Margin financing rules and investor risk By Khaleeq Kiani

THE draft Margin Financing Rules placed on the website of the Securities and Exchange Commission of Pakistan for public comments seem to be inconsistent with the investors’ constitutionally guaranteed right of equality before the law.

The draft rules are also in conflict with statutes under which these purport to have been made and the regulatory body itself has been created.

The draft rules will give the stock brokers an opportunity to make money in two ways: First, they will be able to lend money to their clients at exorbitant interest rates as they did in the past. Second, the leverage so introduced in the market will generate trading volumes and multiply brokers’ brokerage commissions.

On the other hand, draft rules will breed false hopes of gains among investors funded by the borrowed money. As the empirical evidence demonstrates, nobody has ever been able to do it at least in the long run. These rules under section 16 of SE Ordinance protect brokers’ interests.

Investors’ protection lies in the effective enforcement of Sec 22 and 24 of SE Ordinance and Sec 28 of CDC Act which provide heavy penalties and imprisonment for those who misuse the leverage facility provided under the draft rules.

The SECP has consistently protected brokers’ interests through diverse and sometimes very risky leverage facilities. When it came to protecting investors, the SECP established the offence under section 22 of the Ordinance against 56 KSE brokers in April 2007 but exonerated them all on irrelevant grounds.

When five brokers made confessions before the SECP of their offence under Sec 28 of CDC Act in June, 2009, it did not prosecute the offenders. This discriminatory application of capital market law to protect brokers’ interests and deny the investors legally mandated protection was inconsistent with the constitutional provisions.

An Act of Parliament (or Ordinance) can only empower a regulator to register the regulated entities and issue directives to regulate their working. Sec 5 and 5A of SE Ordinance empower the SECP to register stock exchanges and brokers. Sec 40B of the SECP Act and Sec 20 of the SE Ordinance empower SECP to issue directives to regulate their working. The SECP intends to implement the proposed margin financing facility through directives of the sorts which no statute empowers it to issue.

The SECP has resolved the problem by conferring this power on itself through rules 13, 19 and 22 of the draft rules. Moreover, SECP wants stock exchanges and brokers to duplicate registrations for margin financing which no law empowers it to do. It has again resolved its problem by conferring this power on itself through rule 3(4) and on the stock exchanges through rule 8 of the draft rules. Taking a clue from the past, the SECP seems to have made an assessment that the brokers’ abuse of leverage facility is bound to recur.

The SECP has devised a mechanism in draft rules, shedding its responsibility to check brokers’ malpractices. Rule 8 requires a stock exchange to register the broker for margin financing and rule 9 requires to regulate his activities. Its attempt to marginalise its responsibility this way is in conflict with Sec 5A of SE Ordinance and Sec 20(4)(d) of the SECP Act which requires it to register the brokers and regulate their working.

Even otherwise draft rules are a strange mix of irrelevant, ambiguous and non- transparent provisions. The core matters of a margin financing regime like initial margins, maintenance margins and margin calls are missing from draft Rules. Rule 13 couches these concepts in ambiguous terms and leaves their specifications to future directives which no law empowers the SECP to issue.

The earlier Margin Trading Rules, 2004 which the draft rules purport to replace at least made a mention of initial margins and maintenance margins although their numerical specifications were likewise withheld from the rules and kept under the SECP’s discretion.

In Rules 11 and 13 of its earlier rules of 2004, SECP had prescribed a plethora of credit risk assessment, reporting, monitoring and disciplining requirements. However, nothing worked and the massive abuse of margin financing facility by brokers contributed heavily to the market crashes of 2005 and 2008. In contravention of the earlier rules, brokers used clients’ funds for margin financing.

In violation of Rule 4(1)(a) of 2004, brokers pledged en block their clients’ shares without clients’ authorisations, for their personal gains. All the checks against abuse provided in earlier rules failed because the SECP wilfully avoided to specify the percentage wise initial margins and maintenance margins in striking contrast with the international best practices where initial margin is normally fixed at 50 and the maintenance margin at 25 per cent.

Specification and diligent enforcement of these margins could prevent the misuse of margin financing facility better than the plethora of requirements prescribed by the SECP in its earlier rules.

Interestingly, draft rules repeat some of the same provisions which have already been abused by brokers and nobody has been punished. For instance, Rule 12(1)(b) and 21(c) prohibit brokers to use clients funds for margin financing and to pledge clients’ shares without their authorisations. Like the earlier Margin Trading Rules, draft rules avoid specification of margins.

A new provision of shares lending and borrowing in draft rules makes the investors even more vulnerable. Now anyone having no shares will be able to borrow and short sell the same in the hope that market will decline and he will be able to purchase and return to lender the same shares at lower prices.

What if borrowers’ bet fails, market rises and the borrower is trapped in the middle? Who will be responsible to return lenders’ shares if the borrower defaults? Again provisions governing such sensitive matters have not been made part of the draft rules. Rule 19 leaves such matters to the SECP to specify in its directives which again no law gives it the authority to issue.

The Rule 4(1)(b) provides for suspension of registration of the stock exchanges for margin financing for failing to comply with provisions of SE Ordinance. What about the eligibility of a stock exchange to get registered for margin financing if it faces serious allegations of breach of the Ordinance and the SECP has avoided to investigate the matter? What about the eligibility of 56 brokers in terms of rule 7(e) to get registered for margin financing against whom the SECP established the breach of Ordinance in 2007 but exonerated them from punishment?

Whether the arbitrary draft rules will stand the test of judicial scrutiny is not yet clear.

What is clear is that the SECP seems ready to take the first step towards another stock market debacle.

Source: http://www.dawn.com/wps/wcm/connect/dawn-content-library/dawn/in-paper-magazine/economic-and-business/margin-financing-rules-and-investor-risk-460