Risk-based capital adequacy rules will require stockbrokers to make choices around their trading, operations, large exposures and counterparty risks. Overall, it will be safer to trade stocks in the market when stockbroking firms have a better handle on the risks in their business and back these up with more capital when necessary. Risk-based capital adequacy for brokers may be in place in as soon as three months.

Another risk-reducing initiative will be the introduction of Delivery Versus Payment (DVP) as the basis for settling transactions, in the first quarter of 2017. Currently, a seller transfers shares immediately after the sale, but receives payment three days later. DVP will make the transaction of cash and shares simultaneous.

The Colombo Stock Exchange’s Chief Executive Rajeeva Bandaranaike says these and other initiatives will boost liquidity in the market, attract new listings and boost the CSE’s league status. Excerpts of an interview are as follows:

Why is a capital adequacy requirement being introduced for stockbrokers?
Rajeeva Bandaranaike: Currently, stockbrokers have a minimum net capital requirement of Rs35 million irrespective of their trading exposure. This will remain. Of course, net capital is adjusted based on assets once a broker starts trading, but it’s not a very efficient way of stipulating capital for brokers. The Capital Adequacy Ratio (CAR) is used globally, and is recommended by the International Organization of Securities Commissions (IOSCO), to define the appropriate level of liquid capital a broker should have when trading securities.

The minimum CAR is 1.2 times, which is calculated by dividing the liquid capital by the total risk requirement. You arrive at liquid capital by taking the stockbroker’s capital employed (shareholders’ funds, long-term loans, debentures etc) and deducting all illiquid assets, including overdue client receivables. Illiquid assets are also deducted in arriving at the current net capital for stockbrokers, but not to the extent the new CAR rules will require. This new method is far more representative of a broker’s liquid capital. One of the major differences between the two methods is VAR-adjusted (value at risk) client receivables.

There are five types of risks relevant risks here. In computing the total risk requirement, underwriting risks and position risks may not immediately apply because brokers don’t underwrite right now and they don’t take positions in the market, meaning they are not dealers. But counterparty risks, operational risks and large exposure risks will get considered. That’s how you arrive at the CAR of 1.2x. CAR is liquid capital divided by the total risk requirement, and 1.2x is the minimum global standard.

The total risk requirement is an assessment of the risk converted to numbers. There are different ways of computing these. For operational risks, we take 25% of the broker’s annual expenditure requirement. Counterparty risk is total client receivables converted to a Rupee figure, and each risk Rupee value is given as a ratio. We calculate a number for each risk and then aggregate it to arrive at the total risk requirement. Then liquid capital divided by the total risk requirement should be a CAR of 1.2x. Brokers will be given a template to report electronically every day the market is open.

What is likely to be the industry effect when this is put into practice? Will brokers have to adjust their business models? Will some need more capital?
Bandaranaike: If they do not fall within the required minimum ratio of 1.2x, then they may need capital to correct that position. Of course they’ll be given some period of time to adjust, and thereafter we’ll start implementing, following regulatory approvals. We estimate this new risk-adjusted capital structure will be implemented within the next three to six months. Once we implement it, brokers will be expected to maintain it all the time. If they fail to maintain that ratio, the first thing that will happen is that they will not be able to make any new purchases until their capital position is corrected.

I think it will strengthen the overall risk position of the broker community. As a market, we are assessing our risks more effectively.

Assuming that they continue with the same trades and volumes in the same sort of stocks, do you have an industrywide ballpark figure of how much more capital is necessary?
Bandaranaike: We have back-tested for different scenarios, for 2011, 2012 and 2015 at different volumes of trading. It actually depends on the kind of exposures and volumes. I can’t really put a number on that right now, but what we can say is that there may be a few brokers who will have to correct their positions. If it were 2011 levels, the requirement would have been far greater because their revenues were greater and financial position also better. Today, you will see some brokers conform to it, while others may fall short.

Of the four criteria in risk requirement, where is the greater challenge for the industry?
Bandaranaike: I think they are equally important. They will have to look at all of them. For example, large exposure risks with single client receivables are as important as operational risks. All these risks are important in computing the total risk requirement. You can’t prioritize one over the other.

Do you feel the capital adequacy requirement will lead to industry consolidation?
Bandaranaike: If you look at the market size, maybe 30 brokers are a bit too much. As a result, volumes are distributed, so there has to be some consolidation. The market will automatically start consolidating as a result of higher capital requirements.

Delivery versus payment (DVP) is due to be implemented soon. Will this reduce or change the counterparty risk calculation?
Bandaranaike: It will be implemented in the first quarter of 2017. Right now, the DVP project is on course. There are two areas – the SEC act amendment and the necessary legislation, which are being worked on. The SEC is confident of having the act passed sometime this year. If that happens, the legal requirements are taken care of. On the systems side, the broker back office systems are in the process of being installed, and on the exchange side, we are in the process of starting to procure our clearing and risk management systems, and setting up subsidiaries.

DVP and the settlement risk here are two things really. When there is a transaction, the buyer has somewhat of an unfair advantage as the shares move instantly, but the seller gets the payment only three days later, about which there is also no guarantee. So he is exposed to a counterparty risk and there is little he can do about it. That’s why we ant to move to a delivery versus payment system, where shares and money are exchanged at the same time, on the same day.

That’s why we are bringing in a central counterparty system (CCP), as a risk management measure. There will be an intermediary organization called a clearing company, which will interpose itself between a buyer and a seller, and guarantee shares to the buyer and settlement to the seller. So whether you are a buyer or seller of securities, you are guaranteed of your transaction. Right now this is a huge void in the system, where people trade but significant settlement risks exist.

Under the CCP, the clearing company will have access to a settlement guarantee fund, in addition to bank financing and its own capital. They will also have margins. All this will be used to settle transactions. Initially, the clearing company will be wholly owned by the CSE, but the regulator may want it divested in the future to be held by several institutions.

The counterparty risk in CAR is receivables to the broker from their clients. That risk exists anyway. We are talking about broker to broker settlements in the CCP. In turn, the broker has to anyway recover client dues, but irrespective of whether the client pays or not, the broker has to settle the shares.

When DVP is in place, the two systems – ATS and the CDS – will be delinked. That’s why we are building broker back office systems and risk management systems. This project is currently underway. In this system, brokers can sell a share they currently don’t have in the CDS and they will know very well that they are going to go short. If they go short, they have to fulfill the transaction by the end of the day. If they cannot, we will have a buying board the next day and they will be forced to go into it and buy. They may end up having to pay a premium. That’s the penalty.

This type of daily short selling isn’t currently possible. Regulated short selling is a different matter; we will have to speak to the regulator to allow that.

Isn’t this market ready for short selling?
Bandaranaike: To start off, we are giving opportunities within the day. Some markets went into a spin when short selling was allowed and they have had to discontinue it. So if we are going into that, it has to be regulated short selling, for which I think we need a set of rules and regulatory approval.

Besides CAR and DVP, what does the CSE hope to achieve over the next one to two years?
Bandaranaike: In the past few years, we’ve set ourselves a goal to move the exchange from a frontier market to emerging market status. We need to do some things to bring ourselves to that level. For example, we need to increase our market size and liquidity. We want to enter the MSCI Emerging Markets Index. This has thresholds like having at least three companies that qualify for the minimum public float requirement. Right now, only JKH qualifies. Currently, we have equity and corporate debt trading, but we need to diversify our product range to offer more choice to investors like derivative products such as REITs (Real Estate Investment Trusts), structured warrants, ETF (Exchange Traded Funds), Shari’ah products and financial derivative products. But all this can come only after the CCP is in place.

Third is to strengthen the regulatory framework. Everyone talks about investor confidence, but this will only come with proper rules and the enforcement of those rules. This is already being addressed by the SEC. We might see a complete rehash of stockbroker rules, bringing our regulatory framework on par with global standards. The other area is the market infrastructure. That is what we are building in terms of the capital adequacy requirement, CCP and DVP, broker risk management systems, and exchange infrastructure.

The fifth area is the exchange itself to be developed as an institution. We are converting the CSE into a learning organization; we are investing a lot of resources in training and development, to prepare our people to face these challenges. We are also diversifying our revenue streams. We are currently overly dependent on trading income, but over the past few years, we have been diversifying. In developed exchanges like in London, the chunk of income from equity is less than 20%, and a bulk of their revenue comes from other products. That’s the way exchanges are moving.

How far are we to moving from frontier to emerging market status?
Bandaranaike: More things have to happen, and we are some way off. We are building the infrastructure and regulatory framework. The key challenge is to get some new liquid companies that will qualify for the public float requirement. We are looking at a three year horizon. We want to see ourselves as a world class exchange. Moving to emerging market status will give us visibility and the ability to attract more foreign funds so we can grow our size. This will also improve valuations, and encourage large, unlisted private sector companies to consider listing and investors to come to Sri Lanka.

Elsewhere in the world, they have what are called dark pools – exchanges where the quantity of shares is not visible. It aids efficient price discovery. Is it too early to be talking about such things here?
Bandaranaike: Even here, we don’t often find the entire amount available for sale being put into the order book at once. But I think we are still not that size and haven’t reached that level of liquidity. This is partly due to the fact that our market is quite small, the quantity available for sale is small and it’s a very small community. One day, when it’s more liquid, we won’t see people trying to figure out who is buying and selling, but only look at the price. We still need to get there. This is the reason we are focusing a lot on increasing liquidity. Liquidity is a key driver.

You have the fortunate position of being a monopoly, but dark pools can operate outside of the CSE. Would you be open to such a proposal, to share the CDS?
Bandaranaike: Even another exchange can be set up, and that’s fine. I think our concern is more to do with how to improve liquidity in the market. If people want to come up with another exchange, that’s fine, but Sri Lanka might be too small to sustain two exchanges when even one is struggling with size and liquidity. I think our economy has to grow to where we can see that level of activity. Companies don’t access capital because they can fund growth from internal cash. Whereas if they see capital market growth, they will want to come in. We will see this happening with the expansion of the economy.

Should brokerages be allowed to complete transactions when they represent both the seller and the buyer?
Bandaranaike: You can’t run an order-matching engine without a license, so effectively you will be running a stock exchange. If you transact outside an exchange, you run the risk of default and the transaction not taking place. That’s why you bring it to a formal marketplace where your activities are regulated. That’s the basic difference between the two. But once Sri Lanka’s economy develops, there will be room for a commodities exchange. We are aware of that, and we are also diversifying and looking at new products, so we are ready to face competition.