The CSE at 30: Where to now?

Stock exchanges make it possible for companies to raise money. If exchanges didn’t exist people wouldn’t invest in firms, which are unlikely to return their capital. Stock exchanges offer a way out for someone wanting to sell shares by establishing a price for a security and – through the trading infrastructure – sourcing a buyer.

Colombo Stock Exchange is celebrating a milestone: its 30th anniversary. It can count a few proud achievements. The CSE was one of the first exchanges in the world to transition from face-to-face to electronic trading; this was the most important achievement.

However, the CSE has been unable to introduce processes that make trading safer for investors like a Central Counterparty (CCP) clearing house to handle the clearing and settlement of transactions and cash settlement as shares are delivered. Adding to the indignity of the CSE’s inability to keep up with developments in trading, infrastructure was a confidence sapping for a couple of years (2011 to 2012) when an organised group manipulated share prices. This eroded the credibility of the CSE as a place where securities can be traded in a transparent and fair manner. CSE’s Chairman Vajira Kulatilaka discussed these challenges in an interview.

Take a helicopter view, as the head of the board, what do you think are the challenges for the CSE?
Eight years ago the Colombo Stock Exchange was a global leader. We were the eighth exchange in the world to do script-less trading. People came here to learn how it’s done. We were ahead of London, we were ahead of India. After 1997 or so we stopped innovating due to a lack of money or our inability to prioritise. Now we have to look at reclaiming that leadership position, otherwise we have no future.

Some stock exchanges don’t have CCPs (Central Counterparty), you won’t like Sri Lanka to be on that list. CCP is the norm elsewhere in the world. By end 2016 CCP will be implemented. CCP is for risk management. There are so many foreign and regional funds that would like to trade provided counter party risk is taken out.Usually a 20% increase in market trading is a norm following CCP implementation. Liquidity will also improve and derivatives can be introduced, so selling can take place because with CCP delivery versus payment can be implemented.

The calibre of people in the industry has to improve. This institution building is the next pillar. On the governance side the SEC has to update its Act, and regulation has to improve

CCP and delivery versus payment are things that have been talked about for years but nothing has happened. What are those conditions that have changed that give you confidence that this isn’t another false start?
This is a basic necessity and there is a determination to do it. The whole board is committed and the SEC (securities regulator) is committed. I think the system got a shock with The Finance issue when the purchaser refused to pay for the shares of the company. That was a shock to most of us and that gave a signal as to why we need CCP. Most of what McKinsey recommended in a consultancy study for the stock market was already in the strategic plan. Now the thing is to execute. That will happen. People are determined. The SEC is putting plenty of pressure on us.

By end 2016 you will have just CCP? What about delivery versus payment (DVP)?
DVP and also back office risk management systems will be done by then.

What’s that road map like then?
The next step is an RFP (request for proposal) for infrastructure. The major difficulties are the legal changes needed, to make the CCP bankruptcy remote, that’s a very important thing. If something goes wrong, CCP should be able to go and grab the securities and say this is mine because they have already traded. If that facility is not available and the liquidator takes over, the CCP will have problems. So an Act should give priority to CCP if there’s a problem.

That is an amendment to the SEC Act?
It can be a separate CCP Act but designed to give it a low risk profile. We may require legal support and we know that the government can do it in two months if they want to. We hope the government will give us that support. Similar legislation exists elsewhere in the world.

Would this legislation be in place by year-end?
It would be difficult. If we can have it done by June next year that’ll be fine.

What else is on the agenda?
The other main thing is institutional building. The stock exchange should be a company in which people love to work. The incentive schemes, the recruitment methodologies have to change. In fact new incentive schemes have been introduced that are now performance based.

The same things should happen with stock brokers, research should improve, selling methodology should improve, governance has to come in, people should be governance conscious and that has to be taught. The calibre of people in the industry has to improve. This institution building is the next pillar. On the governance side the SEC has to update its Act, and regulation has to improve. I have participated in 30 interviews the world over during the last year and most of them ask “Where’s the action on the regulation side?”. That should happen in a peaceful, calm manner. That’s the way regulations should be implemented.

You’re referring to the regulator taking action against those who violated the securities law?
Yes, that has to be done, but it shouldn’t damage the system. Those who have done wrong should suffer. The market should not suffer. We have to keep market out of this.

A new SEC Act will help because up to now there are two extremes. One is compounding the offence, the other is criminal action. There’s nothing in between. A lot of action around capital market law violation elsewhere falls under civil jurisdiction. If that comes in, regulation can be more effective.

It’s sad to say, but educated young people don’t see stock brokering as a good profession. That will have to change, and that change can only happen with investment

Can retroactive legislation be enacted covering actions of people many years in the past?
It’s not very good to do that. We must put systems in place to make sure these things won’t happen again. That is the most important thing. Give the world the message that Sri Lanka is well governed and clean. The police, lawyers and judges should understand what capital markets are about to handle these cases.

Some of securities law violations that took place can be addressed with criminal action. However the world over it is extremely difficult to prove criminal intent on trading. If someone trades just once there is then evidence, but if you’re a trader and trading all the time it is very difficult to prove this is done with insider information.

There was this golden age in the stock market, the period you talked about when it was among the first exchanges in the world to go script less. Even the quality of broking firms was high. What will it take to have a similar renaissance?
The country needs one thing, about five years of continuous growth. Then the whole atmosphere will change. The problem with stockbrokers is they can’t justify more investment in themselves. A billion a day turnover is inadequate to support 29 stockbrokers. Seven or eight brokers are very badly off. They are unable to spend on hiring people. The prestige of working for stockbrokers has eroded sharply. That has to change.

The days when a stockbroker can just press the button and make a commission are over. They have to sell the right product. It’s sad to say but educated young people don’t see stock brokering, as a good profession. That will have to change, and that change can only happen with investment.

If you are implying that 29 brokers are too many, then there has to be some natural attrition?
Two things happen. Firstly the stock brokering license should be given value. I think we should take the policy decision that we are not giving any more licenses for the next so many years. Then the stockbrokering license will have value and firms can confidently invest. The second thing is consolidation; brokers should merge with each other. Brokering is a human capital driven business, so success is not in brick and mortar. Rather than merging a broker may feel it’s better to hire the person. That’s the risk of doing mergers.

What do you think about negotiated brokerage? Stockbrokers don’t like this but investors do.
This is a global trend. The trend is for transaction costs to come down. Now that we have brought it down, sending it back up is the worst thing we can do. It’s best to focus on the overheads and increasing turnover. If daily turnover goes up to three billion a day, everyone will be happy.

There may be some minimum capital requirement that will come with time. If you want to be small be small. But you can’t be a big player with small capital

What can brokers themselves do? In more developed markets brokers trade more on their own accounts, they offer some depth by offering two-way quotes. How far away is Sri Lanka from this?
People who manage the economy must see capital markets as a necessary element of a growing market. If you take the banking sector the 50% the government controls is not listed, power & energy is entirely in the government’s hands, most of the transport is also. Take ports, infrastructure, 70-80% of the best land is with the government. So if the government doesn’t help us by listing some of these institutions, the capital market will not represent the Sri Lankan economy and market cap will not get to a level equal to at least 70% of GDP, which is what it is in India.

When it represents more sectors the market is then a barometer for the economy. If you can get the government not to privatize but to list some of these ventures, the whole equity market changes, new foreign investors will look at us, it will become a deeper market and the government may get some money which it can spend on social projects.

It’s similar with the debt market. Government institutes can issue listed bonds or municipality bonds, which will improve the market’s depth too. What changes perception of a capital market is a big IPO.

Big IPOs attract new fund managers. Recently Dialog and Lanka IOC attracted new fund managers. Mark Mobius used to invest here around 1994. When I recently tried to sell him a stock, he said ‘if you cannot give me $3 to $4 million daily turnover we cannot take it’. That’s because his fund has grown from around $1 billion to $50 billion in that time. The world has grown but we’re still here. Templeton is the best emerging market fund but they cannot come here for other than for fixed income investments. Why is this?

These you cannot fix as CSE Chairman?
Policy is not within our control, and so we must go and convince policy makers. We have to start a dialogue after the election. We will do it.

What can you do better as an industry. A decade or so ago the Central Bank insisted dealers at its primary auctions for government bills and bonds have a high minimum capital. This has worked fantastically for the government debt market. Is there a lesson here for equity?
That’s why I say the license should be given value. Then people will put money to a valuable thing or sell out if they cannot commit the capital. That’s what we want to see happening.

There are a few hurdles we need to clear which will then force the system to have more capital. One is to put margins.Secondly – we are almost ready to approve this – is for brokers to have risk-based capital.

What we are saying is that if you cannot bring enough capital, trade within those limits. Don’t go and over extend yourself. That gives the message that if I want to be a big broker I have to have capital or I have to continue being a small guy.

What does this mean for brokers? Right now I think the capital requirement is Rs35 million?
I think in the first phase they have to go up to about 100 million and gradually increase it. Stockbroking will require a business plan. You can be a small timer if you are not giving credit and not offering bids and offers on stocks. If you are but a mere connector of a seller to a buyer it will be a low risk and low cost business.

But where would you like to be and based on that you have to adequately capitalize 100 million, 200 million, you will have to increase the capital. Ultimately if you want to be a fully-fledged stockbroker you may need 500 million rupees. So it all depends on what you want to be.

How should a broker read this? Is a Rs100 million minimum capital going to be in place by next year? How much will a broker need to keep doing his business?
There may be some minimum capital requirement that will come with time. If you want to be small be small. But you can’t be a big player with small capital. That will automatically happen when you introduce risk weighting in to whatever assets you have in your book.

What are those broker activities that will have a higher risk weight?
John Keells will carry a lower risk weight because it’s very liquid. The whole thing is statistically driven, they (CSE) have done the calculations, and it was all done internally. A value at risk base calculation was done for each and every stock. Unfortunately for debt we cannot do it because not much debt is traded.For different stocks there are different risks.

So a broker can decide to be a market maker in a certain category of stock?
Yes, based on your size and where you would like to be. If you want to go to less liquid and volatile stocks you have to have the capital.

So should brokers be thinking of Rs100 million?
No, I think the message will have to go first. If not they will be too small and not living up to the value of the license in a growing country.

What about demutualization?
That should happen and it’s beneficial for the stock exchange. Being broker driven is not a good model. We have to finalize one or two variables and after that we are ready to do it. A new Act has to go in to convert the exchange in to a corporate.

We can’t ask people to list or delist, it’s necessity based. When people are forced to do things, governance can go to hell. Even Carsons will want to come to the market if there is 8% economic growth

Carsons-controlled firms have said in their annual reports that they are looking to delist.This is not a good thing, surely liquidity is a desirable thing to have, but forcing shareholders to sell the stock they would rather not is not the way to go?
Listing is necessity based. We can’t ask people to list or delist, it’s necessity based. When people are forced to do things, governance can go to hell. Even Carsons will want to come to the market if there is 8% economic growth. What is happening is that they can live without new capital, they have enough internally generated cash and enough banks to give loans, so they can go on. But great companies the world over start selling down and bringing new capital to finance growth.

Why does it hurt to have them? Shouldn’t delisting be their decision to make?
That’s a decision taken by SEC. I personally don’t think there’s a burden in them continuing to be listed. Let’s see what will happen in 2016.

Why force anybody, it’s the freedom of capital?
Freedom of capital is there but they are enjoying a listed company status. Personally what you say is right I think. Keeping them is not costing us.

SEC was talking about Maldivian companies listing here?
There are many Maldivian companies who would like to list here and these are very big firms. But we have to dollarize the whole thing as they don’t like to deal in Sri Lankan Rupees, so a structure needs to be worked out. That will make us more international. The second thing is it will attract different fund managers here.

From the payment to brokers, broker-to-broker payments and taking the money out of Sri Lanka, this whole thing has to be dollarized. It’s not a difficult thing to do, it can be done through FCBU accounts. We are trying to go to policy makers and get this in to the programme and even the CCP has to give guarantees in dollars. We need exchange control relaxation for identified areas.

Are legislative amendments necessary?
No, I don’t think so. But at every transaction point you should get it cleared and the budget has to say that dollarized returns are capital gains free, which is the same benefit we enjoy here in local currency. Accounting standards, compliance, corporate governance have to be adhered to if they are listed here.

Is there something substantial to be gained with this?
It’s the starting point only, we don’t know the size of the market but there are certain companies that want to list and raise funds. There are monopoly firms there that want to list and the hotel companies are large and some are bigger than that country.

Lanka Ratings Agency is no longer licensed. They have rated a lot of listed debt. What happens now?
We have to take a decision on that. When the debt rules were brought in we never looked at the situation where a rating agency can lose its license. We have to introduce a rule saying you have to then obtain a rating from another company. Credit rating is an extremely important aspect of a debt market. Type of people who invest are low risk low return type of people. So a default is not going to be like some small company going bankrupt.

So the change you are contemplating is to introduce a time frame to get a fresh rating? What is the likely time frame?
We have to discuss this with the SEC. They will call us for a meeting and introduce a time frame.