With concerns mounting that today’s meeting between President Mahinda Rajapaksa and capital market stakeholders would put an end to much needed regulation and a stop to investigations into market malpractice, four stock broker firms have written to the beleaguered regulator commending its regulatory stance.
The stock exchange slump is being blamed on over regulation, particularly with regard to credit restrictions (which were relaxed to an extent earlier this month).
JB Securities Ltd, IIFL Securities Ceylon (Pvt) Ltd, CT Smith Stockbrokers (Pvt) Ltd and Somerville Stockbrokers (Pvt) Ltd have in a letter to the Securities and Exchange Commission of Sri Lanka (SEC), headed by Thilak Karunaratne, said, "Contrary to popular perception our understanding is that the SEC never barred brokers from giving credit thus the ongoing debate is incorrectly framed, the only issue that is at debate is the funding of credit extended by brokering firms."
The SEC adopted a slew of measures after ‘dud’ stocks, also known as ‘junk’ stocks were hyped up and rampant market malpractice was the order of the day. The Colombo Stock Exchange, which grew 125.3 percent in 2009 and 96 percent in 2010, underwent a correction and slumped to 8.5 percent last year. Year-to-date, the bourse has fallen 19.5 percent.
Interested parties believed to be under the SEC’s radar for market irregularities and broker firms suffering with high interest rates hitting them hard because they cannot offload their holding of dud stocks, are blaming the SEC for the current predicament of the stock exchange.
President Mahinda Rajapaksa intervened last year and these interested parties won the day resulting in the then SEC Director General Malik Cader being removed from his post and appointed as an advisor in the Treasury and the resignation of SEC Chairperson Ms. Indrani Sugathadasa. The duo had begun to take a tough stance on market irregularities and analysts say their exit was a huge blow to the credibility of the broker community.
The new Chairman of the SEC Thilak Karunaratne has continued to clamp down on market irregularities and this has understandably irked some who have since tried to blame the woes affecting the bourse on over regulation.
But JB Securities Ltd, IIFL Securities Ceylon (Pvt) Ltd, CT Smith Stockbrokers (Pvt) Ltd and Somerville Stockbrokers (Pvt) Ltd have botched these arguements.
Their letter to the SEC in full:
"We the undersigned would like to concur with the SEC’s recent directive issued on 16 July 2012. For brevity we outline below the reasons for our concurrence with the above.
Contrary to popular perception our understanding is that the SEC never barred brokers from giving credit thus the ongoing debate is incorrectly framed, the only issue that is at debate is the funding of credit extended by brokering firms.
The net capital computation formula before the 16th July directive was extremely accommodative to the current environment. It does not require haircutting based on impact cost (illiquid securities require a greater hair cut) and value at risk (volatility) when determining the collateral value. Thus the degree of credit that can be extended is much greater than if a best practice standard was in force. Further, the required minimum net capital is a mereRs 35 million from which a leverage of 3x is permissible.
Foremost in our minds is the steps that can be taken to reduce systemic risk – risk of collapse of an entire market as opposed to the risk associated with any individual entity, group or component of a system. In particular we are most concerned with contra party risk and the comingling risk of client credit balances, i.e. there is no delineation between client and contra creditors from all other creditors during bankruptcy.
In the normal course of business some clients maintain credit balances in their brokerage account. As per CSE rules client funds have to be segregated into a separate designated account. Although these funds are maintained in a segregated account there is no legal ring fencing of these balances thus in the event of a firm bankruptcy these client credit balances will be pooled with all other assets of the firm. In the event of such an occurrence there exists a strong possibility of a contagion risk to ALL other brokers where market participants will lose confidence in their stability.
The current CSE settlement system is based on bilateral settlement – broker A and broker B net off their positions, this is reflected on our balance sheets. Transfer of funds during settlement on T+3 is done on a consolidated net basis – a broker’s debits and credits against ALL other brokers are netted off and only the net amount is transferred. Although until recently the settlement system had not experienced a settlement failure, it is only a matter of time before we experience a major failure – this will result in a domino effect – broker A will default on B, B will default on C, etc. This is any market participant’s worst nightmare.
The market’s settlement cycle is T+3, thus in the absence of a delivery vs payment (DVP) system shares transfer between sellers and buyers immediately but funds only flow on the settlement day. Thus if a settlement failure does occur the seller is exposed to both the asset risk (his shares have moved) and market risk (difference in market prices between trade date and settlement date).
We have been informed by the CSE that it is actively working towards implementing the first phase of a robust risk management system to reduce contra party risk. We welcome such a move for it will significantly reduce systemic risk. In the interim period steps must be taken to preserve the existing net capital formula for it is based on IOSCO recommendations for emerging markets – Guidance to Emerging Market Regulators Regarding Capital Adequacy Requirements for Financial Intermediaries. Below is an extract from the recommendation section of the report (page 25 of 243).
One approach that accurately reflects changes in the risk profile of an intermediary is the Risk Based Approach, which provides intermediaries with a capital requirement which is proportionate to the element of risk. Thus, the capital requirements are neither too severe, (which would increase costs for the firms and affect their efficiency), nor too slack. In order to strengthen and further develop EMC’s capital markets, it is recommended that EMC’s graduate towards using risk based models as they are more forward looking approaches, in-line with international best practices and most developed economies. One must recognize however, that sophisticated risk based models may be too complicated and advanced for some jurisdictions to adopt, and may initially require considerable investment in the development of infrastructure, personnel and strengthening of existing risk management frameworks.
One significant component of arriving at a representative capital adequacy level is the implementation of adequate haircuts, based on the liquidity of the assets. This is a highly encouraged practice that should be explored by jurisdictions which do not currently have this requirement in place.
On 14th Sep 2010 the SEC issued a directive to the CSE to mandate brokers to refrain from extending credit to investors beyond T+3. At the same time they encouraged brokering firms to setup separate subsidiaries so that they can conduct margin trading business – since such entities are limited liability companies there is adequate ring fencing to prevent a spillover from the credit extending entity to the brokering firm.
As per your 2011 annual report there are 32 registered margin providers out of which 22 firms are affiliated to brokering firms. In many cases, brokering firms have tightly integrated their back office systems to provide a seamless solution to their clients at the same time maintaining the legal ring fencing between the brokering company and the margin providing entity. Further, the SEC has permitted higher financial leverage 4x for a margin provider.
The vast majority of margin providers affiliated to brokering firms do not have a minimum limit on lending – its untenable to do so for one can impose a maximum limit but not a minimum amount for one cannot compel a client to borrow. Further, good risk management practice would necessitate margin firms to entertain a number of smaller borrowers rather than larger one for it disperses the credit risk. We are made to understand that there is an argument being put forward that low net worth investors are deprived from access to credit when investing in equities – the evidence does not support this claim.
We would like to conclude by reinstating that we welcome the SEC’s efforts in regulating the capital markets in the country – a necessary condition for the development of the financial markets is to prevent the self-fulfilling cycle arising out of the economics of trust –Loss of trust -> Withdrawal from risky assets -> Rise in cost of capital ->Impaired returns. If this self-fulfilling cycle is not contained we will deprive businesses from access to equity capital necessary to make long term investments than in turn create economic growth.
Finally, the equity market is a conduit to attract foreign portfolio investments especially from large but more discerningforeign institutional investors thus every effort must be made to adhere to international best practices. To cite a recent example the country improved its ranking by 28 places in 2012 in the World Bank’s Doing Business Ranking under sub segment Protecting Investors – the key contributor towards this was the successful implementation by the CSE of the directive issued by the SEC on related party transactions in 2010."
source - www.ft.lk
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