‘A crucial step in the right direction’

The Securities and Exchange Commission of Pakistan (SECP) has taken a crucial step in the right direction by re-introducing what has been billed as a “New Broker Regime”. The NBR was originally part of the Securities Brokers (Licensing and Operations) Regulations, 2016 but had been rescinded in 2017.

The NBR creates 3 categories of brokers: Trading Only (TO), Trading and Self-Clearing (TSC) and Trading and Clearing (TC). Under the NBR, only well-structured and well-capitalized brokers would be allowed to keep custody of client assets.

The NBR aims to implement best international practices in Pakistan with regard to broker regulation, thereby strengthening the brokerage industry and improving investor protection and market efficiency.

Most markets have a form or another of the NBR. The model emerged in the US in the 1970’s in response to brokers’ desire to outsource back office functions. It is known in the US as an “introducing/carrying broker” relationship.

The rationale is simple: outsourcing non-core custody and back-office operations allows a brokerage firm to focus on its core business, whether that is retail clients, institutional clients or investment banking.

A similar model evolved in Canada around the same time. In addition to back office functions, trading is also often outsourced to the carrying broker, in which case the introducing broker may not be a member/participant of the stock exchange. Over 80 percent of Canada’s roughly 170 brokerage firms are non-clearing (the equivalent of TO) and some of them serve tens of thousands of clients with billions of dollar in assets.

Coupled with other investor protection measures – including a well-structured investor protection fund – this model has made the brokerage industry even safer than the banking industry in North America. It has been decades since a client last lost money to a Canadian registered broker bankruptcy.

Given that it would lead to a stronger brokerage industry, an environment far more conducive to market development – because clients would no longer lose their life savings to broker bankruptcy – and a wider choice of operational models, it is quite paradoxical that so many of Pakistan’s brokers oppose the new regime.

Why is it that a regime that was broker driven in the most successful market in the world is being resisted in the emerging market which is most in need of improvement?

The answer to that paradox lies in the fact that most of Pakistan’s “brokers” are not really brokers to start with: if memory serves me right, in 2018, the bottom 50 percent of Pakistan’s officially “active brokers” accounted for only 2 percent of Pakistan Stock Exchange (PSX) volume. The bottom 75 percent accounted for a mere 5 percent of PSX volume.

These “legacy brokers” are remnants of the old days when the stock exchange was a private club and membership was a status symbol. They obtain heavily subsidized services from PSX (including IT services, office space and some of the lowest trading fees in the world), which starves the exchange of the financial resources required to invest in market development initiatives. Meanwhile, investors and listed companies – rather than brokers – pay the bulk of the fees at CDC.

The presence of these marginal legacy brokers has also caused both the frontline and the APEX regulators to apply the “least common denominator” approach and spread their limited inspection capacity over a large number of brokers. The system protects brokers far better than it does investors.

Although a majority of the bottom 50-75 percent of brokers may not be economically viable as brokers, many of them are nonetheless bona fide market participants who should be encouraged to continue to trade and invest, as clients. That is how these types of participants (proprietary trading houses, family offices and others) operate in other markets.

SECP and PSX may explore the possibility of a “transition program” or incentives for those who wish to relinquish their license.

Those who insist on keeping their broker status must accept to comply with the requirements of the NBR in the TO or TSC categories, just like Pakistan’s mainstream stockbrokers already do. I will state the obvious: not only is the APEX regulator fully justified in enhancing capital and other requirements for clearing brokers, it has a statutory obligation to do so as per its mandate to protect the investing public and promote market efficiency.

The stock exchange is more than a mere microcosm of Pakistan’s economy: it is a vital part of its structure. The country cannot truly succeed economically without a vibrant capital market, built around a modern and efficient stock exchange where investors’ interests are first and foremost. Pakistan can develop its capital market or it can preserve the privileges of a small group of irrelevant legacy brokers, but it cannot do both.

The writer is a former CEO of Pakistan Stock Exchange