers have the right for “Trading and Clearing” with minimum net worth Rs500 million.

Increasing the minimum net worth is deemed as an exercise to discourage small investors to trade directly in the stock market.

The risks are smaller with lower capital requirements. Brokers are allowed to trade up to 10 times their net worth. Defaults of small brokers are manageable, but when high worth brokers default, it creates havoc. Even in the most sophisticated capital markets, brokers can default. So the argument of better regulation was not a guarantee that there would be no defaults. Most of the brokers have compromised on the current increase in net worth as well as categorisation of brokers. However, they have genuine fears about the transparency of the system. Brokers from the trading only category would have to place their orders through category III brokers who have been provided rights to accept orders from trading members.

This breaches the confidentiality of their trade. The category III traders would know the position taken by the trading brokers.

It will also have the list of the clients of that broker. The trading broker would be at the mercy of the category III broker, who may refuse or delay the execution of his/her order if his hands are tied in some big transaction.

Another apprehension of the trading only brokers is that what would happen if the category III defaults?

Would the trading broker be held responsible for part of the default because he/she traded through the defaulting broker?

There is no clarity and transparency in this regard. The system could work more transparently if the original concept of establishing a direct payment system is introduced and the trading only broker does not have the compulsion to trade through category III traders.

In the same way, a professional clearing member if established would ensure the confidentiality of the business of the trading member. It is unfortunate that our capital market has not deepened. Only listed shares are traded; there is no secondary capital market; and term finance certificates are rare.

At the same time the number of investors is also very small. It is the responsibility of the capital market regulator, which in our case is SECP, to develop and broaden the capital market. The current draft would definitely reduce not only the number of brokers but also the number of general investors.

Before demutualisation, the number of brokers in our three stock exchanges was 450. After the formation of the unified stock exchange, the number of brokers has gone down to around 250.

After the categorisation process is fully enforced, the number of brokers would be further reduced by 70-90. This is not good for our capital market. It is the brokers that bring investors in the capital market.

The more the number of brokers the higher are the number of investors. In India, the paid up capital requirement for a broker is equivalent to Rs6 million. Ours is a much smaller market, but minimum requirement for trading only category has been fixed at Rs15 million or 2.5 times higher than in India.

Indian National Stock Exchange has presence in 2,000 cities and small towns through 3,000 leased lines and 2,500 very small aperture terminals (VSAT). Our big brokers have a myopic vision. They want to remain big fish in a small pond. The pie would further shrink if small brokers are routed out.