By Tajammul Hussain
July 11 - 17, 2005
Financial gurus have declared Karachi Stock Exchange as the world's most money-spinning outfit for the last few years
This report is a discussion on the concept of Margin Trading in various investment arenas and its influence on the local and international business community. It also highlights the recent sanctimonious outcries from certain quarters while business as usual continues on most scales on most other levels.
Marginal Accounts are created when a brokerage firm allows an investor to buy stocks and other commodities at a fraction of the purchase price, with the brokerage firm paying the difference. This allows investors the opportunity to open short-term and long-term positions and multiply their actual capacity to invest.
Margin investment is an internationally accepted concept and is also referred to as Hedge Trading and Carry-Over Trade (COT) around the world. In addition, it is also known by several indigenous names such as Badla, a term coined and extensively used across the Sub-continent. The difference lies in the regulations set around the practice by the various governing bodies around the world.
Margin trading is practiced in several major industries including the country's bourses and the FOREX market. However, since this is a technical term for business investment, one could argue that it is used in other countless ways by millions of businessmen around the world. Even consumer banking could be brought under the umbrella as it invests in products and markets on behalf of clients.
The amount or percentage of finance provided by the broker is set by governing bodies such as the Securities and Exchange Commission, a country's central bank and financial investment institutions besides brokerage houses. In our case, the Securities and Exchange Commission of Pakistan (SECP) and the State Bank of Pakistan govern the trade and its inner and outer limits while stakeholders and their associations, and other institutions provide support and positive suggestions.
For instance, on the New York Stock Exchange (NYSE), the minimum maintenance margin is 25%, but brokerage firms can set their own margins (30% being the usual rate). If your investment falls below the maintenance margin, the broker demands additional cash flow from the investor. If the money does not arrive within a specified time period, the broker reserves the right to immediately sell the stock to avoid accumulating bad debts.
Therefore, if you were to enter the securities market or the forex arena as a new investor, you would undoubtedly seek and benefit from some additional cash and support that could be lent for a certain commission and a little interest. This makes complete business sense to investors of all scales. However, you must remember that the broker involved will require collateral, and will sometimes hold on to your stocks for security.
You can invest in major markets such as stocks, the kerb and cotton using borrowed capital that could be recovered conveniently if the market moved in the direction you and your investment partners had anticipated. You can offset the interest payable by utilizing the dividends you earn from the same stocks.
Margin is calculated using the following equation:
M = V - L x 100
M is the margin, V is the market value of the stocks you choose, and L is the loan extended by the broker. The ratio is expressed as a percentage. The lowest initial margin (the margin at the time of the purchase) is 50% in the NYSE as settled by the Federal Reserve Board.
As an investor, you must be sure of your ability to meet the initial margin requirements before you take the plunge into the margin financing mire. It is also important to remind your broker that your margin transaction should be placed in your margin account.
All transactions, including margin deals are usually settled through your money market settlement account when funds are required. In layman terms, your payables and receivables are transferred into or out of your account by your authorised broker as and when he/she deems necessary. It is therefore essential that you keep a close eye on your accounts and margin trading status.
As an option, you can ask your broker to keep your money market transactions account separate from your margin account. This will check the unauthorized sweeping of funds from your account into your margin payments. Remember that the broker still retains the right to draw cash from your account to maintain the minimum margin equity.
According to the US Federal Reserve Board investors must maintain a minimum equity of $2,000 in their margin account at all times. Interest is generally charged on the settlement date. Plus, your broker must favour and marginalise the stocks you intend to purchase before he/she makes a margin investment.
In case of a recent purchase or market fluctuation, you may need additional equity in your margin account. As a rule, a cheque or securities must be received by the due date noted in the margin call letter, failing which your securities could be liquidated from your account to meet call requirements upon the due date.
THE GROUND REALITY
Stock Exchanges: As difficult as it may be accepted, financial gurus around the world have declared the Karachi Stock Exchange as the world's most money-spinning outfit for the last few years. While the Pakistani stock markets nearly crashed in the late 90s and a few times before and after, our bourses seem to be doing exceptionally well in the post Sept 11 business world.
The accounts of investors are startling, to say the least. One American investor reportedly invested $30 million in the KSE and gained 30 percent profit ($9 million) within three weeks.
According to USA Today, an independent US daily, the KSE is presently the world's best performing stock exchange with a recorded 56 percent rise in index since the Sept 11, 2001 incidence that rocked the world and left many businesses out of business forever. This is in stark contrast to the reduced Standard and Poors rating (down 19 percent) and Bloomberg European 500 rating (down by 27 percent) of the KSE.
It is all the more surprising since the international business community does not consider Pakistan in general and Karachi in particular as a safe haven for its investments. It has also been reported that investments from the US, Europe and the Middle East is flowing into the country thanks to the amazing economic growth rate the country has achieved. Although many significant investors have made millions and more from the markets in the last few years, many have lost ground, including small investors who pumped in their hard-earned life savings into the rising sun.
The exceptional performance of the bourses has left many flabbergasted including the powers that be. The SECP head, Khalid Mirza, is reported to have said that in his early days as head of the SECP, "It was hopelessly undervalued. It was almost a no-brainer, honestly, to invest in it." Yet, the rampage by the bulls continued until recently and the KSE shot from well under a thousand index points in 1998 to 3000 points and all the way to 10,000 before the first signs of bearish spells hit the floors.
However, analysts warn of inherent dangers to the country's economy and the exchanges in particular from Islamic extremism as well as the locally derived Badla trading system which is a highly leveraged lending system operated through a complex and unusual financing mechanism. The indigenous aspect of the Badla trade that makes it unique is that investors are allowed to defer final payments as long as they are willing to meet the daily financing costs.
It is a common fact that up to two-thirds of all trading done on our floors is financed with Badla borrowing. Total Badla financing, including carry-overs from the previous day, often exceeds the value of all shares traded in a day. In an alarming turn of events in May 2000, many brokers defaulted on their Badla payments after a scheme orchestrated by the same brokers to inflate share prices went bust.
Badla rates have fluctuated erratically in the past. Many analysts attribute this trend to the fall in the rate of return on most assets, and the fact that Badla returns are considered as tax-exempted capital gains. Moreover, extra money also flowed into the Badla market causing the cost of Badla finance to plummet. Another source of fall in Badla rates may be the rise in daily settlements.
Badla is an important source of financing in the equity market, it is widely believed that Badla or Carry-Over Trade encourages over-leveraged trade and enhances the general risk for the market. Therefore, one can predict that margin financing will replace COT to contain unwarranted volatility in the near future. Also with the development of the futures market, investors will have a new apparatus to dodge their risks.
However, for those who believe in the market fundamentals, Pakistani stocks feature another trait alien to the rest of the world. The KSE 100 annual dividend yield of 11.6 percent is substantially higher than the 7 percent interest-rate yield of government T-bills. Usually, shares appeal to investors due to their appreciation prospects, and not to match the yields on bonds and savings accounts. In the Pakistani scenario, stock investors enjoy the best of both worlds.
As recently as earlier this month, it was reported that the KSE was limping back to normal after many weeks of slender trading and highly volatile price fluctuations on the relative strength and heavy short covering in oil shares. Many financial gurus believe that the storm may be over and the sun may shine once again since the SECP accepted the KSE's request to boost forward trading.
Financial institutions and brokerage houses are expected to take positions once again in the presence of hedge trading. Market capital jumped from Rs.1,950 billion to Rs.2,021 billion and all heavily-capitalized stocks ended the week on a strong note. COT had affected the market sentiment negatively but analysts are optimistic that the market will rebound after the settlement date, which falls mid-week.
A good reason for the optimism is that in addition to individual and corporate financing, the country's banks and financial institutions have offered to thrust around Rs.20 billion into the stock market under margin financing. Investors can therefore be expected to build long-term positions during the coming days and weeks.
Nonetheless, not all analysts are jumping with joy since the index lost about 26 percent in the last six weeks, nose-diving from 10,300 to 7,000 points. "This is massive erosion and it could take several weeks of confidence building measures to bring the bulls back. Investors are sceptical now," says one insider. The impact of the introduction of additional margin investment by these institutions remains to be witnessed.
The FOREX counter: Forex investors and dealers enjoy hedge trading facility available to them in its various forms emanating from various sources. The international forex market reportedly generates transactions between 1 and 1.5 trillion US dollars a day. The liquidity of the market implies that traders can open and close positions within a few seconds since willing buyers and sellers are available round the clock.
The hedge trade works quantifiably for long-term hedge investors as well as short-term investors who utilize massive credit lines and seek hefty short term profits. This makes the forex market more attractive to investors of all sizes. The relatively greater stability of the market, compared to securities and other investments, lures the common man and the businessman.
Additionally, the absence of external controls, free exchange rates, floating currencies, and the complete control exercised by the market's own stakeholders guarantee much more independence and credibility to the entire mechanism.
Marginal trading in the forex market is common around the world. It offers investors the chance to make investments without actually holding or blocking their money supply. It allows investors to invest additional cash with fewer money transfer costs, and open bigger positions with a comparatively smaller amount of actual capital.
In this way, investors can conduct fairly significant transactions instantly with a small amount of opening capital. Marginal trading in an exchange market is quantified in lots, where "lot" refers to approximately $100,000, an amount which can be obtained by putting up as little as $500 (0.5%).
Generally, when you decide to close a position, the initial deposit that you made is returned to you, your profits or losses calculated, and the profit or loss credited to your account.
The future of margin trading in Pakistan looks secure on at least a few fronts but stakeholders in the cotton market may have to undergo a major shift in attitudes to benefit from the help of additional capital in the market.