CSE getting ready for a transformational change
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Investor participation in CSE is very low these days. Despite more than 750,000 accounts at the CDS, many of these 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 Colombo Stock Exchange (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 in 2017 are expected to bring in significant benefits to investors and the country from 2018 onwards.
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, ie converting membership into shares and operating as a public, for-profit institution following trends set by more developed markets is expected to be completed within a year. 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, has drafted a new SEC Act which will give it more powers for civil and administrative sanctions, support the setting up of a clearing house for settlement of securities, depository and demutualisation of CSE.
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 largely an equity centric economy with largely institutional investors active in the primary debt market. CSE currently offer 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. Derivative markets have grown leaps and bounds in emerging markets. The new strategy will offer an increased portfolio of choices and enhanced ability to hedge against risks from an investor perspective and broader choice of financing options from an issuer perspective.
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. 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, stock brokers 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 CSE to achieve true delivery versus payment (DVP), the global standard recommended by IOSCO.
DVP settlement system ensures that delivery will occur only if a payment occurs. The system acts as a link between a funds transfer system and a securities transfer system. 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 impediment by foreign institutional investors, as markets with liquidity and hedging options are usually preferred. The integrated BBO and OMS will facilitate the process of introducing risk based capital for all stock broker firms in line with IOSCO guidelines. CSE has already established a Capital Adequacy Ratio (CAR) methodology which is expected to be implemented during the year 2016.
Consolidation
During the boom years of 2009 and 2010 a number of licenses was issued and, as a result, the country has more stock brokers than required. Given the size and trading volumes of CSE the stock broking industry needs to consolidate to elicit economies of scale. Currently most of the stock broking firms are unprofitable and not able to undertake costly activities such as 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 resort to mergers and acquisitions amongst existing brokers.
Similar to such reforms undertaken in countries such as Malaysia, the regulator will push for good governance criteria and risk based capital adequacy requirements, thus forcing the industry to consolidate forming a core group of well-capitalized 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 gradually permitted.
MSCI Emerging Market Index
Lack of market liquidity, a major constraint for foreign investor participation in the CSE needs to be swiftly addressed. CSE is still classified as a lesser developed “Frontier Market” with characteristics such as low market capitalisation, low liquidity, and higher volatility warranting a higher premium for foreign investors to invest. The government represents a major share of the Sri Lanka economy, controlling banking, insurance, port, aviation, transport, and energy sectors.
It is therefore imperative that the government undertake indispensable State Owned Enterprise (SOE) reforms by listing at least 10 per cent of few large SOEs. This in turn would lead to the CSE being classified as a more developed and mature “Emerging Market” that is widely tracked by foreign investors and considered to be active and liquid than a “Frontier Market”. If CSE is included in the MSCI Emerging market Index by listing of a few SOEs and large companies a significant amount of foreign investors that replicate the MSCI Emerging market Index (tracked by investors managing about $8 trillion in assets) would be investing in the CSE.
Conclusion
A foundation is being laid for the future growth and development of 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 CSE becoming an active and liquid market offering multiple asset classes, CSE will be well positioned to play a pivotal role for capital raising and investment – both internationally and locally.
(The writer is the Group Director of the Candor Group and President of the Colombo Stock Brokers Association. The views expressed in the article are solely his and do not constitute an opinion of the company or any association
the writer represent).