Tariq Hassan elaborates CFC concept

Sep 05 - 11, 2005

The stock business after experiencing torturous agony for quite sometime, specially after the March crash, has now started recovering. The stock markets are coming back on the track mainly due to intervention by the Prime Minister who gave a new set of directives to the joint meeting of the brokers and the representatives of the Securities & Exchange Commission of Pakistan (SECP) at the PM House on August 19 to resolve the issue.

The new regime, Continuous Funding System (CFC), became effective from August 22 and since then stock markets restarted their upward journey. Karachi Stock Exchange has gained over 600 points since then.

With the new system in place, the maximum amount of CFS has been capped at Rs. 25 billion and will be available in the 14 top volume stocks. The new directive offers respite to the weak and small holders and sets the tone for them to take fresh positions.

These steps are taken to improve the liquidity of the stock market and to strengthen the capital market of the country. The replacement of Badla financing with the newly devised mechanism of margin financing by the banks had proved repulsive for a large number of small investors who were practically thrown out of the business due to lack of documentation, NTN number and other procedural requirements for availing the margin financing.

How CFS was different from Badla or Margin financing is the simplest question being asked by most of the people involved with stock business at the grassroots level. The competent authority to answer the question was obviously the Chairman SECP, Dr. Tariq Hassan, who has discerned between the three mechanisms while replying the question raised by the PAGE.

Tariq Hassan says that the Continuous Funding System (CFS) has been implemented in place of COT/badla financing. This is an interim measure to replace badla financing till alternative modes of leverage financing are developed. The introduction of CFS will serve to address the concerns of investors and enhance the liquidity in market.

In terms of the CFS Regulations, the CFS market shall be available for the entire trading period and shall operate in parallel with the ready market. The CFS Regulations include appropriate measures to curtail the risk of market abuse and enhance risk mitigation. This will help preserve market integrity, protect investor interest and engender investor confidence. The salient aspects of the CFS Regulations are as follows:

i) For the purpose of enhanced risk management, the CFS market will be separate from the T+3 market so that purchases of a security by a financier under CFS shall not be netted against sales of the same security in T+3 market.

ii) In order to strengthen margin requirements, the rates of margin for the CFS market will be graduating automatically in proportion to the increase in KSE-100 index.

iii) To address systemic risk, the leverage position of every broker, in respect of CFS and other derivatives, shall not exceed 15 times his net capital balance. This would help ensure that market participants cannot take over leveraged positions, as was possible under badla financing.

iv) The CFS facility shall be available for a period of thirty days at the option of the fiancÚ in contrast to the arrangement under badla financing, where the financier could withdraw funds after ten days. This measure would lend stability to the market and address excessive volatility.

v) The CFS financed securities shall be maintained in a separate account with the Central Depository Company and shall not be available for loaning against blank and short selling.

vi) CFS facility shall be available only against purchases in ready market in contrast to badla financing.

Given the added measures of risk management and curtailing market abuse that have been built into CFS, it emerges as a securer means of finance. Moreover, transactions under the CFS shall take place through the Karachi Automated Trading System (KATS). As a result, the amount of financing through CFS has been capped at Rs. 25 billion (in comparison to Rs. 12 billion cap for badla financing) and eligible scrips for the purpose are fourteen top volume stocks selected on the basis of turnover.

With the introduction of CFS, the badla financing has been abolished; this is a significant milestone in rooting out the ills in the capital market of Pakistan. Market players have repeatedly identified the badla as the root cause of all major capital market crises in Pakistan since it allowed for manipulation and speculation. The financiers could withdraw funds abruptly, resulting in market instability and thereby damaging market integrity and investor interests. As a futures market within a cash market, badla resulted in hampering the growth of a genuine cash market and the development of a vibrant futures market.

The CFS will serve as a transitional tool to facilitate the development and availability of alternative modes of financing, including margin financing and derivatives. Accordingly, the phase-out CFS shall be reviewed by 28th February 2006. In this regard, the Securities and Exchange Commission of Pakistan (SECP) has provided a roadmap to the stock exchanges for the development of derivatives market, catering to options, index futures as well as futures contracts with multiple durations of 30, 60 and 90 days. The margin financing will also be developed over this period with the support from all quarters. This is expected to ensure a smooth phase-out of CFS.

With the elimination of COT/badla financing, the SECP has successfully addressed the major root cause of market volatility and market abuse. Till alternative modes of leverage financing are made available, CFS will provide the liquidity to the market in a more risk-averse framework.