The problem hounding the country's bourses is not that of badla phasing-out; it is about the 'system' that is to replace badla (repo) financing at the bourses and the consequent repercussions and ramifications of that system on the overall risk management system at the bourses.

The very fact that badla is being phased-out without any significant phasing-in of margin financing has already started claiming its toll on the liquidity position at the bourses. It is this liquidity crunch that is compelling investors to stay on the other side of the fence and adopt a wait and see approach rather than taking new positions in the market. While a lot of scrips do look attractive on fundamentals, yet investors are not willing to even look at those scrips - thanks to the current liquidity crunch at the market. On the bottom line, this situation is claiming its toll on the volumes at the bourses.

The stock prices for the last over a month had moved in a narrow band despite the fact that the country's key economic indicators have improved, bolstering the confidence of the overseas investors and rating of the country. The major obstacle in the smooth sailing of the equity market is the new mechanism "the margin financing" aimed to curb speculation and avert market crash, switching the traditional badla system.

Margin financing requires investors to arrange funds before buying shares. Under ''badla,'' an investor can arrange for funds after buying shares, and defer final payment as long as he pays a daily financing cost.

Pakistan's Securities and Exchange Commission, the market regulator, in consultation with the stock market last year issued directives to commence margin financing. Since October 2004, 22 companies were out from the ambit of the badla system and switched to margin financing. But the problem started when seven, which almost contributed more than 75 percent of the daily turnover, were shifted from badla to margin. Several letters were sent to the stock market regulator and presentations were held to get extension for at least six months period. After intervention from Prime Minister Shaukat Aziz and State Minister Omar Ayub, the matter was resolved amicably in April and margin financing will replace badla on August 26. Investors who purchased shares through badla have to reduce their holdings by 8.25 percent each week, starting June 3. Pakistan Telecommunication Co., the nation's largest telephone company, Pakistan State Oil Ltd., the country's largest supplier of fuels, Hub Power Co., an electricity producer, National Bank of Pakistan Ltd., the biggest lender by assets, Pakistan Oilfields Ltd., the third-largest explorer of fuels, D.G. Khan Cement Co., the country's No. 1 cement maker, and Oil & Gas Development Co., the biggest explorer of fuels were the scrips to be gradually phased out from badla mechanism.

According to a leading trader, the representatives of the stockbrokers community, the board of directors of the KSE on the first place should not have agreed to the said mechanism. "The liquidity is day by day drying which showed that our able brokers have not done their homework properly, moreover the regulator who claims to be the supporter and well wisher of small investors community must have allowed parallel badla system so that banks and financial institutions could have easily placed innovative products to run margin financing".

To eliminate the badla investment, which stood around Rs 22 billion on an average per day, the market has received a massive erosion of nearly Rs 100 billion since April this year, he added.

"We have received a number of good news from Islamabad in the past one month, the budget gave us the leeway and capital value tax was not raised, duties on raw material were reduced, banks' tax was cut and above all the government sold 26 percent shares of Pakistan Telecommunication to the tune of $2.6 billion, but the market failed to react. "If this badla system would not have been in vogue the market at present would have easily crossed the 8000 mark," the same trader explained.

Investments through the badla system is continuously declining. From the average of Rs 24 billion it had declined to 12.7 billion rupees ($213 million) on July 1 from 14.9 billion rupees a week ago.



Iqbal Jan Mohammad, Director MAC Securities, said that several banks had announced and allocated amounts for margin financing, but they failed to make the product understandable and in line with the requirement it would never take over the financing market. On the other hand, the phasing out of the conventional but easy financing known as badla is creating a huge gap and causing trade volumes to shrink, he added.

"They assured us that they would provide a credit line of Rs 20 to Rs 30 billion, but failed to create awareness, their balance sheets have the capacity to raise the financing facility to Rs 160 billion, but they have their own limitations. The investors could avail the facility by providing 30 percent margin to the banks, but the banks are reluctant rather fearing to lend us support because in the past we have witnessed several crises and the market share values suffered heavy causalities," said Jan Mohammad.

Hasnain Iman, Research Analyst at Arif Habib Securities, said that the fact that margin financing has not been able to phase-out in the past few months is primarily because of multi-pronged reasons. These are:- Investors' ignorance about margin financing, resistance to change - maintaining the status quo and communication gap between banks and brokers.

Banks engaged in margin financing: How many banks would provide margin financing facility? Do these banks understand the modus operandi surrounding margin financing? Are these banks eager to provide margin financing?

To answer these questions, we would quote what Shaukat Tarin, President Union Bank had to say about margin financing. He said: "Eighteen banks have shown willingness to provide Rs. 20 billion to ordinary investors through margin financing. This shows the preparedness of banks to introduce margin financing for phasing-out present COT. Banks are prepared and equipped to introduce the product and implement margin financing product."

However, as of today the banks providing margin financing facility are : National Bank of Pakistan, Muslim Commercial Bank, PICIC, Saudi Pak Commercial Bank, Faysal Bank and Union Bank. Mechanism of margin financing: Just to understand, the following are the broad parameters of margin financing to be conducted at the bourses.

Assume an investor wants to purchase PTCL shares worth Rs. 100,000 on margin financing. The following would be the mechanism under margin financing:

Investor approaches his broker to purchase PTCL shares worth Rs. 100,000 on margin financing.

•Broker approaches bank to help investor purchase PTCL worth Rs. 100,000 on margin financing.

•Investor deposits 30% of the value of stocks - PTCL worth Rs. 100,000 - as margin with the bank.

•After depositing 30% margin i.e. Rs. 30,000 the investor buys PTCL worth Rs. 100,000 on margin financing. This means, the bank finances the investor to the tune of 70% i.e.  Rs. 70,000.

•These securities - PTCL worth Rs. 100,000 - are pledged with the bank. So now, the bank has a margin of 30% (in cash) and securities (in kind) in full (100%).

•Now two events can happen: Assume an investor had purchased the PTCL for Rs. 60/scrip. It can either gain or lose value per scrip. As long as the PTCL scrip gains value per scrip, all stakeholders in the margin financing deal are perfectly comfortable. If, however, the PTCL scrip loses value, then at the end of the day, the bank would ask the investor to compensate for the loss in value of the scrip so suffered (market-to-market). This would be communicated to the investor by the bank through a "margin call". If the investor can compensate for the loss in value of the scrip so suffered (market-to-market), he can continue with this margin financing deal; otherwise the bank would liquidate this deal and compensate itself from the 30% cash margin so submitted by the investor and sell the investors' scrips (PTCL in this case) - already pledged with the bank - in the market.

What should be done: In an attempt to facilitate the smooth phasing-out of badla and its subsequent replacement by the margin financing, Hasnain believes, the following steps should be taken:

The banks should reduce the rates on margin financing (this is currently being reported by certain quarters at close to 14 percent against the average repo rate of 7.5 percent at the bourses).

The SBP should report the number of shares held in margin financing, the amount of margin financing and average rate of margin financing deals daily, preferably on its website or KSE's website. Any communication gap between stakeholders engaged in margin financing should be reduced.