In the backdrop of stockbrokers and several high net worth investors/traders expecting Presidential intervention to unshackle the Colombo bourse from overregulation, a set of stockbrokers have welcomed the Securities and Exchange Commission’s (SEC) efforts in regulating the capital market in the country.
In a letter sent to the SEC dated July 19, 2012, the brokerages, JB Securities, CT Smith Securities, IIFL Securities and Somerville Stockbrokers asserted that every effort must be made to adhere to international best practices, as equity markets are conduits in attracting foreign investments.
“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 four stock brokers said.
Commenting on the recent directive by the SEC further relaxing credit rules, the four brokers noted that the net capital computation formula before the July 16 directive was extremely accommodative to the current environment.
“It does not require haircutting based on impact cost (illiquid securities require a greater haircut) 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 mere Rs.35 million from which a leverage of 3x is permissible,” the letter sent to the SEC noted.
The four brokers also stressed that foremost in their minds is the step that can be taken to reduce systemic riskrisk 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 commingling risk of client credit balances, i.e. there is no delineation between client and contra creditors from all other creditors during bankruptcy,” the letter said.
The brokers also pointed at the practice of clients maintaining credit balances in their brokerage accounts, though as per the 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 four brokers warned.
They further noted that although the current bilateral settlement system at the CSE until recently had not experienced a settlement failure, it's a matter of time before the bourse experiences 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 brokers said.
The letter further pointed out, since the absence of a delivery vs. payment (DVP) system, the seller of shares is exposed to both the asset risk (his shares have moved) and market risk (difference in market prices between trade date and settlement date).
While welcoming the CSE's actions towards implementing the first phase of a robust risk management system to reduce contra party risk, the stockbrokers stressed that in the interim period, steps must be taken to preserve the existing net capital formula, as it is based on IOSCO recommendation for emerging markets.
The letter also commented on the dubious operations of margin providing entities by stockbrokers, which have been set up due to tightening of credit rules by the SEC in the latter part of 2010.
“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 letter noted.
It also stated that the vast majority of margin providers affiliated to broking firms do not have a minimum limit on lending.
“Further, good risk management practice would necessitate margin firms to entertain a number of smaller borrowers rather than a 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,” the four brokers said.
The letter had been copied to Secretary to the President, Treasury Secretary, SEC Commission Members, CSE Chairman and the director board, SEC Director General and the CSE Chief Executive Officer.