Karachi's experiments with circuit breakers in 2008

by Junaid Khalid, MCB Asset Management Company Ltd.

In a world where volatility skyrocketed while stock markets fell, the Pakistani market volatility held its ground, and diminished to near-zero. A floor on prices ensured that there were no defaults.

The country's obsession with the stock market in the past lead all to believe that it was by far the most important economic indicator. Pakistan's cricket team was once the most talked about asset, but when that started falling apart, the focus shifted to the buoyant stock market index. Poverty, inflation and currency depreciation were all pushed aside and the glorious KSE-100 index embedded itself firmly in every dentist, driver, grandparent and banker's mind. Everyone could play, and all that was required to win a fancy car was riding the bull run with `CFS' (badla) on your side. In India, badla trading ended in 2001, and was replaced by a world of rolling settlement accompanied with derivatives trading. Pakistan has not crossed that hump.

With a rapidly rising market, the KSE managed to pull a fair amount of foreign investors chasing annualised returns in excess of two hundred percent. The mighty greenback started flowing in and the benchmark KSE-100 index reached highs above the fifteen thousand level. Then trouble began when, between April and June 2008, the index fell by around 4500 points. The regulator, in consultation with brokers panicking about the lower 5% circuit breakers being hit continuously, decided to change circuit breakers from their -5 to +5 per cent range to a -1 to +10 per cent range on June 23rd, 2008. This was an asymmetric system of circuit breakers: prices could go down only 1% but they could go up 10%.

The regulator and the KSE administrators were not being price-agnostic; they were trying to force a direction on the index. One goal was to give brokers some time to meet mark to market requirements by selling illiquid assets such as property. Short selling was banned and the market jumped up the next day by 960 points as the shorts covered their positions and the newspapers read 'Stocks on a high after new rule drowns small fry'. This announcement was also treated with suspicion because it came on Tuesday, one day after investors had just rolled over positions from the one month June expiration contract to the new July contract. Small brokers questioned the short sale, saying "If at all the ban were to be imposed, the announcement could have come on Saturday, so that those who entered on Monday were not trapped."

The market, which had recorded a fall of 4,500 points over two months from April 18 to May 23 showed a six per cent increase in the 10 sessions following these 'stabilisation measures'. "Nothing could have been more satisfying to regulators and investors, but that the artificial planks put under the market fall had started to crack," said an analyst. Investors started realising that a market could not artificially be given a direction and if trades had to occur, a 1% lower breaker would only delay the fall in prices. All too often, the circuit breaker was hit and trading stopped because buyers and sellers refused to transact at the price permitted on the screen. Circuit breakers converted price risk into liquidity risk. Average daily volumes fell to 10-year lows to around 20 million shares a day, from last year's daily average of 240 million shares. Brokers started feeling the consequences of the SECP decision as their volume driven income depleted.

The brokers and SECP embarked on a set of meetings to discuss how to build a 30 billion rupee fund to 'stabilise' the market.

On July 11th 2008, in a meeting held on Friday among the chairman of the SECP, Islamabad, Karachi and Lahore Stock Exchanges, the efforts of the SECP to stabilize the market were applauded but highlighted as 'temporary'. The meeting concluded that circuit breakers needed to be restored to their original -5 to +5 per cent range, and short selling was allowed again. In addition to these, the Equity Market Opportunity Fund was discussed again, and a harsh warning was given about blank selling and market manipulation.

The market quickly took a nosedive in 5% decrements which lead to widespread panic as the possibility of defaults on badla positions became imminent.

On 27th August 2008, the board of directors of the Karachi Stock Exchange decided to place a floor based on the closing prices of securities on Wednesday August 27th 2008. On this date, the KSE-100 index was around the 9000 level. It ended its press release with a promise to engage the SECP, the State Bank of Pakistan and the Ministry of Finance in efforts to achieve `stability'.

Since the date that this floor was imposed on the KSE index, trading volume essentially went to zero. Investors are questioning the wisdom of this stasis. In board meetings that followed, various different solutions to the crisis were discussed which included facilitating buy backs, reforming the badla system and providing liquidity and support. The size of the support fund that was discussed varied, and reached peaks as high as Rs.50 billion. Amongst the ideas discussed was a possible Rs.30 billion rupee put option with a maturity of 2 years to be sold to foreign investors by the government, so as to give them confidence to buy shares.

As the market index remained frozen, there was a run on mutual funds heavily invested in a mix of equities, badla financing, and fixed income. Redemptions were first met with cash reserves and then with proceeds from off-exchange transactions which rose in volume and started pricing shares approximately thirty five per cent below the closing prices of August 27th 2008. With increasing pressure of redemption, cries were heard from some asset management companies. In an emergency meeting with the mutual funds association on 6th October 2008, SECP decided to put a freeze on equity and equity related funds till the third day after removing the floor on the Karachi stock exchange index. While this ended pressure on equity fund redemptions, it destroyed the trust that investors had built up over years with mutual funds.

When this trust was lost, redemptions on fixed income funds rose sharply. People had had enough and feared the worst. As pay outs increased, the percentage of illiquid assets (mostly term finance certificates or `TFCs') started rising and most funds found it hard to meet redemptions. SECP did not freeze redemptions on fixed income funds. Funds went through a phase of delayed payments transitioning into an asset management company specific redemption freeze. On 5th November 2008 another circular was issued to mark down the value of all TFC's in the portfolio till 12th January 2008 (regardless of time to maturity) between 5% to 30% depending on their rating. The mutual fund investors who had loyally stayed invested, and not redeemed, now took a hit of up to 32% in one day. The idea of this mark down was to limit redemptions in fixed income funds.

With an ailing economy, Pakistan embarked on an IMF program. The government was forced to withdraw any mention of the market stabilisation fund to the Karachi stock market which was eagerly awaiting a bailout package. The IMF document read: "The government believes that market confidence will improve significantly once the fund-supported programme is approved and the international reserves position is strengthened. Therefore, it does not intend to remove the current floor on stock prices until after the programme is in place. In any event, the timing and terms under which the floor on stock prices will be removed, including any use of public funds to support the stock market, will be decided after reaching understandings with the fund staff." The IMF criticised the proposed Rs.50 billion government fund to buy shares, stating that it would create moral hazard.

The newspapers on 12 December 2008 read 'SECP tells three bourses to remove stock index floor on December 15th'. It should be mentioned that circuit breakers used to be based on the daily closing prices so on any given day a share could move five percent above or below the previous day's closing price. In the absence of liquidity the closing price would be the same as the opening price if there were no sellers or buyers so rules were amended to account for a situation where a stock could be allowed to bring down its trading range even in the absence of a liquid closing price. The Bid/Offer would be taken as the closing price provided that it stood for atleast two hours before closing.

With a two day weekend between the announcement and the day the floor would be removed, two securities firms obtained a stay order from the Sindh high court regarding their badla positions. The court issued notices to Karachi Stock Exchange and Securities and Exchange Commission of Pakistan for December 16 and in the meantime directed parties to maintain status quo. With hurried legal opinions from SECP and NCCPL it was decided on Sunday the 14th of December that 'As per Dec 11 SECP directives, the three local bourses are all set to resume trading on standard parameters (without floor rule) from Monday. The Continuous Funding System (CFS), however, would maintain a "status quo" only for two as per the SHC's Dec 13 ruling.' The newspapers further read that 'The heads of three institutions, the SECP, KSE and NCCPL, which are direct parties in the petition, held a marathon meeting here on Sunday to discuss the issue. The SHC stay order does not restrain the NCCPL (the manager of CFS(badla) market) from giving margin calls to the CFS participants other than the plaintiffs.'

And so the Karachi Stock Exchange finally removed its floor on Monday 15th December 2009 with the lower five percent breaker being hit repeatedly. At the time of submitting this article equilibrium had not been reached.