The road ahead — II
Nadeem Naqvi
Front-line regulator cost compensation: It should be noted that the primary objective of PSX, i.e., facilitating capital formation in the country, cannot really be achieved unless there is thriving trading activity that allows fair price discovery and sufficient liquidity to enable easy entry and exit for investors. This requires a robust front-line regulatory oversight with advanced technology-driven tools and capable human resource base, both in operational aspects as well as in terms of supervision, which entails significant cost. Ultimately, a stock exchange such as PSX has high operating leverage – its fixed cost base is high due to both large infrastructure requirements (regardless of market activity) and its role as a front-line regulator. A mechanism needs to be put in place to cover the regulatory function cost of PSX, otherwise its management and shareholders have little incentive to develop the exchange to its full potential. Prior to demutualisation, a management fee associated with the Clearing House Protection Fund (CHPF) and Investor Protection Fund (IPF) used to provide such a compensation. The rationale was that the IPF was the final aspect of the regulatory process and when a broker defaulted under specified circumstances, the funds could come into play to compensate investors. However, post demutualization, SECP directed that NCCPL should take over management of these funds and this fee income got stopped for PSX. Thus, a new compensation structure is needed to cover the cost of front-line regulation given PSX’s significant responsibility in this regard.
Consolidation of front-line regulatory function: Related to the question of cost, a broader issue is regarding the overall front-line regulatory function – both in terms of regulation development, its implementation and enforcement. Currently, the three capital market infrastructure institutions (PSX, NCCPL and CDC) each have their own regulatory affairs department, with a chief regulatory officer and support staff. There are areas of duplication and overlap can easily be done away with. More important, a single frontline regulator for the entire capital market will have a greater bird’s eye view of market risks starting from pre-trade point right up to the custody level, whereby surveillance and regulatory actions are consolidated in a central focus point. This will improve regulatory effectiveness as well as cost efficiency.
Broker custody issue: While this might appear to be a micro-prudential issue related to risk management, allowing brokers across the board to have custody of investor assets has been the main cause of most past specific and general market crisis. Several initiatives were taken by the SECP to address this critical issue but due to strong opposition from the securities industry, only limited progress was made here. There is a real need to revisit this issue and develop a framework that addresses the risk while providing an efficient mechanism to deploy investor assets for the trading activity. Today, technology is available to do this and the next generation of capital market reforms should make this a priority area.
Debt market development: With over USD 1.0 billion of foreign institutional funds invested in Pakistan government securities over the last six months, there is a risk that developing the local debt market may no longer be a priority for policy makers. But that would be a mistake. Without government initiative, this segment of the market cannot develop given the historic role of the commercial banking sector in providing debt finance to the public and private sectors. The regulatory framework for the debt capital market already exists thanks to SECP and PSX has also developed its own Bond Trading System. However, without government initiative it is difficult to see how this market segment can be kick started.
One initiative can be that, for all infrastructure projects that the government undertakes directly or via CPEC, at least 30-40% of the long-term finance should mandatorily be sourced through the capital market. Banks that wish to supply such funding must therefore go via the capital market. Some form of reduced capital gains tax on such investments can attract other institutional investors – both local and foreign – to fund these important long-term infrastructure projects. Another example is that of Malaysia, where to develop the debt capital market, the government mandated all public sector enterprises to source funding for over one year from the capital market rather than the banking system. In fact, the success of Malaysia in becoming a major global centre for Sukuks owes quite a bit to this early initiative.
Increasing market liquidity: As noted above, for the capital market to fulfil its reason d’etre, it must have depth and liquidity in order to function well both for issuers and investors. According to empirical research, there are some well-known factors that are drivers of liquidity in stock exchanges, including:
Developing a wide and diverse investor base
* Providing an enabling environment for a larger retail investor base (use technology)
* Increasing participation and incentivising local institutional investors (products)
* Establishing a network of professional and regulated intermediaries (financial advisors)
* Attracting international investors from beyond the historic centres
Increasing the pool of securities/products
* Launching exchange-traded funds (ETFs) to attract both existing and new investors
* Developing the debt market segment
* Developing other derivatives, risk management regulations and infrastructure in place
* Government initiatives in encouraging CPEC and other infrastructure project financing via debt and equity issues in the stock market
* Creating a regional marketplace by linking with other markets
Investing in key market enablers
* Improving electronic trading technology to encourage a greater volume of trading
* Enhancing market data to increase investor confidence, trading activity and liquidity
* Implementing market-maker schemes
* Introducing regulated short-selling, securities borrowing and lending schemes
Most of the above factors have been discussed by the SECP and the Board of PSX from time to time and considerable effort and time has been spent by PSX, NCCPL, CDC and the SECP to achieve some of them. However, success has been limited. One of the reasons (and there are several) for the lack of success in improving trading volumes is that a comprehensive approach has been missing and also, that market participants have not really been involved fully in the deliberations and decision-making process. It is hard to see how liquidity can be enhanced if the views of a wide range of market participants are not taken into account and new products and methods do not have their support – because ultimately, they are the users who will generate the demand for Exchange’s platform, products and services. As such, this area has to become a strategic priority for policy makers as a holistic approach rather on a piece-meal basis.
In conclusion, the significant potential of the Pakistan capital market remains to be unlocked and this requires a comprehensive reform of the capital market ecosystem beyond simply focusing on governance alone. The success of reforms will hinge on how successful the capital market industry itself is from the perspective of the suppliers of capital (investors), the bridge between suppliers and users of capital (capital market institutions, asset management industry, brokerage industry, investment banking segment) and the users of capital (listed companies and private companies that can benefit from listing – both in the private sector and public sector, as related to infrastructure projects).
(Concluded)
