Margin trading vs badla
By Basharat Ullah
The Karachi Stock Exchange had floated the draft rules in April 2003 regarding the introduction of a new margin trading system replacing the current badla based system.
Surprisingly, the progress on 'margin trading' front has come to a halt apparently, as neither the exchange nor the Securities and Exchange Commission of Pakistan (SECP) has taken any new initiative for its implementation. The Pakistani market is trading at all time high levels, with gains of almost 150 per cent since July 2002. Following the unprecedented increase in equities' values and trading volumes, it is high time for SECP to make urgent steps for the implementation of modern day margin trading system. The existing age-old badla (carry forward) system is carrying obvious risks to remain in force in the future. So far, the exchange has done an excellent job by taking adequate measures in safeguarding the smooth functioning of the clearing system. The prominent safety measures are the introduction of associate members (lenders in the badla market) on the exchange and the implementation of stricter exposure limits for carry forward transactions. Nevertheless, delaying the implementation of reforms such as margin trading system and even stricter T+1 settlement system will put our equity market out of tune with the rest of the world markets. The appointment of a new full time Chairman of SECP, Dr. Tariq Hassan, after a gap of few months, has raised hopes that the pace of introducing reforms at the exchanges will once again take precedence over other matters.

What is margin-trading system?

Margin is a secured loan, basically, where the collateral is the existing marginable securities in your account. How much you can borrow is determined by how much is in your account. Currently in Pakistan, you open one sub-account with a broker, where all transactions are recorded together, whether cash based (delivery) or badla based (margin financing). Under the new system, the account opening form of a brokerage house would ask whether you would have a cash account or a margin account. If you choose the cash account, then you can buy only stocks which you intend to pay for at the time you put in your buy order. On the other hand, if you open a margin account, it means that you are asking for the brokerage to agree to lend you money from time to time, so that you may use it to invest more money than you have in your account.

Salient features

* All clients- individuals and institutions- will have to maintain separate margin trading accounts with their respective brokers.

* Uniform maximum margin limit will be set for all clients and the brokers will have to strictly adhere to that limit. Excess positions will have to be reduced at the end of the day or additional funds or securities will be put into the account.

* All trades, whether long or short, taking place in these accounts will be reported to the exchange.

* Brokers will arrange funds (long positions) or stocks (short positions) for clients margin accounts by borrowing the same from the market.

Abuses in the badla system

The existing badla based system at the KSE has the ability to protect the clearing system of the exchange running smoothly, however, this system has failed in controlling the following malpractices:

* The current badla based margin trading has been widely misused in allowing highly leverage trades. In an effort to generate more commissions, the brokers allow clients to leverage to the extent of even 90 per cent and above. If a client has Rs100,000 or equivalent worth of securities, he or she is allowed to build open positions in excess of Rs2 million, particularly in stocks like PSO. Another practice in vogue is that some of the brokerage houses demand from clients a margin in terms of rupees per share and not as a percentage of value of open position. For instance, they would simply ask the client to deposit say Rs10 per share in case of PSO (by having Rs100,000 in your sub-account, you can easily keep 10,000 shares of open position in PSO, which cost Rs2,800,000 at the current market value) or Rs 2-4 per share in case of PTC or Hubco (market price ranging between Rs 20-50 per share). These practices have lured the novice investors and habitual speculators to play for high stakes in the market.

* The present system has in-built ability to cover up the existence of short positions of clients by brokers. Since, the KSE monitors the exposure limits of its members to the clearing system only, no matter how the members handle the transactions inside their houses, it has been left practically at their discretion. Therefore, most of the brokerage houses have adopted the practice of doing badla financing for their clients on a consolidated basis. In order to keep a check on their exposure limits, the brokers even encourage their clients to go short in liquid stocks, which effectively reduces their exposure to the clearing system without giving any details regarding the existence of short selling to the KSE. At the same time, the brokers do not feel any problem in allowing excessive leverage trades as the positions could be matched or squared internally without being reported to the clearing system.

* The repurchase agreements between brokers and financial institutions, usually called outside badla, go unnoticed by the exchanges and other regulators. This is a standard borrowing arrangement against listed stocks by brokers from financial institutions, with adequate margin and maturity; however, at any stage the regulators do not know the exact quantum of brokers' borrowings from financial institutions. It is feared that this practice artificially reduces the actual position of weak holdings at the exchange, while at the same time helps the brokers in carrying forward highly leveraged trading positions. The higher the amounts outstanding in shares repurchase transactions with brokers, the higher will be leveraged positions and weak holdings in the exchange. Following the unprecedented rise in the equities values in the recent past, the SBP has issued a circular finally last week, directing all financial institutions to report (amongst other things) all repo based exposures to brokers on a weekly basis.

 

Recommendations

(1) The entire system of margin trading such as setting margin limit (initial margin) and margin call limit (maintenance margin) should come under the domain of the State Bank of Pakistan (SBP), as being done by the central banks in the rest of the world. In the US, the Federal Reserve regulates bank lending to securities markets participants, which has set a minimum initial margin of 50 per cent and a maintenance margin of at least 25 per cent. Individual brokerages could have stricter limits, higher initial margin and higher maintenance margin, but cannot violate the lower limits set by the Federal Reserve. Simply, by applying the same limits in Pakistan, if you want to have an open position of Rs100,000 in a certain stock, you will have to put Rs50,000 or equivalent worth of securities in that account. Similarly, if the maintenance margin limit is 25 per cent, then the brokerage will issue a margin call (asking for either additional cash or liquidating the position), when the value of your equity (value of securities minus the borrowed amount from the brokerage) falls below the maintenance margin. Now the question arises, if in the developed markets the margin limit is 50 per cent, then why should we be allowing higher leverage investment in the Pakistani market by fixing lower margin requirement for clients. As the current practice goes, the brokers provide finances through the current badla system to the extent of almost 90 per cent, while the clients just contribute 10 per cent. The fixing of margin limits by SBP will certainly help in controlling excessive leverage situation in the market.

(2) Currently, the brokerage houses do not ask the institutional clients to provide any margin against their open positions in the market. Since the institutions are believed to be secured (though no benchmark guidelines or criteria devised by SECP to judge the soundness of the financial institutions), therefore they do not keep any deposit in the form of margin with brokers. No matter what open position an institution wishes to take, a broker goes all the way to arrange for exposure requirement and badla, just to oblige that institutional client. In the new system, it should be ensured that the margin limits for institutions are also defined and enforced across the board. We have seen in the past that some institutions did play havoc in this market by taking excessively high leverage positions and seriously putting at risk the brokers and the clearing system of the exchange. In one case, the situation could only to be rescued after the intervention of the State Bank of Pakistan. An institution playing high stakes could be more dangerous for the market than any individual and therefore, they should not have an open license for speculative trading.

(3) Like in the past, quite a few brokers may drag their feet to slow down the introduction of this new system. However, we can not afford delaying these matters just because the interests of few brokers will get hurt. The regulation and monitoring of brokers is no less important than those of banks and other financial institutions. Commercial banks and investment banks report all their operation details to SBP on a regular basis, while at the same time SBP keeps a close watch on these institutions through its own inspecting staff. The draft rules regarding margin trading has indicated that brokers will have to provide and report back to KSE all the details of margin accounts on a regular basis. This will indeed be a major positive development and will bring in necessary transparency in the operations of our capital markets.

(4) The system can only be successfully implemented if KSE and SECP take necessary steps in directing the brokerage houses to introduce some real changes in their internal operations. Most of the brokerage houses lack the necessary facilities and personnel to operate under the new system. The new system requires that there would be regular reporting of margin accounts to KSE. It is therefore utmost important that uniform changes should be introduced and implemented inside the operations of the brokerage houses on urgent basis. Not only staff will have to be trained but also necessary changes will have to be introduced in the back up systems of settlement and accounts. At the same time, the KSE should make some efforts in preparing uniform guidelines for the introduction of new account opening forms as well as make some arrangements for educating the investors before the formal launching of this new system.

The margin trading system will be a major step forward for the Pakistani stock market. Its implementation will eliminate most of the malpractices and will ensure more transparent operations of brokerage houses. At the same time it will reduce the element of excessive leverage trading and speculation. The new mechanism could also ensure more exact information regarding long and short interests outstanding in the market at any given time. In the short term, the trading volumes on the are likely to dwindle, as the brokers will not be able to selfishly leverage their clients into unmanageable open positions. However, one thing is certain that the new system will bring in real money in our stock market and will make the truly comparable to the rest of the world stock markets.

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