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Putting brokerage houses under financial strain

The Securities and Exchange Commission of Pakistan (SECP) has issued a notification recently for the change of Brokerage Regime for Capital Markets. Under the proposed regime SECP intends to increase the Capital and Net worth requirements of TC Holders manifolds. The existing capital requirement of Rs 10 million will be increased to Rs 125 million. The brokerage regime will be split into three categories. The distinction between these three categories is based upon its Net worth and Paid up capital. Trading only category with a net worth of 15 million, Trading and self clearing with 100 million going up to 125 million by next year and trading and clearing with 500 million rupees.

The trading and self clearing category shall appoint at least two or one-third members of the board as independent directors, the chief Financial Officer and Head of Internal audit must meet the minimum qualification requirements, obtain and maintain brokers rating and appoint a statutory auditor from list of A category. In addition, this category will adopt Corporate Governance rules that are applicable to listed companies.

The brokerage and investors community fails to understand the imposition of these requirements for smaller brokerage houses. If complied with, the brokerage houses would incur substantial operating expenses without a proportionate increase in business activity. We have seen in the recent past that several brokerage houses were closed down due to increasing cost of doing business, witnessing drop in the number of investors and over-regulating of capital markets.

The new requirements are very harsh as raising the paid-up capital from present level of 10 million to 125 million within a short period is difficult to manage. It would put lot of brokerage houses under financial strain. As all the trades in the capital markets are conducted on cash only basis, there seems to be no justifiable business need to increase paid up capital forcefully manifold on a short notice. Normally it is one of the prime function of the business entity to assess its own business capital needs and not by anyone outsider to impose mandatory requirements especially for those who are already in a business as a going concern.

The brokerage community is of the view that SECP’s proposals are meant to favour only the large brokerage entities as these proposals were framed by a committee of participants representing from these houses. There was no participation from small brokerage houses at the proposal stage. Therefore, the proposals lack the proper consultation process. The amendments as such will benefit the big brokerage entities that amounts to only 10% and will adversely affect 90% small brokerage entities. It is being estimated that almost 90 percent of the present active brokerage houses would disappear due to not being able to comply with the new requirements.

The splitting of the brokerage business into three categories and diverting the majority business to Trading and Clearing category tantamount to creating a monopolistic situation and promoting and allowing uncompetitive practices in the Capital Market. This will result in creating an uncompetitive behavior resulting in 90% concentration of business and its risk in the hands of 10% brokerage houses. This seems too risky for the entire capital market. We presume SECP has ignored the recent default of Karvy in Indian Capital market which affected 95000 investors with a 322 million dollars’ worth of equities. If we recall the past debacles in Pakistani capital markets, those who defaulted, majority of them were the big brokerage houses. If we revisit the international financial debacles, there seems to be enough evidence that the list included big international well known multi companies. The size of the capital structure is not a guarantee that the entity will be risk-free. The bigger the entity the bigger the risk it carries, if it gets busted. The proposed structure creates concentration of Risk among few hands and if one of these collapses, it could be disastrous for the entire capital market.

There seems to be no financial and/or legislative justifications for appointing Independent Directors, Chief financial Officers/Internal auditors in family owned private companies and to incorporate Corporate Governance Rules as mandatory. These are being required to meet the requirements applicable to listed companies. In this situation, there remains no distinction between listed and private company.

It is intended that only trading and clearing category will be allowed for custody of shares. Why small brokerage houses are not being trusted is beyond ones understanding. During the last two years, the KSE 100 Index dropped from about 53,000 to 28,600, all brokerage houses fulfilled their obligations and there has been no market default to investors. At present, it is impossible for brokers to transfer or misappropriate shares held under custody of their clients. Brokers are required to keep the custody of cash of the clients in a separate bank account and cannot use this for any other purpose.

The Direct Payment System further assures that the payment of the clients’ money can be credited to the respective clients account through National Clearing Company and cannot be misused. Even the payment of one client cannot be made to any other client. This model has been successfully implemented internationally and is being used in the Pakistan Mercantile Exchange. This payment model has not been implemented in PSX for unknown reasons. This model if implemented would totally eliminate the risk of any embezzlement and also benefit the investors as they would get instant payments directly into their accounts without going through the bank’s clearing.

Payment of dividends are being directly credited to the shareholders account successfully. We should be able to settle investor’s trades also directly through banks. SECP’s suggestion to introduce Professional Clearing Company is more acceptable and a neutral option model instead of creating three tier split in the investing brokerage business. The risk factor from capital markets could be easily eliminated provided there is an intent to do so.

Most of the smaller investors do not trade with big houses as trading at the Exchange requires utmost trust and faith, which was provided by the smaller players due to their personal touch in the whole chain. Bigger houses traditionally dealt the institutional buyers and ignored the small investors and therefore, lack the expertise to deal small investors. It remains arguable if the trading and clearing category houses would be able to win them over or the small investors leave the capital markets. It would be extremely difficult to bring in new investors under this changing scenario.

(The writer is Fellow member of Chartered Institute of Management Accountants UK, LLM Corporate Law, and LLB Hons. UK)

Khalil Ahmed, "Putting brokerage houses under financial strain," Business Recorder. 2020-01-22.
Keywords: Economics , Capital markets , Economic growth , Investor community , Financial strain , Brokerage houses , Pakistan , KSE , SECP

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