MARGIN FINANCE — CAUSE FOR LIQUIDITY HARBINGER OR CRUNCH!
Situation has reached a point, where KSE has to suspend the ongoing periodic reduction in COT financing as agreed with SECP
By ZIA BANDAY
July 11 - 17, 2005
Lack of liquidity is an often quoted reason for the recent lackluster performance of domestic stock markets. Numerous discussions on television channels and various articles in newspapers are highlighting this issue as a decisive factor in determining market direction. At one end, we are witnessing a roller coaster decline of COT financing in stock markets, whereas on the other hand its replacement with margin financing is taking place at a snail pace, hence increasing the divergence between demand and supply of liquidity. Situation has reached a point, where KSE has to suspend the ongoing periodic reduction in COT financing as agreed with SECP, indeed a drastic measure. Why the need of this transition from badla to margin financing arises? Is there any other way of making this transition smooth? We will try to find out answers to some of these questions in our article. Here, we also want to elaborate that the two terms of badla or COT financing are interchangeable.
NEED FOR TRANSITION
With the banning of badla financing in India in 2001, Pakistan has remained the last bastion of such financing in the world stock markets. Before divulging into the need for transition, we would reflect upon the mechanics of COT financing for comprehending its marketability. Brokers arrange funds for badla financing through banks, DFIs, mutual funds or its own sources. Stock exchanges run badla sessions after close of market on their automated trading terminals. Cost of financing for specific scrips is achieved through continuous matching of their bids and offer quotes. Brokers bore the credit risk, as they are responsible for setting up margin limits and their subsequent collection from clients. Owing to its existence for decades, COT financing has matured as a product, which is not only comprehensible to investors but also provide necessary liquidity for effecting price movements in stock markets.
However, COT financing also carries a structural weakness, i.e. on assuming greater market risk, providers of badla financing can deny funds to brokers, hence leaving them high and dry to manage their leverage positions. This systemic risk has often caused market crashes. Under a wide ranging capital market reform program, financed by Asian Development Bank (ADB), SECP is addressing this systemic risk by replacing badla with internationally recognized margin financing.
In this regard, SECP has promulgated Margin Trading Rules, 2004. Stock exchanges and SBP have developed Margin Trading Regulations for their respective jurisdictions of brokers and banking institutions. In July 2004, SECP implemented a schedule for scrip-wise exclusion from COT financing. However, upon intense deliberations, the exclusion of last seven securities from COT financing was extended till August 26, 2005. In order to facilitate the transition, SBP has formed a committee of bankers for coordination and early implementation of margin financing.
As per the existing regulatory regime, financial institutions (FIs) will approve margin finance limits for brokers, based upon their internal evaluation. Against these pre-approved limits, brokers will lend funds to their clients for margin financing. Interest rates will be market based, whereas list of eligible securities will be provided by stock exchanges. FIs, providing margin finance, will obtain associate membership of National Clearing Company (NCC), which will transfer shares under margin finance in FI's account. Brokers will be responsible for the collection of initial margin from their clients, whereas banks will monitor their exposure and will make any subsequent margin calls on the broker. With the induction of lenders in margin management and share ownership, margin financing diversify the market risk of leverage, while facilitating steady liquidity in stock market.
FOR SMOOTH TRANSITION
As mentioned above, it appears that all arrangements for margin financing are in place but demand for the same is not picking up despite claims for ample supply. Brokers are saying that they only have pre-approved limits but no money is coming under margin financing as FIs have no software or human resource available for monitoring and managing their margins. FIs are claiming that all their systems are ready, only waiting for the brokers to avail the facility, who are not forthcoming. Wherever fault lies, reality is that COT financing has reduced from PKR 24 billion on its cutoff date of June 7, 2005 to PKR 12 billion by first week of July 2005. Against this reduction of PKR 12 billion, market has only witnessed margin financing transactions of under PKR 1 billion.
What we are watching is a forced reduction in one financing avenue versus market based induction of other financing channel. In a capitalist economy, despite regulatory pressure, market usually moves with a lag period, as evident in the case of monetary policies. Regulators can change the rules of the game, however, residual effects may not always be of their liking. The same is happening in our stock markets, where uncertainty about availability of liquidity is not allowing the market to take a direction. This may not be termed as smooth transition. Here, we would like to take an overview of Indian experience in eradicating badla financing.
SEBI, the Indian regulator for capital market, banned badla financing in 2001. It induced margin financing and derivative trading to replace badla financing. Index futures were introduced in 2000, whereas trading in options and futures commenced in 2001. As with the case in Pakistan, margin financing didn't pick up much in India till this day. However, derivative market has come a big way in generating twice as much volume than cash market. Volatility has remained a part of price discovery mechanism in Indian stock markets, however, parallel development of two markets facilitate different niches of investors with different investment horizon, hence ensuring steady supply of liquidity.
Current situation of our stock markets demands different set of thinking. Objective of a capital market is to ensure efficient price discovery and availability of ample liquidity to facilitate smooth exit and entry in the market. Can we say with certainty that present strategy for liquidity is leading us towards this objective? Margin financing is a means towards an end not an end itself. We can take a leaf from Indian experience, margin financing has to be developed in tandem with derivative market, thereby ensuring the survival of not only small brokers and investors but providing a much impetus to primary market activity. For the transition, we may have to think out of box, if our benchmark liquidity under margin financing has not arrived then we may have to extend the period for COT financing. We have to consider the fact that though margin financing is an internationally recognized mechanism, in our peculiar situation it may become a cause of liquidity crunch instead of liquidity harbinger.