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Regulator Intervention

  • Posted On: 11th June 2013
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There is nothing quite as dull as watching numbers move up and down endlessly on a ticker tape. Strange, therefore, that millions of people around the globe have made number-watching their life long careers. In some instances, such people become so involved while doing so that they suffer from angina attacks, divorce and, more often than not, malodorous armpits. I am, of course, referring to the stock markets and all its participants. Go into any securities brokerage house today and you will find traders on the phone frantically taking instructions to buy or sell, or both; their managers running to meetings with clients abundant in material largesse; market strategists sweating over the next stock to load or unload; and the small investor, usually retired, squandering what little of junior’s college fund is still left. In all fairness, it is a heady business and when stock prices are rising, almost everyone, from buyer to seller to intermediary, is on a winning streak. Reverse the trend and one finds one’s taxpayer Rupees spent largely on scraping the sidewalks clean of dead brokers and the ashes of self immolated investors. Nevertheless, whether the index surges upward or downward, the market is buoyant and, for the clever investor, there is always money to be made.

Although I do not subscribe to the view that the market index is any reflection of an economy, I do believe that it is a good barometer for assessing people’s confidence in an economy which can, thenceforth, indirectly impact it. It was the complete erosion of such confidence last year, consequent upon certain national and international indicators that lead the Pakistani stock markets to collapse. Assuming no price manipulative practices (and none have come to light), the collapse was a natural one caused by the simple, yet, devastating forces of demand and supply. In such a situation, governments the world over, acting out of a sense of social responsibility, tend to intervene; and intervene they must. It is the form and quality of the intervention that is tricky to decide upon. In order to get an idea of what, ideally, a regulator such as the Securities and Exchange Commission of Pakistan (SECP) should do in the situation of a stock market collapse, one need not look further than the law upon which the SECP was established and through which it regulates. Let us also not forget that the law is founded on economic theory. The Securities and Exchange Commission of Pakistan Act, 1997 established the SECP; in the Act, the SECP is delegated the authority to regulate the stock markets through, among others, the Securities and Exchange Ordinance, 1969. The preamble to the 1969 Ordinance reads, “WHEREAS it is expedient to provide for the protection of investors, regulation of markets and dealings in securities and for matters ancillary thereto…” The two main violations for which investors need protection and, therefore, form part of the statute, are price manipulation (being a category of fraud) and insider trading. The former upsets the natural forces of demand and supply and the latter undermines market efficiencies. Nowhere in the law are investors protected from losing their money as a result of simple buying and selling of stock. As such, for a regulator to intervene in ways other than ensuring that standard risk measures are being observed, would itself help in manipulating the market and, hence, benefit certain participants over others.

Keeping the above in mind, the SECP could and should have performed the following tasks: one, ensure the daily inter-day trading breakers are enforced; two, enforce the prohibition on short selling in the daily market on the down tick; three, make damn certain every broker has paid up its exposure liabilities; and, four, make sure no broker is front running. The first measure slows, but does not stop, the downfall in share prices; the second prohibits brokers and investors alike from selling a share that the broker or investor does not own at the time of sale; the third makes certain that, in case of a default by any broker, losses are mitigated and the clearing house is kept risk free; and the fourth protects investors from brokers who sell their own shares before the clients’. And that is it. After that, dear regulator, you can go home and get some rest, there’s nothing more you can or should do.

What the regulator, in fact, did do was to prove its own intellectual deficiencies. Certainly the markets were plunging and, unlike the past, no investor was capable of assessing at what level the market would bottom out. In response, the SECP reiterated the ban on short selling in the ordinary market; so far so good. But, unfortunately, like a doctor who, upon hearing a heartbeat, decides to give his patient one more round of electric paddles, the SECP went on to ban short selling in the futures market as well. Someone obviously forgot to tell the SECP that the future’s market works on short selling and that to ban short selling in the futures market is to undermine the very purpose for which we have that market, price discovery. Allow me to explain in the simplest of terms. Assume, if you will, that share prices are plummeting. Add a further assumption that the price of share X is Rs. 100 today and you, as an investor, believe that its price in one month will be Rs. 85. As such, you will buy a futures contract to sell share X in one month’s time at, let’s say, Rs. 90. The counterparty to that contract believes share X will be Rs. 95 after one month and so agrees to buy share X from you at Rs. 90. Buyers and sellers doing exactly that throughout the market will, ultimately, settle on one average price. Now, overnight, impose a ban on short selling and all of a sudden you have to buy share X immediately at Rs. 100 and sell at Rs. 90. Would any sane person stay in the futures market under such a condition? No and, resultantly, the market dries up. Add further to that turmoil by forcing everyone to roll over their futures market positions by a whole month. This means that share X which you were to have sold in a month at Rs. 90, now you have to sell in two months time. Remember the price of share X is falling by the day and you and your counterparty are suffering losses with every paisa decline.

The fall in share prices had one other negative effect on investors and brokers. A significant portion of the liquidity in the market with which shares are purchased comes in the form of credit. An investor will seek financing for a purchase of shares from his broker by putting up his or her own money and collateralizing the remaining balance with shares. The broker will do the same with his creditor. However, in the case of the broker, the funds acquired from the creditor will go on to fund not only his clients’ purchases but the broker’s own purchases as well for which collateral is also provided in the form of shares. Now, if the shares which were provided as collateral lose value, the investor and broker have to buy more shares and provide them to the creditor to keep the collateralized value on the initial loan the same. Now, let me add one fact: many brokers do more business on their own account than on account of their respective clients and, therefore, the majority, if not super majority, of the loss in collateralized value of shares fell on the shoulders of the brokers, and not their clients, to bear. So what do the regulators do now? The Karachi Stock Exchange decides to place an absolute floor on the market; the price of every share is frozen. The SECP decides to remain eerily silent. The brokers, whose liabilities were increasing everyday by the fact of collateralized share values dropping, are now given respite. The creditor, on the other hand, is, for want of a better term, screwed since the value of the share he holds as collateral is now inestimable and useless.

What happened next defies any modicum of decency, fairness or law. With share prices frozen, the regulators legitimized the grey market (the one that takes place directly between buyer and seller and beyond the four walls of the exchange). Grey markets are generally not allowed as they contradict free market practices and usually serve the purposes of large investors and not small ones. However, grey markets can be permitted only where the sale of a share is made at the prevailing market price. In this case, however, the regulators allowed shares to be sold at anywhere up to thirty percent less than the price quoted on the stock exchange. It’s important to understand this point. The KSE, on the one hand, freezes the share prices, thereby, providing brokers with a respite from their ever increasing liabilities and, on the other hand, opens up the grey markets and allows those same brokers to off load their shares and crystallize their losses. The small investor for whose benefit, ostensibly, the regulators are doing all this is stuck holding shares which he or she can’t sell on any market, be it grey, white or otherwise.

The fact that the KSE took measures which predominantly improved the lot of its members (of whom many sit on its Board) as against the interests of small investors and creditors is the one issue the SECP must tackle; the concept of the operational independence of a stock exchange management which is duty bound to serve the interests of all market participants equally. The other thing the SECP must do when witnessing a fall in the market is mind their own business.

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