Brokers default – PSX finally gives its side of the story

As the Pakistan stock market continues to make steady advances, the news of two brokerage houses defaulting at less than two weeks apart shook the trading floors of the exchange. Media reports regarding default of stock brokerage houses with insinuations of the regulators not performing their job well are enough to shake investor confidence.

The Pakistan Stock Exchange (PSX) has issued a press release to set the record straight and inform readers about certain processes falling under the securities market regulations, as well as highlighting aspects that the investing public should be aware of when investing in the stock market and dealing with stock brokers.

The press release reads as:

To begin with, there is a well-defined and properly structured regulatory regime under which stock brokers (in technical terms, Trading Rights Entitlement Certificate [TREC] holders) have to operate. There are three capital market institutions, viz., Pakistan Stock Exchange Limited (PSX), National Clearing Company of Pakistan Limited (NCCPL) and the Central Depository Company of Pakistan (CDC) all of which play a role in the smooth functioning of the capital market and facilitating investors therein.

Roles of Capital Market Institutions

PSX’s function is to manage that (i) investors’ share buy or sell orders are executed on PSX’s trading system in a timely, efficient and secure manner by brokers and (ii) act as front-line regulator to see that brokers are in compliance with rules and regulations of the Securities and Exchange Commission of Pakistan (SECP) and PSX. NCCPL’s function is to ensure that once orders have been executed, the clearing and settlement proceeds smoothly and no market risk due to non-settlement occurs. CDC’s function is to act as depository of investors’ shares which have been transferred from NCCPL into their investment account or, as per their instruction, in their brokers’ sub-account under the investor’s name.  Each of the above three capital market institutions operate under their own rules and regulations covering their specific area of operations and overall, all three institutions fall under supervision of the SECP. As a result, there is close collaboration between the SECP and PSX/ NCCPL/ CDC not only on regulatory matters but also in the area of capital market development and investors facilitation and protection.

Safeguards for investors

While there are clear rules about how the brokers should deal with their investor clients, under SECP’s guidance the capital market institutions have also created safeguards to protect investors’ interest.

First, when an investor opens an account with a broker he/she also has to open an account with the Central Depository Company (CDC). In the account opening form the investor has the option of instructing the broker to have all his /her shares placed in the “Investor Account” at CDC and not in broker’s sub-account. No one, other than the beneficial owner / investor himself/herself at CDC, can move any share in or out of account for his / her CDC Investor Account. So investors who have their shares in the CDC Investor Account and wish to sell their shares, they must give instructions to CDC to transfer the shares to the broker’s sub-account in their name and then instruct the broker to sell these shares. This is the surest way of guarding against any broker who may transfer / sell investor’s shares without authorization of the investor.                

Next, CDC then adds another layer of protection for investors. When opening an account, it is mandatory for investors to specify how they wish to receive their statements of shares held at CDC, either by e-mail or courier service.

Third, CDC also has a service where every single movement of shares from the investor’s account is sent by SMS to his / her mobile phone.

At the same time, the investor can at any time access CDC website and using password provided, find out what shares are present in their Investor Account or in the broker’s sub-account and also, if any shares have been pledged as collateral for borrowing purposes. The investor can then match this information with the information provided by the broker and see if there is any difference. In case of any difference, the investor can enquire from his broker and if not satisfied, he can lodge a complaint with CDC and even PSX. The PSX website has a section for lodging complaints electronically in a prescribed from, or alternatively, investors can download the form and send it by mail after completing it to PSX Offices.                

Similarly, NCCPL also provides a facility to investors for their protection. An investor with valid UIN (Unique Identification Number) provided by the NCCPL when a brokerage account is opened, can register with NCCPL and using his / her password, see the history of his / her buy and sell transactions that are done by the broker on his / her behalf.

If investors avail of these facilities and services it is highly likely that they will be able to safeguard their shares better. Not only that, but by using these facilities they will be able to alert quickly the regulatory authorities of any unauthorized transaction in their name or related to their shares. This will enable the regulatory authorities to take timely action to protect investors’ interest and also examine the affairs of the broker to ascertain if there was genuine mistake or deliberate deception / wrong doing and if there was, then take appropriate action against such broker(s).

Institutional check and balance system

At their end, the capital market institutions and the Apex Regulator SECP, have evolved a system of checks and balances to see if brokers are complying with regulation and ensuring safety of investors’ assets. There are periodic audits of brokers as well as spot inspections. If discrepancies between broker record & CDC record are discovered, the CDC sends out notices and letter to investors which have CDC account balance details and asks investors to verify these balances. Investors can check if the CDC statement matches with broker statement sent to investors. When an investor responds to CDC by saying this is not a match, CDC immediately contacts the broker to explain the difference and rectify the discrepancy by giving the broker a chance to explain. If the broker does not respond or does not satisfy CDC, penalty is imposed on the broker with notification to the SECP, PSX and NCCPL. In case of serious non-compliance, the broker can also be suspended as per laid down regulations.           

A similar process is followed by PSX and NCCPL as related to non-compliance of brokers as related to these two institutions’ regulations. At the same time, SECP also conducts its exercise to check broker compliance and imposes penalties and actions when broker is found to be non-compliant.

Despite the above measures, there are cases where investors have lost shares due to some brokers’ illegal behavior. In some cases it has also come to light that investors themselves have given loan to brokers and received fixed monthly returns which is a completely illegal activity by both parties under the relevant regulations.

Regulations Tightened Over Time and New Initiatives Underway

Over time, regulations have continually been made more stringent and regulatory oversight strengthened. In this regard, in September 2015, the SECP took a major initiative to notify JOINT INSPECTION Regulations under which a specific Joint Inspection Team (JIT) was formed. The JIT started operating under the supervision of JIT Oversight Committee composed of Chief Regulatory Officers of CDC, NCCPL and PSX. Every quarter, based on predefined criteria, sixteen to eighteen brokers are randomly selected for inspection with final report of the inspection to be submitted to the JIT Oversight Committee in 75 days from the start of inspection. Based on the JIT final report the Committee informs SECP and asks respective capital market institutions to take regulatory action against the broker if a non-compliance is confirmed.

It is worth noting that in the recent incidents of some brokers such as M.R. Securities and AWJ Securities, it was the Joint Inspection Team that found non-compliances of the brokers. No investor complaints had been lodged. These firms had been brokers of the former Lahore and Islamabad stock exchanges and only came into PSX’s ambit after the January 2016 Integration of the exchanges. As such, this was the first direct audit with PSX involvement. A System Audit of M. R. Securities by outside, independent authorized auditor had not highlighted any wrongdoing. Thus the JIT initiative of SECP actually was effective. Unfortunately, before the full report with evidences could be completed, the broker shut down. The SECP and PSX are now fully focused on recovering the maximum assets of genuine investors and return those to investors as early as possible.

Further, specifically as related to the issue of custody of investor assets, the SECP along with CDC, PSX and NCCPL are working to fast-track implementation of two key initiatives:        

(i) Standardization of broker back office system so that all brokers follow clearly specified standardized recording and accounting procedures of their dealing / transactions with investors and same can be audited easily by the Joint Inspection Team (JIT) on regular and spot-check basis.

(ii) Formation of specialized company as subsidiary of CDC, to be called Professional Clearing Member (PCM) which will take over the responsibility of managing all assets of investors (both money and shares). When implemented, this will allow investors the option to use PCM rather than have assets in brokers’ sub-account.

Capital Market Remains Strong and Vibrant

Despite the recent setback, Pakistan’s capital market remains strong and vibrant. In the half year ended December 2016, the average daily value traded rose to Rs15 billion from Rs10 billion a year ago, showing a 50% growth. During January 2017, the average daily value traded further improved to Rs18 billion. In calendar year 2016, the KSE-100 increased by 40%, making  Pakistan the best performing stock market in Asia. Thanks to the improvement in macro economy and excellent financial results of the listed companies, earnings growth of KSE-100 companies is amongst the top in Asia and the Return on Equity of these companies is one of the best in Asia. These factors and continued improvements in functioning of the capital market has led to Pakistan market being upgraded to be included in the MSCI-Emerging Market Index from its previous position of being in the MSCI-Frontier Market Index.

Furthermore, just last week a SECP formed Committee on Derivatives Trading has submitted its report to the Commission with specific recommendations on launching derivative products and their risk management regime. It is hoped that this will enable SECP to make appropriate Regulatory changes in order for PSX to launch derivatives trading in Pakistan capital market. This will further improve liquidity and provide investors with greater choices in managing their investment portfolios.

No doubt there is room for improvement in the systems of checks and balances, technology driven control and audit systems that can identify non-compliances early so that regulators can become more proactive.

The Bottom Line: Vigilance

At the heart of it all is safeguarding investor interest. To be successful in this, partnership between capital market institutions and investors is essential. While PSX, CDC and NCCPL will continue to improve their systems regarding market and broker risk management under the guidance of the SECP, investors also need to exercise care. They need to be vigilant and use the facilities discussed above to keep a check that their broker is providing them with correct position of their assets and trading activity. If at any time investors find discrepancies between what the broker statement is showing or what broker is telling them and what CDC or NCCPL data show, they must immediately inform the regulators so that timely action can be taken to safeguard their assets. Again and again, it has been observed that investors simply accept broker’s explanations and do not independently check the facts which are easily available to them. Investors must be also be aware that brokers are not allowed to obtain loans from investors in any form and pay fixed return. That is an illegal action. If any broker offers this kind of service, investors must immediately inform PSX and SECP, and strong action will be taken against such broker if there is proof. Finally, investors must be very cautious when broker offers them financing for purchase of shares. They must make sure they understand how it is being done and only accept if it is through the NCCPL’s margin trading system or margin financing system. Anything outside this may carry risks beyond the risk of share price going down.


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