The age old saying, "every dog has his day" is meant to convey

the truism that all arguments can find support at some point
in time. In the context of Pakistan's stock market, two distinct
arguments are vying for public attention today. One school of
thought is looking at the collapse in share traded volumes by
8 times relative to 3-4 years ago as evidence that Capital Gains
Tax (CGT) has scared away retail investors. This group is
supposedly supported by brokers whose earnings are dependent
on commissions generated from trading volume. Collapse in
volume means collapse in income, hence the fixation of blame
on the tax regime. The crisis facing the stock brokerage industry
can be gauged by the fact that over the last one year out of
approximately 2,500 KATS terminals available to members of
the KSE, around 1,000 have been disconnected due to lack of
business.
The other school of thought is joyously announcing that collapse
in trading volume is a sure sign that speculation has stopped
and, in fact, the Capital Gain Tax should not be viewed simply
as a revenue generating mechanism but rather, as a conscious
policy decision to promote long-term investment and curb
speculation. This view Is supposed to be supported by anti-
broker lobby within political and bureaucratic circles.
Which view is correct? And why should anyone other than
immediate parties - investors, brokers and finance/tax officials
- be concerned about this issue of liquidity? In this article we
attempt to break a few myths and conventional wisdom
regarding market liquidity and speculation and highlight some
actions that we believe can be beneficial to promote the primary
objective of the stock market. This is to facilitate efficient
sourcing and allocation of capital to productive sectors of
Pakistan's economy on the one hand, and to provide a repository
of an attractive asset class for savers & investors on the other
hand.
Let us focus on the issue of liquidity and speculation as that
currently appears to be the central theme related to the stock
market. Assume for a minute you are in a world where there
is no speculation, all investors are able to understand how listed
companies are likely to perform and can freely make the choice
of investing in the shares of various listed companies. In this
world different investors are unlikely to have widely differing
views about a company's future prospects. So if a company is
expected to perform well everyone will want to buy it's shares.
But in this case, who will sell? Who is the seller? Conversely, if
everyone expects a company's performance to be poor, everyone
will want to sell it's shares. If so, who will buy it? Where is the
buyer?
Luckily, we do not live in such as idealized world. In the real
world, investors are of varying skills and views. Thus, an investor
who has greater insight into a company, its industry dynamics,
regulatory framework, etc. can make a more accurate estimate
of future performance than an investor who has done a naive
analysis. Therefore, at any given point in time, there will be
sellers for a particular stock and there will be buyers. The more
people that participate in the market, the more buyers and
sellers there will be and thus the more liquid the market will be.
Now, also in the real world, there are different types of investors.
Some invest for the long term because it has been shown than
over long periods, equity investments generally provide greater
protection against loss of purchasing power due to inflation
than many other liquid financial investments. The emphasis is
on "liquid". One can perhaps get better return from real estate,
but it is not liquid. You can not quickly dispose off real-estate
if you need urgent liquidity. Even with bank fixed-deposits or
national saving schemes, early withdrawal attracts considerable
penalty which can sharply reduce your return on investment.
Equities can be more liquid depending on the shares you invest
in. When you want to sell, you would like to sell your shares as
near the current market price as you can get. This means there
needs to be a ready buyer for those shares - some one who
feels that the share price has the potential of going up after
you have sold it and he/she has bought it. He or She is willing
to take that risk. It is that risk taker who is providing the liquidity.
The larger such participants in the market, the more liquid the
market is. .
Now this risk taker may or may not be a long-term investor. It
is entirely possible, in fact more often then not, it is usually the
case that the risk taker has a much shorter investment horizon.
If you, the initial investor, are selling not because you think the
The Karachi Stock Exchange
(Guarantee) Limited
STOCK MARKET LI QUI DI TY -
" EVERY DOG HAS HIS DAY"
by Nadeem Naqvi, Managing Director, KSE
This article was printed in The News - July 12, 2011
Stock Market Liquidity 02
shares of a company have no future but because you need
liquidity then you should find ready buyers. At the same time,
it is also possible that you are selling because you have achieved
your targeted return (e.g. 20%) over one year and don't want
to take any further risk of holding on to these shares, so you
sell. Someone else may have done their analysis and feel that
the return potential (from the time you bought those shares)
was 35% in a year's time, so there is still a 15% return potential
left and they are willing to take that risk for the remaining part
of the year. So they buy the shares from you for achieving 15%
return in, say, six months. .
Consider next the case of a Fund Manger, managing a mutual
fund equity portfolio. He or she is limited by regulations as to
how much percentage of the fund they can invest in a particular
stock or sector. Once that limit is reached they have to sell.
Who will buy from them? Either another fund manager who
likes the same stock/sector and is within limits or our so-called
individual/retail risk taker. In practice, all over the world, it has
been observed that Fund Managers tend to behave as a herd.
Thus chances are that when a Fund Manager wants to sell due
to reaching maximum limit of holdings, other Fund Managers
may be in similar predicament and may not wish to or be able
to buy. So who will provide liquidity? It is the individual/retail
risk taker.
The above examples were highlighted to show the crucial role
of the individual/retail investor in providing liquidity for an
efficiently functioning stock market which allows for economically
viable price - discovery of shares. The larger the number of such
retail investors, the more risk taking capacity is available to the
market/system as a whole along with greater liquidity. Absence
of retail investors has the opposite effect. In India and Bangladesh
for example, retail investors make up 60-80% of market volume.
In Pakistan today, they account for less than 40% of market
volume. As far as holding period of investments in concerned,
less than 10% trades are for periods of one year or more all
over the world. Reportedly, the average holding period of a
trade (buy & sell) is less than 5 minutes for over 90% of daily
volume traded at the New York Stock Exchange (NYSE).
This brings us to the question of speculation. The term speculation
is generally used loosely and with negative connotations - i.e.
it is a really bad thing. My view is more nuanced. Speculation
per say is not bad. If I am willing to put my money where my
mouth is because I am confident about my insight regarding
a company's potential performance, why should I not be allowed
to do that? Yes, I am speculating and as long as I am not having
an unfair advantage like insider information or front running,
then I am taking a considered risk and providing liquidity to
the market. The problem arises when the speculation is based
on excessive leverage (borrowed money) which is far greater
than the investor's loss absorption capacity. This magnifies risk
to the broader market. If many investors / speculators do this,
than the overall market risk becomes large and creates
unacceptable risk to all market participants, including long term
investors. This is known as "systemic risk" and this is what
happened in 2005 when Badla was used recklessly and without
much checks and balances. Similarly in 2008, the problem was
over leveraging followed by regulatory failure of keeping the
ready market floor for a long time while allowing off-market
transactions. On top of this, additional regulatory lapse was a
lack of strong legal action by the Apex regulator against a few
(about 6-8) broking firms who were alleged to have committed
outright fraud of using client shares for settling their own debt.
It was not speculation per se but a combination of regulatory
mismanagement and fraud by some brokers that caused losses
for average retail investors to multiply hugely due to excessive
leverage and sudden withdrawal of credit facilities by banks. In
fact, the bulk of losses accrued to investors who went for the
loosely regulated badla market. For genuine long term investors
who bought in cash and invested in strong companies the value
of their shares have substantially recovered by 2011. Yes, they
have had to pay opportunity cost of seeing their principle
diminish for a time and lower paper returns, as fixed income
interest rates have gone up - but this is the cyclicality of markets.
As the cycle turns these investors are more likely than not to
come out winners. The lesson is that if you are investing for the
longer term, invest in quality companies with strong performance
track record. And if you want to trade and take the risk of shorter
term trading in shares, do not use excessive leverage and never
take more risk than your capacity to absorb losses.
Having said that, I believe it is the duty of the frontline regulators
(stock exchanges) and the Apex regulator (SECP) to create an
environment where systemic risk is contained, cheating is
minimised and there are checks & balances on excessive greed
by means fair or foul.
In terms of the KSE, significant measures have been taken over
the last two years to minimize: (a) the potential of excessive
leverage-based speculation and (b) the potential for misuse of
client shares and fraud by brokers. Concurrently, to deter
"baynami" (unrecorded origin) money from the exchanges,
know-your-client (KYC) regulations and anti-money laundering
measures have been enacted by the SECP and implemented
by the stock exchanges.
As a result today, with implementation of the Automated
Securities Settlement System at CDC, the National Clearing
Company (NCCPL) deposits shares directly into investor sub-
account instead of first transferring shares into broker's main
account. In fact, in the next phase a project is under study
whereby brokers should have no control over investors' shares
or investors' funds. They should simply perform the brokerage
function of research and order execution. Another system now
implemented is to prohibit trading by employees of brokerage
houses through other brokerage houses by linking all CDS
accounts with respective Unique Identification Numbers (UIN's)
in the NCCPL UIN database.
In order to help improve liquidity in the market, a very tightly
controlled Margin Trading System (MTS) was introduced and
dealing requirements in the deliverable futures market (DFM)
were made ultra stringent. After observing that over regulated
requirement led to these products being a non-starter, a more
balanced approach is being considered by the Exchange while
keeping systemic risk management framework intact. This is an
evolving situation and will require reality checks at each step.
The Exchange is finalizing, under SECP guidance, procedures
for delisting companies that have been on the defaulters counter
for a long time. As the Exchange does not have legal powers
to take action against these companies, it is working out a plan
of action with the SECP so that the SECP can initiate legal
proceedings against such defaulter companies, their directors
and office bears to provide relief to investors. .
The Exchange is also working hard to find ways to help in
compensating investors who lodged complaints with the
Exchange against defaulted or expelled brokers. Under Pakistan
law and due to certain court rulings there have been problems
in providing early compensation by way of sale of forfeited
membership and through the Investor Protection Fund. However,
the Exchange is working with its legal advisors and in conjunction
with the SECP to overcome these legal hurdles and start whatever
payouts are possible as early as practicable. Unfortunately, as
is often the case in this country, many fictitious claims have also
been received. The Exchange has obtained the services of
reputable independent auditors to verify all claims so that
genuine investors who lost money are able to be compensated
as much as possible.
Based on the above developments, I would like to say that
today's risk management system at KSE, CDC and NCCPL is
much more stringent and security of investors' assets is
significantly better than previously. I have personally informed
members of the brokers community that the frontline regulator
function of the Exchange has, as its prime responsibility, the
protection of investors, providing a level playing field to big &
small investors and strive to deter wrong doing. In the last case,
the Exchange's future operating philosophy will be that there
is zero tolerance for bad apples in the brokerage industry, if
this industry is to survive and serve investors.
A final thought for investors: As the title of this article says,
"Every dog has his day," we are at that point in the economic
cycle where fixed income investments are preferred due to high
risk free rate (on government bonds). But this too shall pass.
Interest rates cannot stay high indefinitely, industrial & consumer
demand cannot remain suppressed for long. As the cycle turns,
equities will outperform again. Actually, Pakistan is ahead of
the Asian region where monetary tightening is at early stages
while in Pakistan we may see monetary easing as early as the
first quarter of calendar year 2012. Those who have the financial
risk taking capacity and are able to spend time and energy
doing proper research, have the opportunity to go against the
crowd and invest in high quality, proven performance record
companies, to obtain higher potential returns over time as
compared to fixed income securities. But remember, with
potential for higher return comes higher risk - please do not
fall victim to greed, do not take more risk than you can bear,
aim for reasonable return and once you achieve it, sell and
relax.
Stock Market Liquidity 03
Disclaimer: Investing in stocks & shares carries various risks, including loss
of the principal amount. Investors are advised to conduct this own research
before investing or take advice from professional investment advisors.