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SECP recommends new measures

Reforms plan devised by the Commission to regulate the stock market making its business safe, transparent and risk free

Mar 12 - 25, 2001

In the aftermath of last year's crisis in Karachi, Lahore and Islamabad stock markets in which investors lost billions, the Securities and Exchange Commission of Pakistan (SECP) has taken numerous measures to strengthen its risk management controls over the trading pattern in the three stock exchanges of the country in order to avoid reoccurrence of such incidents.

Those measures which conform to international practices were already under consideration as a part of the comprehensive reforms plan devised by the Commission to regulate the stock market making its business safe, transparent and risk free as far as possible, but the same had to be expedited in view of the untoward incidents in Karachi Stock Exchange (KSE) and Lahore Stock Exchange (LSE) in May 2000 and later in Islamabad Stock Exchange (ISE) in October 2000 which badly shattered the investors' confidence. a source in the Commission revealed. The Inquiry Committee headed by S. Itrat Rizvi, Managing Director of the National Development Leasing Corporation which investigated in to the KSE and LSE financial scam emphasized the need for strict risk management control by the Commission to safeguard and protect the investors and thereby restore their confidence. The Inquiry Committee conducted that "the crisis at KSE and LSE was aggravated by the laxity of the management for non-implementation of the exposure/loss regulations already existing". The Committee recommended strict surveillance and supervision of the managements of the three exchanges to detect such laxities at the initial stages before causing any substantial harm.

Among other measures, the committee recommended:

A. The management of the stock exchanges must be given operational independence. Hiring and removal of the Chief Executive of the Exchange should be with the approval of SECP.

i) the management of the Exchange be required to submit to SECP a compliance report on quarterly basis on the implementation of decisions taken by the respective Board and the directives issued by the Commission.

ii) The role of outside directors need to be made meaningful. They should be required to submit a quarterly report to SEC.

iii) The present system of selecting directors from amongst the nominees of professional bodies by the Stock Exchanges needs to be reviewed. The selection of outside directors be made by SECP.

iv) The SEC should carry out risk management and system audit of sample stock brokers of the Exchanges annually.

v) The net capital balance requirement of stock brokers should be raised substantially and a cap be placed on their capacity to trade in relation to their net capital.

vi) A surveillance department with online data transmission facilities with all the three stock exchanges needs to be established at SEC. This will enable the SEC to quickly spot abnormalities and take corrective actions, if any.

The above three ugly incidents followed by the strong recommendations of the Inquiry Committee headed by an independent professional, the Commission expedited implementation of its reform package. The Commission felt that if the desired reform which had already been adopted by almost all emerging capital markets, if delayed any further, stock market of Pakistan will not only loose it competitiveness vis-i-vis other markets in the region, local investors may also shy away because of risk considerations.

Soon after the crisis, the Commission took up the question of strengthening risk management with the managements of all three stock exchanges and the following decisions were taken:

The present exemption in exposure upto Rs. 50 million available to brokers will cease to be effective from 1st October 2000 and brokers will be required to deposit 5% on exposure up to Rs. 50 million.

The requirement of net capital balance for members has been increased from Rs. 0.25 million to Rs. 2.50 million for exchanges having trading volume of more than 7.5 billion shares in 3 calendar years and to Rs. 0.75 million for exchanges having trading volume of lower than 7.5 billion shares per annum. Members shall be required to file net capital balance certificates with the respective stock exchanges every quarter and with the Commission every year duly certified by a practicing Chartered Accountant.

The definition of net capital is being redefined to make it more realistic.

 Capital adequacy of brokers has been prescribed for the first time. Stock exchange members will only be allowed to trade upto 25 times their net capital balance.

The existing of 5 days trading cycle with settlement on the 10th day puts the clearing house of the exchange at high Ask. In order to minimize this risk, stock exchanges have been asked to switch over to the internationally accepted T+3 settlement system. The exchanges are also in the process of setting up the National Clearing and Settlement System. The introduction of T+3 Continuous Net Settlement (CNS) facility would reduce risk substantially.

The exchanges have also been asked to develop regulations for short selling with facilities for lending and borrowing of securities.

The laxities and lapses in the stock markets however, cannot be effectively checked and controlled until their management is controlled by an independent and competent professional who has no vested interest in the trading and free from influence of brokers and stock manipulators. This is an internally accepted practice which is yet to be established in Pakistan. Besides being strongly recommended by the Inquiry Committee, the Asian Development Bank which is financing the capital market reforms plan has also demanded that the Commission should strengthen its role as a regulatory authority in the selection of the Chief Executive Officer of the stock market and Board of Directors.

The Commission has accordingly initiated action to ensure that chief executive officer of all the three stock exchanges are appointed from outside profession with approval of the Commission as well as the Board should also include outside directors. This is going to be most vital step to make the regulatory system more effective and make the capital market more safe and transparent. Naturally the Commission is facing resistance from certain quarters but the Commission seems to be determined to carry out its responsibility.