Continuous Funding System (CFS): an interim arrangement of financing in Karachi Stock Exchange (KSE) and its after effects

______________________ A thesis Presented to the faculty of Management Sciences Bahria Institute of Management & Computer Sciences, Karachi

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In Partial Fulfillment of the requirement for the Degree Masters of Business Administration

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by

MEHWISH ZAFAR 6th FEBRUARY 2006

CHAPTER 1

PROBLEM STATEMENT & BACKGROUND OF TOPIC

1.1 INTRODUCTION:
1.1.1 INTRODUCTION OF THE TOPIC:
For many years Karachi Stock Exchange had been using Carry-Over Transaction (COT)/ Badla Financing system for trading. After some bitter and long drawn controversies, financing of speculation through Carry-over transaction (COT) in the stock market Security Exchange Commission of Pakistan (SECP) decided to implement Margin Financing because it is more secure than COT.

Due to some reasons the system of CFS has been introduced as an interim measure to replace COT / badla financing in order to enhance the level of liquidity in the market as desired by various stakeholders and in response to the concerns of investors while alternative modes of leverage financing are being developed.

1.1.2 INTRODUCTION OF CFS: CFS is a variant of the badla system, but majority of traders and market watchers pointed to some features of the system that are quite different from the 55-year old badla system. The maximum amount of CFS is capped at Rs: 25 billion and will be available in 14 top volume stocks selected on the basis of their turnover recorded in the Exchange during February 21 to August 19,2005. The companies available for CFS system are: PTCL, OGDC, NBP, FFC, D.G Khan Cement, PSO, Pakistan PTA, POL, PPL, SNGPL, BoP, MCB, Fauji Cement and Hubco. According to CFS regulation, phase-out of CFS would be reviewed by February 28, 2006. 1.1.3 DIFFERENCES B/W CFS AND BADLA FINANCING: CFS session would run parallel to Ready market while COT session took place after Ready market.

 CFS would allow finances to lock financing up to 30 days at compared to 10 days in COT. Maximum finding in CFS has been capped at 25 billion, thus limiting market wide exposure, whereas there was no limit on COT funding prior to the last leg of its phase-out. CFS would require linking margins rates on exposure in CFS to KSE-100 index while margins in COT were based on exposure slabs. Exposure of a brokerage house in CFS reduced to a maximum of 15 times its net capital balance from 25 times in COT. CFS requires broker-financiers to keep financed securities in a designated depository account (on which they should not have any direct control) while financiers could take unfair advantage of financed securities in COT. CFS would discontinue netting of trading and financing positions for financiers, which was permissible in COT. Finances would not be able to directly raise cash from CFS, which could be done in COT. COT was problematic because it had post-trade arrangement but CFS have pretrade arrangement.

1.1.4 EVOLUTION: In July 2004, SECP announced the schedule of badla financing phase out. In initially stages, those companies have low volume were phased out. From 2005, large volume companies were started phasing out. In March 2005, crisis hit Karachi Stock exchange, after which brokers found difficulties to implement Margin Financing because at that stage the high volume companies were started phasing out and many investors and brokers dont have awareness and knowledge of system.

It mean while brokers was arranged meeting with SECP for negotiating phasing out Badla financing. As a result of negotiation CFS (Continuous Funding System) was introduced. So, the implementation of CFS provide room to analyze its after effects and future prospects.
1.1.5 PRESENT STATUS:

Continuous Funding System was introduced in Karachi Stock Exchange in August 2005; up to January 2006 it utilized its capped amount, which is Rs 25 billion.

1.2 STATEMENT OF PROBLEM:

Would CFS be a lesser evil than COT? Is CFS a permanent solution for market problems? Does CFS hurdle the development of future market?

1.3 SIGNIFICANCE OF STUDY:

To explore the causes due to which Carry-over transaction was phased out. It helps in highlighting problems, which occur after the implementation of Continuous Funding System. Ongoing market trends.

1.4 SCOPE:

The scope of this study revolves around the time frame of Jul 2004 to Jan 2006. All related information i.e. financial data; news, reports, regulations etc would be from this time frame. Entire research focuses on Karachi Stock Exchange.

1.5 DELIMITATIONS:
1.5.1 Variables:
The changes in these factors will not affect the research: Increases in the amount of financing from 25 billion. Imposition of margin requirement. Increases in number of companies available for CFS.

1.5.2 ASSUMPTIONS:
Regulatory framework may be change: State Bank of Pakistan would extend the bank financing limits or SECP make changes in regulations. Economic conditions would be worst than today, due to any natural disaster.

1.6 DEFINITION OF TERMS:

Short selling: the sale of securities not owned by the seller in the expectation of falling price or as part of an arbitrage.
CFS: Continuous Funding System

SECP: Security and Exchange Commission of Pakistan Long purchase: first purchase security then sell. Small cap companies: few shares are issued to general public

 NIT: National Investment Trust is government mutual fund .At the time of crisis it purchased shares

CNS: Continuous Net Settlement is same day clearing Demutualization: conversion of non-profitable companies into profitable. Integration: consolidation of the three exchanges through merger. Free float: number of shares available for trading. Capital value tax: it applied on purchase of securities. The rate is .01%.
Blank selling: sale of securities which is not owned by the seller and there is need of special arrangement for it. Brokers can only do this transaction.

T+3: it is system of clearing and settlement, which stands for transaction day plus third working day as the day of settlement. Speculation: short term movement of funds with the hope of getting profit. Ready market: it is the regular market in which transactions are done on the basis of T+3 system. In this system full payment is required against the delivery of shares. Future market: a market in which contracts are traded for future delivery of commodities, currencies and financial instruments. The purchase or sale of a future contract requires that a deposit, called margin. SEBI: Securities Exchange Board of India.

CHAPTER 2

RESEARCH METHODOLOGY AND PROCEDURES

2.1

RESEARCH DESIGN:

Exploratory design will be used for this research. Secondary and primary sources will use for data collection.

2.2

RESPONDENTS OF THE STUDY:

This research is directly related to the problems will occur in Karachi Stock Exchange, so the respondents of the study will be the brokers and investors of Karachi Stock Exchange.

2.3 RESEARCH INSTRUMENT:

Data will be collected by means of the following methods: Interview Financial magazines Research Reports

2.4 TREATMENT OF THE DATA:

As the capital market of Pakistan is growing, there is a need for strong financial system. As the CFS is a latest financing system adopted by stock exchanges, so the data gathered will analyze the system as pathway to another system or as a permanent solution.

2.5 PRESENTATION ANALYSIS:

The presentation of the research analysis is in the form of graphical representation. This graphical presentation will be helpful in deriving the conclusion.

CHAPTER 3

REVIEW OF LITERATURE & STUDIES

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3.1 LOCAL LITERATURE COMMENTS ON CONTINUOUS FUNDING SYSTEM1:

Continuous funding system has replaced the Badla system to resolve the liquidity problem with in the market. There are 14 companies available for the CFS. This article mentioned some general condition related to CFS, the risk management measures incorporated in and rules for settlement of claim in case of default of a broker. Market participants did not accept margin financing as a viable alternative for Badla because regulators failed to convinced participants and creating required infrastructure. The CFS phased out shall be reviewed by February 28, 2006. One question comes into mind that will market face another crisis at the time of CFS phase out. CFS regulations and rules are tilted in favor of broker rather than aiming to protect the interest of the investors. Two key issues also discussed in this article: 1) free float and 2) small investor. Market has lack of adequate availability of quality scrips and free float is too small. The range of free float is from 5 to 25 percent, in which institutions and large net worth individual hold the bulk of the shares of blue chip and good performing companies. Economic manager of Pakistan support speculative trading rather than encouraging investment. So, only 14 companies eligible for the CFS look disappointing because the exchange has also expressed to introduced KSE sensitive index.

Shabbir H. Kazmi (Pakistan & Gulf Economist, Sept 5-11, 2005) 11

Two other policy decisions, exemption of Capital gains from tax and taxing dividend income, also prove that policy makers encourage trading and discourage real investment in capital market.

COMMENTS ON PHASING OUT BADLA FINANCING FROM THE STOCK MARKETS2:

Security Exchange Commission of Pakistan (SECP) has declared that Badla would be gradually replaced with margin trading and futures, because is a source of systemic risk and market abuse and an obstruction in the development of the derivatives market. The SECP and management of the stock exchanges should appoint an independent team to devise a roadmap, which is one approach for badla phase out. This team should have two simple and clear objectives. The primary and short-term objective is to phase out badla without adversely affecting liquidity to the extent that it affects investors and other stakeholders. The secondary and medium-to-long-term objective is to increase and spread liquidity in the market. This team should also study the impact of the implementation of every significant measure and give recommendations for refining future steps in light of new information till the completion of the phase out. Three short-term plans are: I. The number of shares in futures should be increased. II. Margin trading should be initiated under the new Margin Trading Rules. III. A deadline should be announced for badla financing. Seven proposed steps: 1. Integration of the three stock exchanges should be considered. Integration would increase the size of the liquidity pool and lead to better price discovery.
2

Usman Hayat (Blue. Chip, August, 2004) 12

2.

Demutualization of the three stock exchanges should be considered. It would convert a broker-dominated financially weak not-for-profit into financially healthy for-profit listed company, structured to ensure better governance for all stakeholders.

3. Market access should be increased to new investors whose participation would increase liquidity in the market. 4. New derivatives should be introduced. 5. An ongoing requirement of minimum free float for listed companies should be introduced. Increase in free float would cause an increase in activity in the regular as well as the futures market and alleviate potential loss of liquidity. 6. Listed companies should strengthen corporate governance to provide on-going disclosure of material information. 7. For Balance Order Settlement (BOS), the NCC should adopt Continuous Net Settlement (CNS) and remove restrictions on short and blank selling. The benefit of CNS over BOS is that it facilitates speculation by allowing a free carry-over of positions base4d on long and short positions available in the market. By using these short, medium and long-term measures, badla would be phased out from our stock exchanges and liquidity would be increased and spread out within listed companies. In fact, total turnover in the regular and derivatives segment would be greater than what it is today. Investors in Pakistan shall have liquid markets without the systemic risk and abuses of badla financing.

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REASONS FINANCING

BEHIND

NOT

IMPLEMENTATION

OF

MARGIN

COMMENTS ON WHATS BEEN BOTHERING THE MARKET?3

Speculator has an important role in market sentiment and activity. Speculator adding volume and in long term damage the market because of excessive volatility. In old Badla system cost of borrowing was set on the basis of share price not according to the credit worthiness of the borrower. In new margin financing bank will lend funds at a lower rate to large, credit worthy brokers as compared to smaller brokers with a smaller client base, lower volumes and higher credit risk. The effects will be that small investors shift towards futures market.

Aliya K Dossa (Blue. Chip, August, 2004) 14

COMMENTS BROKERS4:

ON

MARGIN

FINANCING

MAY

HIT

SMALL

80 percent of total trades at Karachi stock exchange are short term and speculative in nature and driven by borrowed money mainly provided by brokers and individuals. By the implementation of margin financing, small investors/ traders face difficulty to get finance because banks prefer to give loan to large individual and institution, which has large volume and low credit risk.

Dawn, 2005 15

3.2 FOREIGN LITERATURE COMMENTS ON FINANCING SYSTEM IN INDIA5:

In India two type of Badla system was exist Seedha Badla and Undha Badla. The 'seedha badla' financier enters into the system to lend money to the market player for a return. This is measured as interest on the funds made available for one settlement cycle. In undha badla does the stock borrower to the stock lender pay returns. In any badla transaction there are two key elements, the hawala rate and the badla charge for the scrip. The badla charge is the interest payable by the investor for carrying forward the position. The hawala rate is the price at which a share is squared up in the current settlement and carried forward into the next settlement in the next trading session. Buying on margin means to borrow money from a broker (similar to a loan) to purchase stock. The investor can take position in the market by paying an initial margin of 50 per cent (your own money), while the broker could finance the balance 50 percent. The broker can lend from his own resources or can borrow from banks, non-banking finance companies and other qualified lenders such as insurance companies. To trade on margin, one needs to open a margin account. This is different from the regular cash account in which you trade using the money in the account. Some features make margin financing different from Badla system. Such as Stringent disclosures and limited scope.

Badla system and Margin system in India (www.rediff.com) 16

Retail investor must keep from jumping into margin trading immediately due to the following factors:

Any financial and trading system in Indian market conditions will need some time

to settle down. There will be hiccups and possibly changes in the margin trading system, as required.

Margin trading is a high-risk strategy. Indulge in margin trading only if you have 'risk capital'. Risk capital is surplus Buying on margin should be used for short-term investments. The longer you hold

money set aside, which the investor can afford to lose.

an investment, the greater a return you need, to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you.

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1.3

GAPS TO BE BRIDEGED BY THIS STUDY:

This study helps to articulate the advantages, disadvantages and affects of Continuous Funding System. On this basis we can take decision that Margin Financing should be implemented or not.

3.4 AREA FOR FUTHER STUDIES:

This study helps to convince investors about the importance of margin financing.

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CHAPTER 4

PRESENTATION ANALYSIS

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4.1 Weighted Average CFS %:

DATES 26 sept 2nd oct 3rd oct 9th oct 10th oct 16th oct 17th oct 23rd oct 7th nov 13th nov 14th nov 20th nov 5th dec 11th dec 12th dec 18th dec 19th dec 25th dec 26th dec 1st jan 2nd jan 8th jan 9th jan 22nd jan 23rd jan 29th jan
th

CFS% 15.98 16.68 19.63 20.81 15.36 17.22 17.23 16.45 16.49 17.64 17.38 17.73 17.82

COMMENTS
The above chart shows the average daily rate of CFS on weekly basis. The chart shows slight increase in percentage as the demand increases for the CFS.

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4.2 Average Daily Volume:

DATES 26th sept 2nd oct 3rd oct 9th oct 10th oct 16th oct 17th oct 23rd oct 7th nov 13th nov 14th nov 20th nov 5th dec 11th dec 12th dec 18th dec 19th dec 25th dec 26th dec 1st jan 2nd jan 8th jan 9th jan 22nd jan 23rd jan 29th jan Number Of Shares 231,166,480 224,031,320 221,435,450 224,083,540 219,001,300 200,180,3225 201,796,900 192,320,080 191,320,080 198,102,580 201,769,375 192,393,300 190,267,200

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COMMENTS
The above chart shows the average daily volume in CFS on weekly basis. It shows the decline in volume i.e. number of shares in CFS trading, as the CFS rate in previous chart shows the increase.

CHAPTER 5

CLOSING UP

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5.1 SUMMARY OF FINDINGS:

Continuous Funding System (CFS) is primarily meant to resolve the deadlock created by the replacement of Badla with the margin financing. However, this is a short-term measure as the regulators are planning to review the situation during 1 stQ FY06 and will then announce the phase-out of CFS along with the re-launching of margin financing. By enhancing the CFS limit of Rs 25 billion the market will be in a similar situation once the enhance limit hits. The CFS will serve as a transitional tool to facilitate the development and availability of alternative modes of financing, including margin financing and derivatives.

5.2 CONCLUSION:
This study drives the conclusion that CFS is the pathway towards the margin financing in Pakistan and it was introduced because of lack of awareness of margin financing among

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the investors, brokers and bankers. As we look towards the financing system in our neighboring country stock exchange i.e. India we can see that there is no need for CFS for the implementation of margin financing because there was sufficient learning available about the margin financing.

5.3 RECOMMENDATIONS:

On the basis of my research work, I have recommended some efforts for making margin financing a viable financing alternative: In order to increase the free float, listing of new companies should be encouraged. The government must also ensure listing of all state owned enterprises on the local stock exchanges and their shares should be offered to general public. The government should also encourage delisting of small cap companies because the sponsors tightly hold their shares. The secondary market for bonds (Term Finance Certificates) should also be developed. The corporate tax rate applicable on listed companies must be slashed substantially, brought to half the present rate to encourage new listings. Dividend income should be exempted from tax. The exemption on capital gains should be abolished immediately. Development of future market.

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5.4 APPENDIXES:
APPENDIX 1:

CONTINUOUS FUNDING SYSTEM

(An attempt to overcome liquidity crunch) By Shabbir H. Kazmi
The Karachi Stock Exchange (KSE) with the approval of the Securities and Exchange Commission of Pakistan (SECP) has replaced the Badla system with Continuous Funding System (CFS). There are all praises and it is being said that CFS will resolve the liquidity crunch, plaguing the performance of the KSE for many months. While preliminary details of CFS have been made available at the KSE website, the complete mechanism is yet to be clearly understood by the participants and the investors. However, the market has started responding positively and there has been convincing impact on the KSE-100 index as well as the daily trading volume.

It is being said that the introduction of CFS coupled with an increase in number of scrips and enhanced funding limit are likely to bring back the investors to the market. There has been exuberance but analysts also caution the investors and advise them to be selective while picking up the scrips. The credit of the introduction of a new system is being given to Prime Minister Shaukat Aziz and his team. The much talked about margin financing seems to have taken the back seat. 25

According to the notice issued by the KSE on 22nd August, Pursuant to the meeting of the Board of Directors and senior members of the Exchange with the Prime Minister of Pakistan, Advisor to the Prime Minister on Finance, Minister of State on Finance and Chairman SECP, Continuous Funding System Regulations 2005 have been approved by the KSE Board and the SECP. It also says, As agreed in the above referred meetings, the maximum amount of CFS is capped at Rs 25 billion and the facility will replace COT/Badla and will be available in 14 top volume stocks selected on the basis of their turnover recorded in the Exchange During last six months, i.e. from February 21 to August 19, 2005 and will take place under the Continuous Funding System Regulations 2005. The lists of the companies which will be available for the CFS include: 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) 12) 13) 14) Pakistan Telecommunication Company Oil & Gas Development Company National Bank of Pakistan Fauji Fertilizer Company D.G.Khan Cement Pakistan State Oil Pakistan PTA Pakistan oilfields Pakistan Petroleum Sui Northern Gas Pipeline Bank of Punjab MCB Bank Fauji Cement Hub Power Company

The general conditions are: 1) The maximum amount for the purpose of CFS is capped at Rs 25 billion. 26

2)

CFS facility will be allowed in 14 top volume approved securities to the selected

in accordance with the criteria laid down by the Board. The list of these approved securities shall be subject to review by the Exchange after every six months. 3) The CFS market shall be available for entire trading period. The CFS market shall run in parallel to the Ready Market and Transactions there under shall take place through the Karachi Automated Trading System (KATS). 4) 5) The CFS facility shall be available for a period of 30 days at the option of the CFS facility shall be provided against purchase in Ready Market. fiance.

The risk management measures incorporated are: 1. For the purpose of ensuring risk management, the CFS market shall be separated from the T+3 market and purchases of a security by financier under CFS shall not be netted against his sale in the same security in T+3 market. 2. The rate of margin as shall be determined by the Board for the purpose of CFS market shall be graduating automatically. The margin shall be increased in proportion to the increase in KSE-100 index. 3. The financier shall keep the CFS financed securities in a separate account maintained with the Central Depository Company of Pakistan Limited in order to ensure that these securities are not used for loaning against bank and short selling. 4. Every broker shall maintain the leverage position in respect of CFS and other derivates not exceeding 15 times of his Net Capital Balance. Rules for settlement of claim in case of default of a broker are: 1) The members Default and Procedure for recovery of losses Regulation shall be applicable to default and under these Regulations. However, in case of default of a broker, all his assets available in the control of the Exchange, except the margin, will be first utilized for settlement of T+3 trades and then for CFS transactions. 2) No claim under CFS shall be entertained outside KATS.

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The Board may amend these regulations with the prior approval of the Commission after giving reasonable notice to the market participants. The phase-out of CFS shall be reviewed by February 28, 2005. After having read the notice, two points become clear 1) the Carry Over Transaction Regulations, 1983 have been replaced by CFS and 2) the new system has to be phased out. It also becomes evident that this makeshift arrangement has been put in place to overcome the situation emerging due to phasing out of Badla. The market participants did not accept margin financing as viable alternative for COT. However, it is also on record that more than sufficient time was given to the market participants and the banks to evolve the margin financing system. The immediate question, which comes to minds is, will the market face another crisis at the time of CFS phase-out? The most probable reply is yes. The reason being that as nation we keep on deferring important decision making till possible. The deadlines are fixed and extended repeatedly but only to gain extra time. On top of this, most of the time is wasted in discussion about non-issues and core issues are swept under the carpet. The same is also true about the Badla system, being in practice for ages. The regulators were bent upon replacing it with margin financing but failed in convincing the banks to come up with rules of the game and creating the required infrastructure. The unilateral decisions of the regulators created more confusion and caused mishaps rather than ensuring smooth working and transition from one system to another. Though, many analysts attribute the March crisis to Badla phase-out, the fact is contrary. This crisis was not an outcome of Badla phase-out but a settlement crisis. There were also some regulatory lapses and the inherent weaknesses of the regulatory system allowed the unscrupulous elements to create the havoc. Though, last minute efforts were made to avert the crisis but vested interested remained dominant. One has to accept the fact that rules and regulations are tilted in favor of brokers rather than aiming to protect the interest of the investors. 28

The reasons for terming the March debacle a settlement crisis is based on the fact that when prices started plunging many brokers faced a near-default situation because most of the buyers were not able to withstand their commitment. As the prices went down margin calls were also to be raised. Presence of circuit breakers also made selling almost impossible. Then came the NIT-led rescue plan, which helped in the settlement of one scrip only that was OGDC. However, it is debatable whether the move was aimed at saving the small investors or the brokers from eminent default. Most certainly investors holding thousand of OGDC shares did not fall in the category of small investors. It will not be out of context to talk about two key issues1) free float and 2) small investors. It has been reiterated repeatedly by the analysts that the market lacks adequate availability of quality scrips and free float is too small. The estimates of free float range from 5 to 25 percent, based on the classification of investment being followed by different analysts. Though, it is being said that with the listing of large-cap companies free float has increased, it is not correct. The institutions and large individual investors hold the bulk of the shares of blue chip and good performing companies tightly. Even the small investors love to retain these shares due to handsome dividend payout by these companies. Therefore, the free float of quality companies is around 5 percent, at the most. The average daily volume is often close to the free float. It is difficult to believe the entire free float could change hand on regular basis. It is also on record that the settlement is around 10 percent of the average daily trading volume. This shows that bulk of the volume is generated through trading and buying/selling by the investors is negligible. The smaller lots trade belongs to investors and large lots pertain to the activity of the activity of the institutions, only institutions hold shares in millions. The retail investors cannot even afford to buy one million shares of the PSO or PPL and even OGDC and PTCL. It may be correct to say that sale/purchase of large lots have the potential to drive the price in either direction. All these lots mostly pertain to institutional investors, including 29

mutual funds. Often their average purchase price is far below the quoted price. If an institutional investor or a mutual fund wants to make capital gains it has to do this conveniently by offloading part of its holding. They have accumulated a large portfolio through Bonus and / or Right issues. The economic managers often brag that now the number of investors in equities market runs into millions, which is incorrect and misleading. The thousands of applications received in response to public offer of shares of state owned enterprises either belonged to one-time applications or were the multiple applications submitted by large investors. They had submitted applications in the names of their wives, children, domestic servants and others only because preference was given to the applicants of 500 shares. The lot size was reduced to 200 shares in case of United Bank but the response was pathetic. Kausar Javid, Chairman Small Investors Association, has been arguing virtually at every forum that small investors had lost billions of rupees due to March crisis. It is suggested that he should use the term small traders instead of small investors. All of those who were working on delivery only basis were not the losers. Those who lost virtually every penny or life saving were indulging in Badla financing without realizing their capacity and ability to settle in case a delivery has to be taken. Kausar also agrees that Badla financing is of hardly any consequence for the small investors. It may not be wrong to say that financing, be it Badla or CFS, is aimed at generating volumes. It has been said repeatedly that small investors should abstain from indulging in hay trading and should only invest in those companies, which have credible dividend payout record. They are also often told to invest in companies enjoying growth potential. Since they have limited resources, they are also advised to invest in mutual funds rather than putting all their eggs in one basket. It seems that economic managers of the country support speculative trading rather than encouraging investment. They take pride in saying, Pakistan is the best performing market but are reluctant to accept the fact that equities market is not the true reflection 30

of the performance of countrys economy. To establish the credibility of the other point of view it is suffice to refer the number of listed companies, number of active scrips and the volume of settlement. Nearly 90 percent of the daily trading volume pertains to about two dozen companies and only four scrips drive the index movement. The support for speculative trading is also evident from the recent decision about the number of companies eligible for the CFS. Only 14 companies have been selected out of KSE-100 index companies. It looks a little disappointing because the Exchange has also expressed its intention to introduce another index, KSE Sensitive Index to comprise 30 most liquid scrips on free float basis. The Exchange has also circulated the working papers for seeking comments of the members. Abamco has launched a similar index lately. Therefore, it is not a question of reinventing the wheel but selection of companies on the basis of core facts. Two other policy decisions, exemption of capital gains from tax and taxing dividend income, also prove that policy makers encourage trading and discourage real investment in capital market. The decision to exempt capital gains from tax was bad and its continuation for years is even worse. The argument given in the support of the exemption is that it generates volumes. But one fails to understand the logic because the objective should have been to broaden the investors base rather than generating volumes. Only a few and selected benefit from the exemption but thousand of investors are penalized for providing the capital for listed companies. When will this anti investment law be repealed? According to some analysts the laws and rules governing the equities market operations are aimed at facilitating the brokers fraternity and not the real investors. Brokers in the name of small investors are seeking capital gains exemption. Continuity of Badla system was also pleaded in the name of small investors. Even the statement of Commission is not in an apposition to take action against the strong brokers. There is also loud talk about the conflict of interest of brokers but regulators seem helpless. Short selling and insiders trading are prohibited by law but are being practiced blatantly. 31

Strangely, the regulators are also victim of brokers boggy that there should be large daily trading volume and index should move towards new record highs. Higher trading volume is the ultimate objective of brokers because it generates commission. It is not the index or volume, which makes a market best performing market. It is transparency, efficiency and ability to attract new investment, which makes it the best or the worst performing market. While the economic fundamentals have improved since March, the market has remained completely in the grip of bearish sentiments. Almost all the recent public offerings, except NetSol, were under subscribed. Moin Fudda, the outgoing Manager Director of KSE, has said repeatedly that stock market is driven by greed and fear. Some analysts say, First the brokers build a hype, which creates greed. Once they sell off their holding fears are created to reacquire the holding and the cycle continues. Globally shares are bought/sold on the basis of economic fundamentals following the rules of thumb- buy when the prices are high. As against this most of the investors in Pakistan enter the market when it is too hot and do not look towards it when the prices are very attractive. This is only because they look towards trading gains rather than capital gains. (Pakistan & Gulf Economist, Sept 5-11, 2005)

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APPENDIX 2:

Phasing out badla financing from the stock markets

By Usman Hayat Badla financing, also known as carry-over financing, is to be phased out from our stock markets. The Securities & Exchange Commission of Pakistan (SECP) has declared that badla would be gradually replaced with margin trading and futures. Badla is being phased out because it has become a source of systemic risk and market abuse and an obstruction in the development of the derivatives market. Now that the Margin Trading Rules 2004 have been finalized, the badla phase-out is once again under the spotlight. Badla finances speculation, which creates liquidity. It is estimated that purely speculative trading is as much as 90% of total trading. In the first quarter of 2004 average badla financing done at the Karachi Stock Exchange (KSE), Lahore Stock Exchange (LSE) and Islamabad Stock Exchange (ISE) was about Rs 22 billion. Almost 87% of this financing was done at the KSE, 12% at the LSE and just about 1% at the ISE. On average, 6% of securities in book entry form were badla financed, which is a lot because of the limited size of free float in the market. While the desirability of badla phase-out is established, it is critical that its possible affect on liquidity in the market is carefully understood and planned for. This is because liquidity is a fundamental reason behind the existence of a stock exchange. Investors shy away from buying shares that they cannot quickly sell 33

when the need arises. Reduced liquidity also means lower incomes for brokers, stock exchanges, and related organizations such as the Central Depository Company (CDC) and the National Clearing Company (NCC). In our markets, liquidity is essentially confined to 30 companies (out of the current 689 listed companies), which account for 95% of market activity. Some of them are liquid to the extent of being excessively speculative. Badla financing is even more concentrated than trading in general as half of badla is usually confined to five shares. Therefore, it is equally important that along with badla phase-out, measures are taken to spread liquidity and reduce excessive speculation. It was back in 2002 that a sub-committee of the Capital Market Consultative Group, a forum of experts used by the SECP for consultation, gave a roadmap for badla phase-out. That roadmap was only about six months long and had set June 30, 2003 as the finishing point for badla financing. A year has passed since that deadline and none of the significant milestones in phase-out have been achieved. New developments have taken place in the capital markets in the last year. Therefore, a new approach and a new plan are needed in light of the current situation. One approach for badla phase-out and a set of short- and medium-to-long-term measures is suggested here.

At the outset, the SECP and managements of the stock exchanges should appoint a new independent team to devise a new roadmap. This team should include some members from earlier sub-committees to ensure continuity. It should have two simple and clear underlying objectives. The primary and short-term objective is to phase out badla without adversely affecting liquidity to the extent that it affects investors and other stakeholders. The secondary and medium-to-long-term objective is to increase and spread liquidity in the market. This team should also study the impact of the implementation of every significant measure and give recommendations for refining future steps in light of new information 34

till the completion of the phase out. A three step short-term plan could be used to meet the primary objective of phasing-out badla financing. First, the number of shares in futures should be increased. Currently, futures are being traded on only 15 companies at the KSE whereas badla financing is available in 29 shares. Note that futures traded in our exchanges can be settled by actual delivery; therefore they are less vulnerable to manipulation than usual future contracts where settlement is done only by means of paying profits and losses. Unlike badla, futures are subject to strict cash-based margining by clearinghouse to minimize settlement risk. It is important that futures are expanded to all relatively liquid large cap companies that have a reasonable free float available. Once the number of futures is increased, the number of shares eligible for badla financing should be reduced to those on which futures are available. This would set the stage for moving speculative activity from badla to the futures segment. Second, margin trading should be initiated under the new Margin Trading Rules. Financial institutions should be encouraged to provide financing for margin trading and develop adequate procedures for smooth lending but tight management of default risk. Unlike badla and futures, where continuous open auction trading is used, margin trading is a fragmented market where individual borrowers and lenders shall draw their own customized contracts. This is why the potential of margin trading in generating speculative turnover is limited. However, to satisfy the demands of market participants, it is important that margin trading is seen to be set into action before any significant move is taken against badla. Third, after having increased the number of stock futures and allowed margin trading under the new rules, a deadline should be announced for badla financing. This deadline should give sufficient time to speculators - say three months - for arranging margin financing for their outstanding positions or squaring their badla financed positions and

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opening fresh positions in the futures market. It is important that during this period speculators should only be allowed to reduce their badla-financed positions. Through the trading system, any increase in badla-financed positions should be precluded. As speculators see the deadline approaching, turnover and open interest in stock futures would drastically increase. Many would also arrange for margin financing in shares on which futures would not be available. Liquidity would flee from the regular T+3 market to the futures market but combined turnover of futures and regular market before-andafter is unlikely to differ substantially. Currently, turnover in futures is only about one-tenth of the turnover in the regular market at the KSE. It is likely that this ratio will reverse and turnover in futures would be many times more than the turnover in the badla market. Open interest in futures shall also be many times more than outstanding margin financing. Incomes of brokers, exchanges, and related organizations would be protected because all shall earn from the turnover in futures. Markets would welcome a dramatic rise in activity in futures but would also be quick to raise concerns about a drop in activity in the Regular Market. After these short-term measures, a new set of medium- and long-term measures would be required to increase liquidity in the regular market with low levels of concentration. Seven proposed steps

One, integration of the three stock exchanges should be considered. Integration would increase the size of the liquidity pool and lead to better price discovery. There would be a number of other substantial advantages of integration as well, such as economies of scale for the exchanges. This would be the single most effective step for increasing liquidity in the medium term.

Two, demutualization of the three stock exchanges should be considered. It would convert a broker-dominated financially weak not-for-profit exchange into a financially healthy for-profit listed company, structured to ensure better governance for all

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stakeholders. Demutualization would create sufficient commercial pressures from within the exchange, with full access to economic and human capital to expand its business through development and innovation. In a demutualized exchange, all new members who meet prescribed criteria are welcome to act as brokers. There is no economic barrier to buying a membership card worth many millions of rupees. This would make it financially feasible for many institutions and professionals to set up brokerage houses that would significantly increase turnover.

Three, market access should be increased to new investors whose participation would increase liquidity in the market. Instead of relying on brokers to open branch offices, the exchanges themselves should open branch offices in other cities and allow their members to open their branch offices within the branch office of the exchange. The LSE is in the process of opening a branch office in Faisalabad where it would provide necessary facilities to brokers for opening their branch offices. The CDC has announced that it would be opening branch offices with the help of banks. Branch offices opened by exchanges and the CDC would add large chunks of liquidity to the market in a relatively short time. Four, new derivatives should be introduced. A good starting point would be index futures. The KSE has already been working on the development of index futures. These should be followed by options and warrants. The derivatives and the regular market both fuel and feed each other as the two are linked by arbitrage. Growth in one leads to growth in the other and this is how derivatives would facilitate liquidity in the Regular Market. Five, an ongoing requirement of minimum free float for listed companies should be introduced. Many companies, including some large cap profitable companies, lack liquidity because their shares are tightly held by a few. Increase in free float or the number of shares actually available for trading would cause an increase in activity in the regular as well as the futures market and alleviate potential loss of liquidity. Six, corporate governance should be strengthened to provide on-going disclosure of

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material information by listed companies. News brings activity: the greater the news the greater the liquidity. Many listed companies do not understand their obligation for providing information to the stock exchanges. The boards of directors of listed companies need to be made aware of the importance of on-going disclosure of material information by penalizing those who fail to meet disclosure requirements. Seven, for Balance Order Settlement (BOS), the NCC should adopt Continuous Net Settlement (CNS) and remove restrictions on short and blank selling. The benefit of CNS over BOS is that it facilitates speculation by allowing a free carry-over of positions based on long and short positions available in the market. To implement CNS, a borrowing and lending system would be necessary. Once CNS and a borrowing and lending facility are in place, restriction on short and blank selling should be withdrawn. By using these short, medium and long-term measures, badla would be phased out from our stock exchanges and liquidity would be increased and spread out within listed companies. In fact, total turnover in the regular and derivatives segment would be greater than what it is today. Investors in Pakistan shall have liquid markets without the systemic risk and abuses of badla financing. (Blue. Chip, August, 2004)

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APPENDIX 3:

Whats been bothering the market?

By Aliya K Dossa Fears due to changeover to margin finance to abate the gradual changeover from the familiar carry-over (share-financing) system to margin finance over the next twelve months has unsettled speculators. Like all market participants, the speculator has an important role to play in market sentiment and activity. The good thing about speculators is that they are always there in the market to deal with other players, adding depth and volume as a regular participant. The bad thing about speculation is: speculation on borrowed money in the longer-term it can cause damage because of excessive volatility. The fear of the smaller speculator is that they will be shut out of the formal sharefinancing system, being unable to borrow under the new margin-finance system. Under the old COT system, the cost of borrowing was set depending on the share price and not according to the credit-worthiness of the borrower. Under the new margin-finance system, banks will lend funds at a lower (better) rate to larger, credit-worthy brokers as compared to smaller brokers with a smaller client base, lower volumes and higher creditrisk. For all players, we feel the more convenient and efficient alternative to both borrowing and lending in the COT market is the futures market, where spreads are less 39

volatile than the COT market that is being driven increasingly by demand and supply factors. In time, we expect the futures market to grow in volume and small investors to shift there. (Blue. Chip, August, 2004)

APPENDIX 4:

Margin financing may hit small brokers

ISLAMABAD, Sept 7: Pakistan's move to replace 'badla' based equity financing with globally accepted margin financing will bring the country's stock markets in line with international standards, but the transition is not likely to be without volatility in the shortterm, analysts say. The Securities and Exchange Commission of Pakistan (SECP) announced over the weekend its plan to introduce margin financing in place of badla or carry-forward financing to curb growing speculation in local stock markets. The state regulator's move to replace badla financing was not well received by investors. Reflecting the bearish tone in markets on Monday, the Karachi Stock Exchange 100share index fell 2.5 per cent, or 131 points, to an intraday and two-month low of 5,185 points in afternoon trading. The key index fell below key support levels of 5,290 and 5,200 on Monday, before closing 2.3 per cent lower at 5,195.50. Analysts say the index may go below 5,000 in the near term as investors come to grips 40

with the new system. "The new system will bring about a change in the culture of our markets, and this change may bring in some turmoil in the beginning," said Mohammed Sohail, research head at Invest cap Securities. According to analysts' estimates, around 80 per cent of total trades at the Karachi Stock Exchange is short-term and speculative in nature, and driven by borrowed money mainly provided by brokers and individuals?

However, market regulator SECP said it had given enough time to market players to adapt to the new system. "The gradual phase-out enables brokers to acquaint themselves with the new system and educate their investors," said Tariq Hassan, chairman of the SECP. In the first phase beginning October, margin financing will be introduced for 50 out of 663 currently active listed companies. The whole process should be completed by June 2005. Pakistan is among the few emerging markets in the world with badla trading in place. India phased out badla in 2001. Industry participants say the transition to margin financing is likely to be the most difficult for small brokers with no history in dealing with banks and financial institutions, unlike the big players who have a clearer credit history and credit standing. "The current system is indifferent to small or big brokers. But in margin financing you can't force banks to lend to everyone," said Nasim Baig, CEO of Arif Habib Investments. In badla or carry-forward financing, traders and investors can roll over their costs by paying a daily settlement fee. Roughly banks through big brokers provide half of the daily badla financing, while the rest is private money from individuals and other brokers.

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The authorities say only two to three per cent of daily trade is actually settled in full while the rest is financed through badla and can be rolled over as long as investors pay the daily fee. Money flows will be tighter in the case of margin financing, which will involve banks and other financial institutions. In the case of banks, for example, investors will be required to deposit 20 per cent of the amount they want to trade, in the form of cash or approved securities that include shares of listed companies.

The regulator's move to replace badla with margin financing is part of plans that include the demutualization of stock exchanges - or conversion from member-owned to shareholder-owned entities - and developing the country's futures market. The SECP plans to increase the number of shares traded in the country's sluggish futures market to 30 from 14 currently. Phasing out badla may well give the futures market a boost, industry participants say, noting that like badla, settlement for futures trades is not immediate and can be done up to one month after the trade. "My feeling is that a lot of speculative trade will move to the futures market once margin financing is fully implemented," said Mr. Baig. "I think whatever may come, we need these reforms to make our market more vibrant," said the SECP chairman. -Dow Jones Newswires (Dawn, 2005)

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APPENDIX 5:

What is Badla? In the badla system, a position is carried forward, be it a short sale or a long purchase. In the event of a long purchase, the market player may want to carry forward the transaction to the next settlement cycle and for doing this he has to compensate the other party in the contract .The 'seedha badla' financier enters into the system to lend money to the market player for a return. This is measured as interest on the funds made available for one settlement cycle, i.e. one week or a longer period in case of book closure badla system. Similarly 'undha badla' or continuo charges does the stock borrower to the stock lender pay returns. In a short sale, when the market player wants to carry forward the transaction to the next settlement cycle, he has to borrow the stocks to compensate the other party in the contract. The charge paid on the borrowed stock is called continuo charges. How is Badla done? On every Saturday in the Stock Exchange, Mumbai, a badla session is held. The scrip in which there are outstanding positions is listed along with the quantities outstanding. Depending on the demand and supply of money, the carry forward rates are determined. If the market is over bought, the demand for funds is more and the badla rates tend to be high. However, when the market is oversold, the badla rates are low or even reverse i.e.

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there is a demand for stocks and the person who is ready to lend stocks gets a return for the same. This is known as the undha badla. We can use an example to illustrate the concept of badla trading. You have purchased 100 shares of INFOSYS for Rs 7000, which is trading at Rs 7180 in the market at the end of the trading session, which runs from Monday to Friday in BSE. You feel that the stock price will rise further. Therefore you wish to carry the contract forward to the next trading session by paying what are called badla charges. In any badla transaction there are two key elements, the hawala rate and the badla charge for the scrip. The badla charge is the interest payable by the investor for carrying forward the position. The badla charge, as explained earlier, is market determined and primarily dependent on the supply of funds for financing a share. It is fixed individually for each scrip by the exchange every Saturday and it is calculated on what is called the hawala rate. The hawala rate is the price at which a share is squared up in the current settlement and carried forward into the next settlement in the next trading session. The existing position you have is squared up against the hawala rate fixed and carried forward after factoring in the badla rate. The difference is paid to your broker or received from him. You have purchased 100 shares of INFOSYS at Rs.7000 in the current settlement and you wish to carry it forward to the next settlement. You have indicated to your broker that you wish to carry forward the transaction. The hawala rate is fixed at Rs.7180 and the badla rate say is fixed at Rs.24.23 for the settlement usually a week. The badla charge works out to an annualized rate of 18%, but badla is usually denoted in actual cash terms. In this case, the badla charge accrues to the investor. If the hawala rate is lower than the initial rate, the difference has to be paid to the broker. In actual practice, your broker will request you to maintain a margin for arranging the badla finance. There can be other charges too and it can vary from broker to broker. All the charges apart from the badla charges depend on your relationship with your broker.

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The amount of leverage you get, effectively, depends on the margin insisted upon by your broker. If your broker insists on a 25% margin, you get 400% leverage or four times the amount you are ready to deposit as margin. At the end of each settlement, you carry forward your position at the hawala rate. This position will also be adjusted for badla. You can carry forward the transactions for settlements.

What is margin trading? Margin trading is a high-risk strategy that allows you to buy more stock than you would be able to normally and can yield a huge profit if executed correctly. Buying on margin means to borrow money from a broker (similar to a loan) to purchase stock. The investor can take position in the market by paying an initial margin of 50 per cent (your own money), while the broker could finance the balance 50 per cent. The broker can lend from his own resources or can borrow from banks, non-banking finance companies and other qualified lenders such as insurance companies. However, the broker can only borrow up to five times his net worth. The broker cannot use the funds from other clients or individuals. Sebi has stipulated that only corporate brokers with a net worth of more than Rs 3 crore (Rs 30 million) can carry out margin trading on behalf of their clients. How does margin trading work? Opening a separate account: To trade on margin, one needs to open a margin account. This is different from the regular cash account in which you trade using the money in the account. 45

The broker will be required to obtain your signature to open this margin account. The margin account may be part of your standard account opening agreement or may be a completely separate agreement. Let us look at how margin trading works. Say you wish to buy 500 Reliance Industries shares but do not have the entire finance upfront. You could do the trade through margin trading, wherein you would bring in 50 per cent as the initial margin (through your own funds) and the broker would provide the balance 50 per cent funds. In this same case, if you feel that the Reliance Industries stock has a potential to provide 25 per cent returns, you could buy more, by equally bringing in more money and borrowing the balance from the broker. There are some key issues that have to be kept in mind while opting for margin trading. o First, when you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan, until it is fully paid. The stocks are kept as collateral for the loan taken and remain in the broker's possession. o Secondly, the investor has to keep a minimum amount of equity (as maintenance margin) in the margin account, which can range from 25-40 per cent. This balance must be maintained before the broker forces you to deposit more funds or sell stock to pay off your loan. Note: If the value of the security or stock falls and the margin falls below 40 per cent, then the amount (as margin) will have to be increased again. A broker will make a 'margin call' if one or more of the securities you have bought (with borrowed money) decreases in value past this point. The investor will then have to pay the margin on a T+1 basis, i.e., the cheque would have to be paid to the broker the next day. 46

In case the margin falls below 30 per cent, then the broker -- without intimating you could also sell the stock in the market. In the case of higher profits, the interest on the loan taken will have to be paid. The interest charges are applied to your account unless you decide to make payments. These interest charges in current market conditions are high and differ from broker to broker. Over time, your debt level increases as interest charges accrue against you. "Currently these interest charges are very high, as this system has been relatively unregulated. In the new system, the interest charges could come down. Further, we expect demand for margin trading to be high considering the investor interest in the stock markets," a dealer in the investment division of a state development bank said, on condition of anonymity. How different is margin trading from other finance schemes? In principle, margin trading is similar to ' badla financing,' but there are more stringent norms governing this. Currently, only banks are permitted to undertake margin funding of investors. However, this method of margin trading failed to take off due to stiff conditions imposed on the banks by the Reserve Bank of India. The onus is placed on the bank's board to ensure that there is no nexus between interconnected stock broking entities/stockbrokers and the bank. Stringent disclosures: Sebi is working out the final modalities; it has specified that strict disclosures will have to be maintained for margin trading. Brokers will have to disclose on a daily basis, their client-wise, scrip-wise and lenderwise positions to the stock exchanges.

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The exchange will disclose details of scrip wise margin financing to the public. Limited scope: Margin trading will be allowed only in the top scrips, taken from the Bombay Stock Exchange's specified 'A' group, i.e., those with a impact cost of less than 1 per cent which signifies high liquidity, the regulator has said. What it means for the broker: The broking community has been through rough times in the period 2000-2002. However, most have had a windfall in 2003 with the current Bull Run. But competitive pressures will force the broking industry to constantly seek new areas for growth and revenues. Margin trading has become one such avenue. It also brings the stock broking community to a slightly higher status as an industry/corporate entity, which carries out varied financial services. Should retail investors opt for margin trading? There are clear benefits from margin trading, offering you leverage for your trade. If the scrip you have bought moves up, one can make handsome gains. On the flip side, a fall in prices would mean shoring up the maintenance margin (bringing in more money) or liquidating the stock. Further, interest has to be paid on the sums borrowed. Hence, one could actually stand to lose more money than originally invested. Leading BSE institutional brokerage firms like KJMC Capital Markets and ULJK Securities say that margin trading would benefit the high net worth individuals more than retail investors. We feel the retail investor must keep from jumping into margin trading immediately due to the following factors: Any financial and trading system in Indian market conditions will need some time to settle down. There will be hiccups and possibly changes in the margin trading system, as required. Margin trading is a high-risk strategy. You stand to make higher profits, but might also lose heavily, if the market conditions move against you. 48

Indulge in margin trading only if you have 'risk capital'. Risk capital is surplus money set aside, which the investor can afford to lose.

Buying on margin should be used for short-term investments. The longer you hold an investment, the greater a return you need, to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you.

5.5 BIBLOGRAPHY:
Pakistan & Gulf economist. Blue Chip. Rediff.com Dawn.com

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