As Pakistan International Airlines (PIA) has been going through the process of privatization, the stock market recently felt the aftershocks of this decision. The events which started in August of 2023 snowballed into a mess which came into reckoning in May of 2024. With investors having to scramble at the last moment, questions are being raised in regards to the systems that have been put into place by the Pakistan Stock Exchange (PSX).
The PSX would contend that everything was done according to the law and that they had no other option. Investors are claiming they are facing massive losses. What ended up happening was a perfect storm of events in a case of everything happening all together. Critics feel that exceptions could have been made or the disaster could have been avoided altogether. Who is at fault really? Profit explains the whole ordeal.
Please put your tray tables in an upright position and fasten your seatbelts.
The making of the disaster
Our story starts in the air conditioned halls of the Government of Pakistan. In August of 2023, it was decided that PIA was going to be privatized. The decision had been made to cut out much of the bureaucratic red tape and the deal was going to be made to plug in the hole which was draining the exchequer. The task was given to the Privatization Commission to do all that was necessary and in November of 2023, a financial adviser was tasked with carrying out the transaction. As PIA is a listed company, the formal announcement of the deal was made public on the 14th of December.
As soon as it was announced that PIA was going to be privatized, the stock price jumped by 50% from Rs 6.22 to Rs 9.22 and the share price saw upper locks being hit everyday. There were buyers interested in buying the shares as they saw that the company had a higher value and once it was sold, they would be able to get a much better price for it. With buyers excited for the prospects of the company, the stock price had doubled from Rs. 6.22 to Rs 12.07 by January 2024.
Once the due diligence had been carried out, the financial adviser, EY Consulting LLC Dubai, proposed a legal segregation plan and based on that drafted a Scheme of Arrangement. This Scheme was presented to the Federal Cabinet who approved it and directed the Aviation Department and PIA to carry out the regulatory actions in order to implement this scheme. The approval was given on 19th of February 2024.
The market reacted to this announcement as the share price rallied again from Rs 10.8 on 29th of February to Rs 27.61 on 21st March 2024. This was an increase of 255% which saw the share price hit new highs. As the share price again started to lose some steam, on 26th March , the company announced that its board had approved the Scheme of Arrangement. This further pushed the share price to Rs 31.54 by 29th of March.
The book closure is announced
The system that has been designed by the PSX and the Securities and Exchange Commission of Pakistan (SECP) mandates that different requirements need to be met when a company is going through a restructuring process. In the case of PIA, the privatization would mean that different approvals are required by the SECP in order to make sure the investors are made aware of any developments.
On May 3rd, SECP approved the Scheme of Arrangement. In simple terms, the Scheme would have meant that shares of PIA would have been canceled and PIA Holding Company (PIAHCL) would be allowed to own 100% of the paid capital of PIA. This would have meant that Non-Core Undertaking of PIA would be transferred to PIAHCL while the aviation business is maintained by PIA. After this restructuring had been carried out, shareholders would be given the shares of PIAHCL in the same proportion as the ones they held in PIA before the restructuring had been carried out. This is a roundabout way of saying that some assets of PIA would be transferred to another company (PIAHCL) and the shareholders who held the share of PIA would be given shares of PIAHCL.
Seems simple enough.
But then who will get how many shares of the Holding Company? In order to determine this, companies are required to announce a date of book closure. What is a book closure? In the olden days, shares used to be physical and a complete record was kept by the share registrar of the company to make sure they had an accounting of who held how many shares.
As the system has become digital, shareholders hold shares in electronic form. There is still a registrar who sits in the middle to make sure his records are updated. Every day thousands of shares are traded and the registrar keeps track of these sales and purchases. Book closure is a date or a line in the sand that is set which states that all shareholders who held shares as on that date will be assumed to be the rightful owners of those shares. If the company has to give out any dividends, bonus shares or any other entitlement, the shareholders who actually hold the shares on that day will get that benefit. In the case of PIA, those shareholders will get the shares of the holding company who held the shares on 25th of May 2024.
The book closure date was also going to be the date when the shares of the company would stop trading in the stock market as well. This would allow the shares of PIA to be delisted and the holding company would soon see its shares being traded in the market. It is like a date when a clean cut from the market can take place.
Are you with us so far? Good. Now is when the complicated part begins.
The future market problem
This all seems like the run-of-the-mill kind of stuff and comments on the efficiency of the stock market and the regulator that they have devised systems which are so effective that they can guarantee smooth operations without any glitches.
This seems to work until layers of complexity are layered on the top. This all starts with a notification released by the PSX on the 17th of May 2024 at 4 PM after the market has closed. The notice stated that as PIA had announced its own book closure on 16th of May, the PSX would pre-maturely expire the future contracts of PIA.
Confused? We know we have just introduced a huge concept into the mix. Let’s back up a little and explain what the future contracts actually are.
When the market is operating in a normal manner, shares of a company are being traded. While this market is functioning, there is also a future market that runs in parallel to the normal market. The price of the future contracts is linked to the regular market. The future market allows a buyer to buy a share in the future rather than buying it right now. The benefit? The investor does not have to put up the money right now. Let’s understand this with an example. Consider ABC is currently trading at Rs 100. An investor feels that the company will see a better share price in the future but does not want to put up the money for the share right now. So he goes to the market and buys a future contract of ABC-Feb at the start of February at Rs 101.
The future contract is usually trading at a higher price but the investors are not that concerned as he does not have to put up a total of Rs 101 for his shares right now. The market allows him to hold a position in the shares by only investing a fraction at the start. On the last Friday of each month, the investor has an option. Either he can put up the Rs 101 at which he was willing to buy the shares or roll over his position. This would mean he can buy the future contract in the next month which could be for Rs 103 and sell his position in the current month for Rs 102. He would lose out a bit as the contract he holds would be trading at a lower price and the contract for the next month would be expensive but again he does not have to put up all the money in one go. This allows the investors to hold a position in a share without having to invest a large amount.
On the other end of the spectrum are investors who feel that the share of the company is being traded at a higher price. In normal markets, such investors can short the share. After the 2008 stock market crash, shorting the stock has been banned in Pakistan. A work around to this ban is that the investor can sell the shares in the future. An investor does not even need to own the shares currently as he can buy them later. Let’s say he sells the shares for Rs 200 in the market right now. He expects the share price to fall going forward. By the end of the month, he sees that the share price has actually fallen. He can buy the cheaper share in the regular market and sell it as he has contracted to do. This means that he ends up making a profit. Just like the buyer, a seller can also roll over his position indefinitely by selling the share in the next month and buying in the current month. This allows him to square his position in the current month and roll over his position into the next month.
PSX used to allow only one future contract in the past. Meaning you could only buy or sell a future contract for the next month. Recently, this has been changed and now it allows buyers and sellers to trade three future months simultaneously.
Are you still with us or do we have to go over something again?
Now that you are all caught up, let’s get back to the notification. The notification stated that as the shares of PIA were going to be delisted and a book closure date had been given, the PSX was going to end all future contracts prematurely. They were supposed to end on 31st May, however, now the contracts would end on 21st of May. The contracts of May, June and July would end trading in the market on a single day.
In normal circumstances, the investors would see only one contract ending and that would allow them to roll over their position into the next month.
This could not happen here. As all the future contracts were going to end, there was no option for investors to roll over.
When all the contracts were going to end, investors had two options left. As they had bought the shares, they were required to either put up the money and buy these shares in totality or they could sell these shares in the market. The notification also stated that the future contracts for the Holding company were going to be opened on the 3rd of June 2024. This would leave a gap of more than 10 days where no future contract for the company would be trading.
This is where the problem started. With no option to roll over, investors had to either procure the funds or sell the shares they have pledged to buy in the future.
This led to a panic situation in the market. The investors who had bought the shares in the futures market scrambled to get funds in order to buy the shares and put up the money which was going to be required from them. They were willing to borrow money at 28% in the market in order to procure the finances.
On the other hand, they also had an option to sell. This option also proved to be a dud as everyone entered the market to sell their shares. This led to a fire sale where everyone was trying to liquidate their position as soon as possible. The market saw the price of the shares plunge from Rs 26.2 on 16th May to Rs 18.31 on 23rd of May. In 5 trading sessions, the share lost 30% of its value. Buyers were squeezed from both sides. On one hand they did not have the capacity to buy the shares and on the other they were not able to sell their positions either. With everyone entering the market at the same time, the lower lock was triggered which meant sellers were stumbling over each other to sell the shares while there were no buyers in the market.
The desperation in the situation can be seen by the fact that some investors sold their shares in the Negotiated Deal Market (NDM) at Rs 13.99 in order to sell their shares at any cost.
What PSX to blame?
In such a situation, it can be easy to point the finger at the stock exchange. According to the laws on the books, the PSX had little it could do. The Scheme of Arrangement was sent to the SECP on the 3rd of May and it was approved. The ball was in the court of the company to announce a book closure date which suited it. This was done on 16th of May. PSX had little that it could do. As they were given 9 days of time, they had to announce a date at which the future contracts would stop trading. With Saturday and Sunday being off and the settlement schedule in place, it only had 3 days in which it had to pre-maturely expire the future contracts which it did. All the laws and regulations had been followed which is expected.
Could it have been handled in a better manner though?
A situation similar takes place in the stock market on a quarterly basis. This is due to the fact that every earnings season,dividends are announced by a company. In order to determine the shareholders who should be entitled to the dividend, a book closure is given. After the book closure takes place, the dividend is credited to the account of shareholders. An example of this can be illustrated as follows. On 10th of October, a company states that it will give a dividend of Rs 1 to its shareholders and sets a book closure date of 15th October. What this means is that shareholders who hold the shares on 15th October will get a dividend. In terms of the share price, the share price will fall by Rs 1 as shareholders will get that in the form of cash dividend.
Let’s say that on 15th of October, the share price was Rs 100. After the book closure date passes, the share price will start trading from Rs 99. A shareholder who held the share on 15th of October will hold a share worth Rs 99 and would have gotten a dividend of Rs 1. He will be in the same position where he was when the share price was Rs 100.
Again this all seems simple enough. But what about the futures contract? The value of the futures contract is tied to the price of the share. On 15th of October, the future was worth Rs 101. Now when trading starts the next day, the future price cannot be reset to Rs 1 lower. What happens in that case is that as soon as dividend and book closure is announced, the PSX will list a B contract in the future. ABC-October will now have two contracts. ABC-October(A) and ABC-October(B). This allows the investor to roll over his position from Contract A to Contract B as he wishes to keep holding the future contract. Once the book closure takes place, Contract A will expire and B will continue trading in the future.
Investors who had to face a panic in the market state that something similar could have been done here. They state that a proxy could have been created where they could have rolled over their position from one contract to the other which was not allowed. PSX contends that as PIAHCL had not been listed and did not have a certificate of approval, no such proxy could have been created. No future contract could have been created for a share which was not listed in the market before that.
Again, the PSX is not wrong.
But the concern shown by the investors is correct. Not only for their own sake but for the sake of the whole market. In case the investors had not been able to cover their positions, this would have led to the whole system crumbling under pressure. What was the pressure? The case that cascading defaults would have taken place. If these investors had not been able to buy or sell their shares, they would have not honored the commitment that they had made in the market. An investor has promised that they would buy the share of PIA in July. Now that they were forced to buy it earlier, they could have backed out from this commitment as they did not have the necessary funds.
Similarly, someone had promised that they would sell their PIA shares to the buyer in July. Now, the PSX was mandating that the seller sell his shares while the buyer buys the shares. If the buyer would not have been able to buy the shares, they would have defaulted. The seller had the better position in such a situation as the stock price was crashing and he could easily buy the shares from the market. He had his pick as so many people were willing to sell their shares.
A default by a buyer can have a disastrous impact on the market. If one buyer defaults, the system is equipped to handle such a situation. The problem becomes larger when a lot of investors end up defaulting. There is a chain of commitment that links brokerage houses and investors. Once a trade takes place, the buyer and seller commit to the fact that they will buy or sell their shares respectively. In case one of them does not follow through, the market mandates that they do so with different mechanisms. If a lot of participants end up defaulting, it might become a contagion risk where brokerage houses start to topple over in the form of dominoes.
What the recent case highlights is that there is this risk that exists in the system. Maybe the market has been able to dodged a bullet for the time being. The actual impact of this incident will see ripples far into the future. The effects of the 2008 market freeze are still felt to this day. What needs to be pondered is that could exceptions have been made in this case where things could have been kicked down the road? Could a one-time exception have been made where PSX could have extended the date of book closure a few days to provide an easier escape to the investors. This would have eased some of the pain and panic which was seen in the market.
According to the data released by PSX itself, there were more than 33 millions shares that were active in the May and June futures markets. The book closure had been called by the company and PSX to only change the symbol of the company being used in the market. The book closure did not have any material impact in terms of dividends or stocks. In face of an action with such little consequence, maybe this could have been handled in a more delicate manner rather than doing it in such a hurry.
There is also speculation in the market that traders who had an inside track carried out blank sales in the future market. Around 22nd April, blank sales or short sales of future contract stood around 2.42 million which had increased to 8.64 million shares on 17th May. An insider who had knowledge of the book closure date could have used this information to their own advantage. They could have shorted the shares in the future in the lead up to the date of book closure. As the market panic would be triggered, the stock price would fall and they could buy the shares at a lower price pocketing the difference. There are concerns that as the Scheme had been passed on 3rd of May, an earlier book closure date could have been mandated seeing the future contract was trading.
The weight of the recent disaster was mostly borne by the investors which is the case most of the time. There was hue and cry over the sudden nature of these events. But this disaster also showed that there are vulnerabilities in the system which not only cost the investors but also have the potential to impact the whole market. Measures need to be devised by PSX to make sure similar episodes do not take place in the future. This will protect the investors and also look to protect the broader market as well.
