Stock market readying for transformational change

The Colombo Stock Exchange’s plans to improve surveillance and governance, develop new products, reduce risk, strengthen market infrastructure, grow the investor base and develop institutional capabilities will bring the capital market out of the shadows

Guest Column By Ravi Abeysuriya

The discussion about stock market regulation has concentrated on the implementation of new risk-based capital rules and reforms that have been on the agenda, some for over a decade. The Colombo Stock Exchange (CSE) announced the adoption of risk-based capital adequacy from March 2017. Other long-outstanding reforms may also soon be implemented. The stock exchange is an integral part of the capital market that provides the platform for buyers and sellers of securities to trade, and hence, assures liquidity for investors.

However, investor participation at the CSE is very low. Despite there being more than 750,000 central depository accounts, many are duplicates or dormant. In total, it is estimated that only about 25,000 accounts trade actively. It is a vicious cycle, as low participation makes the market less attractive to investors, leading to yet less participation. The CSE has ambitious plans to improve surveillance and governance, develop new products, reduce risk, strengthen market infrastructure, grow the investor base and develop institutional capabilities. These plans, once implemented, are expected bring in significant benefits from 2017 onwards.

Over the last few years, the stock market has seen its collective brand suffer greatly. The lack of investor confidence is just a symptom of broader challenges faced by the industry: competitive pressures and low margins, brokers ignoring rules and good governance, as well as misaligned incentive structures that create conflicts of interest and disproportionately reward turnover over governance.

Stockbroking firms today face difficulties ensuring that their employees act responsibly and in the best interests of their clients. Some businesses have struggled to live up to their fiduciary responsibilities, and significant reputational damage and distrust has resulted. In the stock market, we expect market stakeholders to inculcate professionalism and ethics in all their dealings in order to foster trust. Trust is critical to build capital market confidence. It’s confidence that underlies the development of a robust and efficient stock market.

Establishing a strong culture of ethical conduct is essential to correcting these conflicts of interest and restoring investor confidence. Stockbrokers would have to ‘change for the good’ and embrace a cultural transformation that fosters transparency and high professional standards, while minimising conflicts of interest.

These changes will increasingly become key value drivers and differentiators of the future as society assesses the social utility of stock markets and its participants. The ‘change for the good’ will restore confidence in the very institutions the country depends on for capital formation and economic growth.

During the boom years of 2009 and 2010, a number of licenses were issued and, as a result, the country has more brokers than it probably needs. Given the scale of trading at the CSE, the stockbroking industry needs to consolidate to elicit economies of scale.

Currently, most stockbroking firms are unprofitable and unable to undertake costly but value-adding activities like high-quality research, technology enhancements and expanding the branch network. In order to create greater depth and enhanced ability to invest in technology, thus achieving cost effectiveness, efficiency of service delivery and profitability, the industry will have to be encouraged to instigate mergers and acquisitions among existing brokers.

Similar to such reforms undertaken in countries like Malaysia, the regulator is likely to push for good governance criteria and more robust capital adequacy requirements, forcing the industry to consolidate, forming a core group of well-capitalised stockbroking firms. Subsequent to the restructuring of the industry, universal brokerage and market-determined broking fees due to increased trading volumes for each broker is likely to be permitted.

Regulators should also embrace technology, where ordinary investors could check at a CSE or SEC website where the regulatory compliance and governance of market intermediaries and individual Registered Investment Advisors could be easily verified before they deal with them, similar to other countries.

In order for a capital market to function properly, there are several prerequisites. The participants are the driving force of the capital market, and provide the fuel that is needed to run the market.

The capital market in Sri Lanka is under-owned by domestic investors versus its emerging market peers. Less than 6 percent of the 2.6 trillion market capitalisation of the CSE is owned by institutional institutions such as EPF, ETF, insurance companies and unit trusts.

The Colombo Stock Exchange (CSE) announced the adoption of risk-based capital adequacy from March 2017. Other long-outstanding reforms may also soon be implemented.

The absence of a professionally managed, non-captive, large institutional investor base in Sri Lanka is an enormous challenge. The main long-term superannuation funds are largely captive and saddled with conflicts of interest. Most have been used for deficit financing the government budget and politically directed investments rather than to serve the primary objective of generating long-term retirement income for those who contribute. Insurance companies are unduly constrained by statutory liquidity requirements, investment directives that limit their exposure to unit trusts, and equity and corporate debt markets. Retail investors alone usually cannot support the market’s growth.

Some of the planned changes and reforms will gradually alter the landscape.

Demutualisation
Currently, the CSE operates as a self-regulatory organisation, formed as a mutually owned company limited by guarantee owned by 15 member firms. The process of demutualisation – i.e. converting membership into shares and operating as a public, for-profit institution following trends set by more developed markets – is expected to be completed soon. This will ensure a more flexible governance structure fostering decisive action, greater transparency and broader investor participation in the exchange. The SEC, which regulates Sri Lanka’s capital market, is in the process of revising the SEC Act, which will have more powers for civil and administrative sanctions, and support the setting up of a clearing house for the settlement of securities, depository and demutualisation of the CSE. The amended SEC Act is expected to put Sri Lankan capital markets at the level of international standards recommended by the International Organization of Securities Commissions (IOSCO).

Product Diversity
Investors and market players in Sri Lanka are crying out for innovative and versatile financial products such as Exchange Traded Funds (ETF), Real Estate Investment Trusts (REITS) and derivative securities. Sri Lanka currently is primarily an equity-centric economy, with largely institutional investors active in the primary debt market. The CSE currently offers only cash market products, namely equity, warrants, closed-end funds and corporate debt securities. The CSE’s strategy already under way is to achieve product diversity by introducing Multi-Currency Equities, Exchange Traded Funds (ETFs), Structured Warrants (SWs), Real Estate Investment Trusts (REITs) and financial derivatives. Derivatives markets have grown leaps and bounds in emerging markets. Financial derivatives could include futures contracts and options contracts on securities, indices, interest rates, currency, futures and commodities. Derivatives securities can strengthen Sri Lanka’s capital market, both in terms of boosting returns, risk mitigation for portfolio management and creating alterative investment vehicles for financial market development.

The new strategy will offer an increased portfolio of choices and enhanced ability to hedge against risks from an investor perspective, and a broader choice of financing options from an issuer perspective. The diversity of products offered through the exchange will make the Sri Lankan economy stronger, as well as attract more investors.

Risk Management
The CSE has embarked on a project to address the settlement and counterparty risks prevalent in the market today, which is a major concern for foreign institutional investors. The CSE will introduce a central counterparty (CCP) for all secondary market transactions through a new clearing house that would be set up for this purpose. As a part of the CCP project, stockbrokers are strengthening their risk management systems with an integrated Broker Back Office (BBO) and Order Management System (OMS).

The clearing house, which will be owned by the CSE, will guarantee cash and securities delivery, and allow the CSE to achieve true delivery versus payment (DVP), the global standard recommended by IOSCO. The DVP settlement system ensures that delivery will only occur if a payment occurs. The system acts as a link between a funds transfer system and a securities transfer system. The CCP will be backed by a Settlement Guarantee Fund. In addition to bringing the market up to international levels, the CCP will allow short selling and listing of derivative products. Sri Lanka is one of the few in the region that doesn’t allow for short-selling, and the lack of that option is seen as an impediment to efficiency and a discouragement to international investment, as markets with liquidity and hedging options are usually preferred.

A foundation is being laid for future growth and development of the CSE, and many long-delayed reforms are being undertaken. Once the new market infrastructure is up and running, with the excesses of the past being dealt with, and Sri Lanka becomes an active and liquid market offering multiple asset classes, the CSE will be well positioned to play a pivotal role for capital raising and investment – both internationally and locally.

 

Ravi Abeysuriya is a Group Director & Chief Executive of Candor Group