An attempt to overcome liquidity crunch

Sep 05 - 11, 2005

The Karachi Stock Exchange (KSE) with the approval of the Securities and Exchange Commission of Pakistan (SECP) has replaced the Badla system with Continuous Funding System (CFS). There are all praises and it is being said that CFS will resolve the liquidity crunch, plaguing the performance of the KSE for many months. While preliminary details of CFS have been made available at the KSE website, the complete mechanism is yet to be clearly understood by the participants and the investors. However, the market has started responding positively and there has been convincing impact on the KSE-100 index as well as the daily trading volume.

It is being said that the introduction of CFS coupled with an increase in number of scrips and enhanced funding limit are likely to bring back the investors to the market. There has been exuberance but analysts also caution the investors and advise them to be selective while picking up the scrips. The credit of the introduction of a new system is being given to Prime Minister Shaukat Aziz and his team. The much talked about margin financing seems to have taken the back seat.

According to the notice issued by the KSE on 22nd August, "Pursuant to the meeting of the Board of Directors and senior members of the Exchange with the Prime Minister of Pakistan, Advisor to the Prime Minister on Finance, Minister of State on Finance and Chairman SECP, Continuous Funding System Regulations 2005 have been approved by the KSE Board and the SECP."

It also says, "As agreed in the above referred meetings, the maximum amount of CFS is capped at Rs 25 billion and the facility will replace COT/Badla and will be available in 14 top volume stocks selected on the basis of their turnover recorded in the Exchange during last six months, i.e. from February 21 to August 19, 2005 and will take place under the Continuous Funding System Regulations 2005."

The list of the companies which will be available for the CFS include:

1) Pakistan Telecommunication Company,
2) Oil & Gas Development Company,
3) National Bank of Pakistan,
4) Fauji Fertilizer Company,
5) D. G. Khan Cement,
6) Pakistan State Oil,
7) Pakistan PTA,
8) Pakistan Oilfields,
9) Pakistan Petroleum,
10) Sui Northern Gas Pipeline,
11) Bank of Punjab,
12) MCB Bank,
13) Fauji Cement,
14) Hub Power Company.

The general conditions are:

1) The maximum amount for the purpose of CFS is capped at Rs 25 billion.

2) CFS facility will be allowed in 14 top volume approved securities to the selected in accordance with the criteria laid down by the Board. The list of these approved securities shall be subject to review by the Exchange after every six months.

3) The CFS market shall be available for the entire trading period. The CFS market shall run in parallel to the Ready Market and transactions thereunder shall take place through the Karachi Automated Trading System (KATS).

4) The CFS facility shall be available for a period of 30 days at the option of the financee.

5) CFS facility shall only be provided against purchases in Ready Market.

The risk management measures incorporated are:

1) For the purpose of ensuring risk management, the CFS market shall be separated from the T+3 market and purchases of a security by financier under CFS shall not be netted against his sale in the same security in T+3 market.

2) The rate of margin as shall be determined by the Board for the purpose of CFS market shall be graduating automatically. The margin shall be increased in proportion to the increase in KSE-100 index.

3) The financier shall keep the CFS financed securities in a separate account maintained with the Central Depository Company of Pakistan Limited in order to ensure that these securities are not used for loaning against bank and short selling.

4) Every Broker shall maintain the leverage position in respect of CFS and other derivatives not exceeding 15 times of his Net Capital Balance.

Rules for settlement of claim in case of default of a broker are:

1) The Members' Default and Procedure for Recovery of Losses Regulations shall be applicable to default and recoveries under these Regulations. However, in case of default of a Broker, all his assets available in the control of the Exchange, except the margin, will be first utilized for settlement of T+3 trades and then for CFS transactions.

2) No claim under CFS shall be entertained outside KATS.

The Board may amend these Regulations with the prior approval of the Commission after giving reasonable notice to the market participants.

The phase-out of CFS shall be reviewed by February 28, 2005.

After having read the notice, two points become clear 1) the Carry Over Transaction Regulations, 1983 have been replaced by CFS and 2) the new system has to be phased out. It also becomes evident that this makeshift arrangement has been put in place to overcome the situation emerging due to phasing out of Badla. The market participants did not accept margin financing as a viable alternative for COT. However, it is also on record that more than sufficient time was given to the market participants and the banks to evolve the margin financing system. The immediate question, which comes to minds is, will the market face another crisis at the time of CFS phase-out?

The most probable reply is Yes. The reason being that as a nation we keep on deferring important decision making till possible. The deadlines are fixed and extended repeatedly but only to gain extra time. On top of this, most of the time is wasted in discussion about non-issues and core issues are swept under the carpet. The same is also true about the Badla system, being in practice for ages. The regulators were bent upon replacing it with margin financing but failed in convincing the market participants. They also failed in convincing the banks to come up with rules of the game and creating the required infrastructure. The unilateral decisions of the regulators created more confusion and caused mishaps rather than ensuring smooth working and transition from one system to another.

Though, many analysts attribute the March crisis to Badla phase-out, the fact is contrary. This crisis was not an outcome of Badla phase-out but a settlement crisis. There were also some regulatory lapses and the inherent weaknesses of the regulatory system allowed the unscrupulous elements to create the havoc. Though, last minute efforts were made to avert the crisis but vested interest remained dominant. One has to accept the fact that rules and regulations are tilted in favour of brokers rather than aiming to protect the interest of the investors.

The reasons for terming the March debacle a settlement crisis is based on the fact that when prices started plunging many brokers faced a near-default situation because most of the buyers were not able to withstand their commitment. As the prices went down margin calls were also to be raised. Presence of circuit breakers also made selling almost impossible. Then came the NIT-led rescue plan, which helped in the settlement of one scrip only that was OGDC. However, it is debatable whether the move was aimed at saving the small investors or the brokers from eminent default. Most certainly investors holding thousands of OGDC shares did not fall in the category of small investors.

It will not be out of context to talk about two key issues 1) free float and 2) small investors. It has been reiterated repeatedly by the analysts that the market lacks adequate availability of quality scrips and free float is too small. The estimates of free float range from 5 to 25 percent, based on the classification of investment being followed by different analysts. Though, it is being said that with the listing of large-cap companies free float has increased, it is not correct. The institutions and large net worth individual investors hold the bulk of the shares of blue chip and good performing companies tightly. Even the small investors love to retain these shares due to handsome dividend payout by these companies. Therefore, the free float of quality companies is around 5 percent, at the most. The average daily volume is often close to the free float. It is difficult to believe that the entire free float could change hand on regular basis.

It is also on record that the settlement is around 10 percent of the average daily trading volume. This shows that bulk of the volume is generated through trading and buying/selling by the investors is negligible. The smaller lots trade belong to investors and large lots pertain to the activity of the institutions, only institutions hold shares in millions. The retail investors cannot even afford to buy one million shares of the PSO or PPL and even OGDC and PTCL.

It may be correct to say that sale/purchase of large lots have the potential to drive the price in either direction. All these lots mostly pertain to institutional investors, including mutual funds. Often their average purchase price is far below the quoted price. If an institutional investor or a mutual fund wants to make capital gains it has to do this conveniently by offloading part of its holding. They have accumulated a large portfolio through Bonus and/or Right issues.

The economic managers often brag that now the number of investors in equities market runs into millions, which is incorrect and misleading. The thousands of applications received in response to public offer of shares of state-owned enterprises either belonged to one-time applicants or were the multiple applications submitted by large investors. They had submitted applications in the names of their wives, children, domestic servants and others only because preference was given to the applicants of 500 shares. The lot size was reduced to 200 shares in case of United Bank but the response was pathetic.

Kausar Javid, Chairman Small Investors Association, has been arguing virtually at every forum that small investors had lost billions of rupees due to March crisis. It is suggested that he should use the term "small traders" instead of "small investors". All of those who were working on "delivery only basis" were not the losers. Those who lost virtually every penny or life savings were indulging in Badla financing without realizing their capacity and ability to settle in case a delivery has to be taken. Kausar also agrees that Badla financing is of hardly any consequence for the small investors.

It may not be wrong to say that financing, be it Badla or CFS, is aimed at generating volumes. It has been said repeatedly that small investors should abstain from indulging in hay trading and should only invest in those companies, which have credible dividend payout record. They are also often told to invest in companies enjoying growth potential. Since they have limited resources, they are also advised to invest in mutual funds rather than putting all their eggs in one basket.

It seems that economic managers of the country support speculative trading rather than encouraging investment. They take pride in saying, "Pakistan is the best performing market" but are reluctant to accept the fact that equities market is not the true reflection of the performance of country's economy. To establish the credibility of the other point of view it is suffice to refer to the number of listed companies, number of active scrips and the volume of settlement. Nearly 90 percent of the daily trading volume pertains to about two dozen companies and only four scrips drive the index movement.

The support for speculative trading is also evident from the recent decision about the number of companies eligible for the CFS. Only 14 companies have been selected out of KSE-100 index companies. It looks a little disappointing because the Exchange has also expressed its intention to introduce another index, KSE Sensitive Index to comprise 30 most liquid scrips on free float basis. The Exchange has also circulated the working papers for seeking comments of the members. Abamco has launched a similar index lately. Therefore, it is not a question of reinventing the wheel but selection of companies on the basis of core facts.

Two other policy decisions, exemption of capital gains from tax and taxing dividend income, also prove that policy makers encourage trading and discourage real investment in capital market. The decision to exempt capital gains from tax was bad and its continuation for years is even worse. The argument given in the support of the exemption is that it generates volumes. But one fails to understand the logic because the objective should have been to broaden the investors' base rather than generating volumes. Only a few and select benefit from the exemption but thousands of investors are penalized for providing the capital for listed companies. When will this anti investment law be repealed?

According to some analysts the laws and rules governing the equities market operations are aimed at facilitating the brokers fraternity and not the real investors. Brokers in the name of small investors are seeking capital gains exemption. Continuity of Badla system was also pleaded in the name of small investors. Even the statement of Chairman SECP is on record that the Commission is not in a apposition to take action against the "strong brokers". There is also loud talk about the conflict of interest of brokers but regulators seem helpless. Short selling and insiders trading are prohibited by law but are being practiced blatantly.

Strangely, the regulators are also victim of brokers' boggy that there should be large daily trading volume and index should move towards new record highs. Higher trading volume is the ultimate objective of brokers because it generates commission. It is not the index or volume, which makes a market best performing market. It is transparency, efficiency and ability to attract new investment, which makes it the best or the worst performing market. While the economic fundamentals have improved since March, the market has remained completely in the grip of bearish sentiments. Almost all the recent public offerings, except NetSol, were under subscribed.

Moin Fudda, the outgoing Managing Director of KSE, has said repeatedly that stock market is driven by greed and fear. Some analysts say, "First the brokers build a hype, which creates greed. Once they sell off their holdings fears are created to reacquire the holding and the cycle continues". Globally shares are bought/sold on the basis of economic fundamentals following the rule of thumb - buy when the prices are low and book gains when the prices are high. As against this most of the investors in Pakistan enter the market when it is too hot and do not look towards it when the prices are very attractive. This is only because they look towards trading gains rather than capital gains.


The CFS is a breather for the market and has to be phased out ultimately. Therefore, efforts for making margin financing a viable financing alternative must continue.

In order to increase the free float listing of new companies should be encouraged.

The government must also ensure listing of all the state owned enterprises on the local stock exchanges and their shares should be offered to general public.

The government should also encourage delisting of small cap companies because the sponsors tightly hold their shares.

The secondary market for bonds (Term Finance Certificates) should also be developed.

The corporate tax rate applicable on listed companies must be slashed substantially, brought to half the present rate to encourage new listings.

Dividend income should be exempted from tax.

The exemption on capital gains should be abolished immediately.

The market is expected to remain volatile in the days to come. Profit taking will be common because investors would not like to miss the opportunity to reprofile their portfolios. Institutions have also exhausted their capacity to make fresh purchases. They also need more funds and time to reorganize their portfolios.

Last but not the least even the Rs 25 billion amount being offered under the CFS is not sufficient. The market needs injection of Rs 50 billion, at least. If the market is not interested in utilizing margin financing, can the banks pool their resources to float a couple of more mutual funds? Equities prices are attractive and economic fundamentals are strong, what is holding them?