A decade lost: The fault in our capital markets

The recent phenomenon of crypto assets has further upended the business model of the exchange

The business of an exchange (whether equity, or commodity, or any other) has been completely upended by technology. Trading pits have been replaced by trading terminals, and in most cases traders have been replaced by algorithms. Access to data even a nanosecond earlier is considered to be an advantage worth exploiting in most developed markets. The marginal cost of executing a trade for an exchange is close to zero given the prevalence of technology, pushing exchanges to look for additional streams of revenue, or greater cost efficiencies.  

Additional revenue streams propped up through introduction of new and innovative products, ranging from a wide range of Exchange Traded Funds (ETFs), to vanilla and exotic derivatives, tracking everything from a price of an equity, to an obscure commodity like cardamom. Exchanges created a market structure which incentivized availability of greater liquidity. Over the last decade there has been consolidation of exchanges globally, as survival was dependent on either scaling up through an expanding product suite, and consequently higher number of market participants, or through realizing cost efficiencies through technology.

The recent phenomenon of crypto assets has further upended the business model of the exchange. The market for crypto assets works round the clock, and every day of the year. Its a truly global phenomenon where an investor from Pakistan can sell or buy crypto assets from an investor anywhere in the world through a mobile app, something which is not typically possible in conventional markets, unless one is a High Net Worth Individual (HNWI), or an institutional investor. Investor onboarding takes only a few minutes, another few minutes for transferring funds, and one is ready to invest. Clearing and settlement is instantaneous, a far cry from a traditional T+2 mechanism. The operational efficiencies as introduced by crypto exchanges will shape the way conventional exchanges operate, maybe even led to convergence in the middle somewhere. If anything, it’s only going to get faster, and more efficient, with capital gravitating towards platforms providing ease of access.

Meanwhile, in Pakistan we have had a lost decade for capital markets.  The number of investors have largely remained flat while they have risen substantially across the region.  Fintechs in India add more new investors on a monthly basis than the current number of total investors in Pakistan.  Young professionals here are more likely to have an account with one of the crypto exchanges than with the local bourse, largely due to a simple and no-nonsense onboarding process.  The investor onboarding process for the local bourse involves signing multiple documents, going through multiple hoops to justify your source of income, and waiting for a few more days till you can finally trade.  Some efforts have been made by the regulator in making the process more investor friendly, but not much has changed, as the onboarding process continues to be rooted in inefficiency with the rare exception of a few.

On the product side, the local exchange has only two major products, a ready (cash) market, and a futures market. Overall leverage in the market has been consistently declining in US$ terms given sparse liquidity. The exchange recently introduced ETFs, but scant volumes have ensured that the activity remains sublime. Despite trying multiple times, the exchange is yet to offer derivatives as a product, largely due to inherent inefficiencies in the market. Presence of circuit breakers, which basically do not allow most stocks to move beyond 7.5 percent is not conducive for any sort of market making. In absence of market makers, it is not possible to ensure availability of liquidity for derivatives, or ETFs.  A fixed income market (outside of banks) is also non-existent, with a handful of trades being done on a daily basis despite half-hearted efforts to gain traction every once in a while.

There have been many capital market plans, often funded by sovereign debt, but not much has changed. A key element missing in all those plans is implementation, and that is often done in a manner which is contrary to principles of a free market. Minor kinks to control market dynamics, or to create an environment where only a selected few market participants can succeed often leads to a market failure, or a flawed implementation.

Locally, capital markets not only need fresh human capital, but also fresh institutional blood, wherein existing market participants are too comfortable with the status quo.  The blueprint has been replicated across many jurisdictions, and that has enhanced the ability of markets to raise capital, while providing investors with a broad suite of products — the question remains of who is going to bell the cat, and actually catalyze market development rather than serve vested interests.

Ammar H. Khan
Ammar H. Khan
The writer is a non-resident Senior Fellow at the Atlantic Council. He has previously worked at several financial institutions in Pakistan, both in commercial banking and capital markets.

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