bonds automated trading system (bats)

BONDS AUTOMATED TRADING SYSTEM (BATS)

REPORT OF REVIEW COMMITTEE CONSTITUTED BY THE SECURITIES AND EXCHANGE COMMISSION OF PAKISTAN

TABLE OF CONTENTS

Preface………………………………………………………………………………………………. 1

Executive Summary……………………………………………………………………………… 2

A review of existing corporate debt market ……………………………………………….. 5

Review of BATS model and comparison with international practices…………………… 8

Review of risk management system…………………………………………………………… 17

Review of pricing methodology………………………………………………………………… 19

Unlisted TFCs ……………………………………………………………………………………….. 20

Roadmap……………………………………………………………………………………………… 21

Annexure A 22

Annexure B………………………………………………………………………………………… 25

PREFACE

The Securities and Exchange Commission of Pakistan (SECP), in consultation with the relevant stakeholders constituted a committee comprising of representatives from SECP, Karachi Stock Exchange, National Clearing Company of Pakistan Limited, Mutual Fund Association of Pakistan (MUFAP), Financial Markets Association of Pakistan (FMA) and Brokers to review Bond Automated Trading System (BATS) as per the following term of reference:

1. Determine reasons for poor market reception of BATS and identify genuine practical problems and shortcomings in existing regulatory and operational framework which needs to be addressed to make BATS more acceptable for the debt market participants.

2. In light of the above, analyze modifications, if any, required in the BATS model and the regulatory framework;

3. Review the existing risk management regime applicable for trading in the debt market securities in line with international best practices best suited to our local capital market needed to address any practical hindrances.

4. Determine suitable methodology for pricing of TFCs on BATS in light of current pricing methodologies for TFCs and issues faced therein.

Members of the Committee are as follows:

1. Mr. Shamshad Nabi, CEO Mutual Funds Association of Pakistan

2. Mr. Yasir Qadir, Director and Chairman Board Committee for pricing and trading of debt securities

Mutual Funds Association of Pakistan

3. Sani-e-Mehmood Khan, GM—Market Development and New Product

Karachi Stock Exchange

4. Mr. Muhammad Lukman, CEO National Clearing Company of Pakistan Ltd.

5. Mr. Muhammad Ismail Usuf, Assistant Secretary

Financial Markets Association of Pakistan

6. Mr. Adnan Qaseem, SVP, Head of Fixed Income and Corporate Treasury

BMA Capital

7. Mr. Mateenullah Khan, Joint Director Securities and Exchange Commission of Pakistan

8. Mr. Asif Iqbal, Joint Director Securities and Exchange Commission of Pakistan

9. Mr. Waseem Khan, Joint Director Securities and Exchange Commission of Pakistan

Report on Review of BATS Page 1 of 27

EXECUTIVE SUMMARY

The Committee deliberated the situation of poor market reception for BATS with a view to identify

practical problems and shortcomings in existing regulatory and operational framework. Committee

followed a two step process whereby:

i) the existing model was compared with international best practices to identify gaps and

anomalies; and

ii) the practical problems and shortcomings were identified in the operational and regulatory

structure which could hamper the active participation of market participants

The results of research encompassing practices adopted by major jurisdictions are covered in detail in

section 2 and a snapshot is also provided in Annexure A of the report. The research reflected that

internationally the OTC markets are allowed and account for the major trading volumes in the

corporate debt market. Furthermore, the exchanges around the world offer automated undisclosed

systems parallel to features that facilitate negotiated dealings and reporting of the same. It was

observed that there is more focus on establishing a centralized reporting platform to ensure effective

price discovery and transparency in the market.

Committee feels that while the off-market trades act as an impediment to active participation on the

BATS, at the same time the small number of listed TFCs and the low level of liquidity implies that the

negotiated deals cannot be completely eradicated. For the success of an undisclosed-automated

order matching system, the liquidity and the availability of bid/offer with sufficient depth is essential.

The above factors call for first introducing a hybrid model with automated order matching and

facilitation for negotiated deals both available on the system and ensuring the reporting of all trades at

one platform. The next step should focus on allowing the negotiated dealing only for bulk deals,

whereas for regular trades the automated system should be used to encourage participation from all

segments and should be accompanied by appropriate market awareness efforts.

On the basis of above findings the Committee recommends that migration from the current OTC

based market to an exchange based model should be achieved in a phased manner to ensure a

smooth transition and prevent adverse impact on the market. Accordingly, as a first step, the off-

market transactions should be discontinued. Simultaneously, the BATS model should be equipped

with certain features to facilitate negotiation between market participants in a transparent manner.

These include the option to quote All/none orders, the Request for Quote feature, the option to

disclose the member ID and the indicative quotes. These recommendations are discussed in more


detail in Chapter 2. Committee also recommends effective surveillance mechanism to capture the

manipulative trades executed between counter parties with a view to affect the net asset values of

mutual funds.

The review of operational and regulatory structure identified following areas requiring improvements:

1. The risk management system (RMS) is recommended to be revamped. The margins are

recommended to be decreased considering the liquidity needs of the market. In the event

of default, a close out process is recommended to be followed with cash margins serving

as penalty and the defaulting party to be blacklisted.

2. The Circuit Breakers are recommended to be removed to enable efficient price discovery

and prevent disruption in trading.

3. Pricing methodology for BATS is proposed to be changed with a 30 day look-back period

and monetary thresholds of Rs. 15 million for issue sizes upto Rs. 1 billion and Rs. 25

million for issue sizes of more than 1 billion for selecting transactions that can affect a

change in the closing price to avoid manipulative trades. The proposed methodology is

provided in section 4 of the report

4. Certain improvements are identified in the BATS interface, which are enlisted in Annexure

B of the report.

5. Currently only a handful of TFCs are listed on more than one exchange which prevents

active participation by investors through BATS in TFCs which are listed at different

exchanges. Exchanges are requested to grant waiver in listing fees and share listing

information to facilitate cross-listing of TFCs across all exchanges.

6. For unlisted TFCs, the reporting of all transactions to exchanges must be made

mandatory. This information must be disseminated to market through BATS. Restrictions

in this regard should be imposed in the CDC and all settlements must be made through

NCCPL. Committee also recommends that an incentive package should be provided by

exchanges to those unlisted TFCs that meet the eligibility criteria for listing by waiving/

relaxing the listing fee and providing for a speedy mechanism for listing.

Committee also feels that the above recommendations should form the phase 1 of a long term

roadmap for the development of debt market and the Committee should re-convene after six months

to review the results and recommend future course of action in line with a vision to provide the market

with an efficient and transparent trading platform which enables equal participation from all segments

of investors. The next review should focus on introducing a VaR based RMS, prescribing thresholds


above which the negotiated deal features would be allowed with a view to gradually move towards a

completely automated model and encourage participation from the retail segment, reviewing the

pricing mechanism in the light of trading information, suggesting the appropriate levels for the circuit

breakers and reviewing the reporting of trades in unlisted TFCs in accordance with its

recommendations and suggest improvements.

Committee also recommends that extensive efforts should be undertaken by exchanges and NCCPL

to create market awareness regarding BATS through presentations and workshops. The committee

observed that active participation of MUFAP members, banks and money market dealers is the key

for development of a well-functioning corporate debt market in Pakistan and requests all stakeholders

including money market association, PBA, members of all three exchanges and MUFAP to play their

due role in bringing Corporate and retail investors on BATS. The Committee noted that both

intermediaries’ classes eligible for trading of Government and Corporate Debt Securities need to

adhere and understand the principle of coexistence, cognizant of international practices best suited to

us and reciprocate the positive steps to introduce and open the pool liquidity to each other in the best

interest of an emerging economy which has a long way to go.

Committee also recommends active coordination between SECP and SBP to ensure consistencies in policies and achieve a symmetrical approach for the development of debt market in Pakistan.


1. A Review of Existing Corporate Debt Market

1.1 The Corporate Debt market in Pakistan consists primarily of Term Finance Certificates

(TFCs), Commercial papers and Sukuks which represent Sharia compliant mode of raising

finance in the corporate debt market. Till date, the market is pre-dominated by TFCs which

contribute for more than 53% of the total corporate debt outstanding. As per the statistics as

on June 30, 2011, there are total 90 TFCs in issue with a total outstanding amount of

Rs.160.257 billion, whereas the total number of Sukuk in issue is 53 with a total outstanding

amount of Rs.138.720 billion. Following is the summary of corporate debt market:

No of TFCs Listed TFCs Non-listed TFCs Sukuk Total Number 40 50 53 143 Amount outstanding (Rs. in billion)

69.087 91.170 138.720 298.977

Listed TFCs PPTFCs Sukuk

CPs

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

Rs. i

n Bi

llion

s

Amount Raised till June 30, 2010

Listed TFCs PPTFCs PPSukuk

CPs

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

Rs. i

n B

illio

ns

Amount Outstanding as on June 30, 2010

Amount Raised through Debt Instruments (Dec 31, 2010)

Listed TFC24%

PPTFC24%

PP Sukuk49%

CP3%

1.2 The corporate debt market in Pakistan, particularly the listed TFC market, has failed to follow

the progress made by the equity segment and remains under-developed.

1.3 The details of exchange-wise listed TFCs are given in the table below:

KSE LSE ISE UnlistedNumber of listed TFCs 24 13 3 50 Outstanding Value in Billion (as at 30 June 2010) 48.124 16.233 4.730 91.17

1.4 With regards to the secondary market of listed TFCS, Stock exchanges used to offer the

same trading platform which was available for the equity segment. As a result the secondary

market for TFC remained fairly illiquid and trading of listed and unlisted TFCs have always

been carried out at Over the Counter (OTC) market as a result of direct negotiation between

buyers and sellers and through brokers. The investor base of both listed and unlisted TFCs

primarily consist of Commercial Banks, DFIs, mutual funds, employee benefit funds,

insurance companies and other institutions with a very low participation from the retail sector.


1.5 The transactions by the mutual funds in both listed and unlisted TFCs are reported to the

Mutual Funds Association of Pakistan (MUFAP) which also carries out the pricing of TFCs in

accordance with the requirements prescribed by the SECP vide its circulars. However, there

is no central platform for reporting of transactions outside the mutual fund industry.

1.6 The absence of an active trading platform and the unavailability of complete trading information

at one central portal have resulted in inefficiencies in the price discoveries of listed TFCs and

created misbalances in the market since although the mutual funds follow the pricing calculated

by MUFAP, other market participants do not have a transparent pricing medium. It is worth noting

that commercial banks use the prices quoted on the exchanges for calculating fair values of their

investments in listed TFCs and the quoted price or the trade price whichever is lower is used for

this purpose. No Mark-to-Market calculations are performed by banks for unlisted TFCs. As

evident, currently the prices quoted on exchanges do not represent the correct market value of

listed TFCs.

1.8 Introduction of BATS:

As a result of coordination between MUFAP, KSE, CDC and prominent market participants, in

2009 a separate trading platform developed specifically for trading of debt securities was

introduced by KSE with the name of Bond Automated Trading System (BATS) which aimed to

provide a trading interface suited to the needs of debt market participants with appropriate risk

management and pricing mechanisms and sought to remove the anomalies present in the

previous model. Despite the introduction of BATS, the major volumes of trading persisted to be

carried out at OTC or off-market. Following is a summary of the trading details of TFCs since the

inception of BATS in November 2009 to January 2011:

Category Number of trades Volume traded Value of trades (Rs. in million)

Listed TFCs –BATS1

51 145,864 672.503

Listed TFCS-off market2

597 3,820,481 17,661.5

Unlisted TFCs3 263 1,255,658 5,948.1

1.9 Off-market transactions:

The BATS Regulations which were approved by SECP in September 2009 prohibited the

negotiated deals or off-market transactions carried out outside BATS. However, exemption is

being granted by SECP form this restriction for last one year, thereby allowing the off-market

transactions in the listed TFCs. Simultaneously SECP also made it mandatory to report all

transactions in listed TFCS executed outside BATS to the stock exchanges and restrictions were

1 Data as per KSE 2 Data as per MUFAP-trades reported by mutual funds 3 Data as per MUFAP-trades reported by mutual funds


imposed in Central Depository System (CDS) upon transfers of listed TFCs which did not meet

the above condition. Subsequently, the reporting system of KSE was improved which now

provides the facility of real time reporting of off-market trades as compared to the previously

applicable system of reporting at the day end. Hence, the first stage of debt market development

is completed which represents development of a centralized reporting platform for all trades in

the listed debt instruments.


2. REVIEW OF BATS MODEL AND COMPARISION WITH INETRNATIONAL PRACTICES

2.1 International Practices and Local Perspective

In order to determine the reasons for poor market reception of BATS, as a first step it was

considered necessary to compare the existing model with the international practices to

identify the gaps and areas for improvements. The Committee analyzed the models and

methods pursued by various jurisdictions including India, Thailand, Malaysia and many other

jurisdictions (Annexure A) while making recommendations.

The key findings of the analysis are as follows:

2.1.1 Hybrid structure

Majority of jurisdictions offer an exchange based model with undisclosed trading and automatic order matching mechanism. However, OTC is also allowed in almost all countries. It was also noted that in all jurisdictions, negotiated dealing is facilitated by the exchanges in a variety of modes. For example, at Madrid Stock Exchange (Spain), trading is conducted through an electronic trading system on anonymous basis. Nevertheless, an option of bilateral netting is also made available which enables communication of previously agreed trades which are disseminated and are settled through the same systems as the rest of the transactions. Similarly, in the Stock Exchange of Thailand (SET) two systems are offered to the investors namely the “Put through system” (PTS) and the Automatic Order Matching system (AOM). The PTS records and disseminates approved transactions negotiated privately by members without relying on a price mechanism of the exchange, whereas under the AOM method, brokers can key-in buy or sell orders directly from their offices to the trading system of the SET then the orders are automatically arranged and matched according to price and time priority principles. Once matching is done, confirmation is sent simultaneously to the brokers’ terminals. In Bursa Malaysia, transactions in debt securities can be carried out through three types of functions namely “Order Matching”, “Trade Negotiation” and “Trade Reporting”. These features provide an automated –undisclosed interface together with the options for direct negotiation and reporting of trades between identified counter parties.

2.1.2 Reporting of OTC Trades

Majority of jurisdictions are resigned to the fact that the bulk of trading volumes in the bond market are carried out at OTC or on negotiated deal basis and efforts are more concentrated towards establishing a centralized reporting platform which ensures that all trades in debt securities are reported and disclosed to the market participants. Examples of India and USA are most relevant in this regard. In USA, the NASD launched the Trade Reporting and Compliance Engine (TRACE) system for reporting and dissemination of last sale information on corporate bonds on July 1, 2002. TRACE is a system that facilitates the mandatory reporting of OTC market


transactions in eligible fixed income securities. NASD rules require dealers to report trades on all eligible U.S. corporate bonds to the NASD on real time basis. TRACE disseminates transaction information to the public on investment grade, high yield and convertible corporate debt together know as TRACE eligible securities representing all OTC market activity in these bonds. Liquidity of a corporate bond is not a factor in deciding whether a transaction is reported to TRACE. In India, both BSE and NSE have developed reporting platforms over which all trades in the debt securities are reported. As mentioned above, the Bursa Malaysia also provides the facility of reporting of off-market trades to the exchange.

2.1.3 Participation from the Retail Sector:

It is also interesting to note that in majority of countries, the trading in government securities is carried out at the exchanges which have participation from the retail segment. In India the Retail Debt Segment is being offered for trading of government securities at exchanges. This implies that for successful trading of securities, participation from general investors and a wide investor base is a pre-requisite. On the contrary, corporate bonds are traditionally traded in large denominations among institutions and the high net worth individuals, necessitating an OTC market or a market segment with facilitation for negotiated deals.

2.1.4 KSE’s Experience:

While reviewing international practices, the KSE experience in 1997 of KATS launch was also considered, which faced similar challenges resulting in the negotiated deal system to run parallel to KATS for about a year.

A thorough review of other jurisdictions revealed that Indian, Thailand, and Malaysian models contained various commonalities and are therefore, briefly discussed in this section, whereas a comparative matrix capturing a snapshot of market practices is enclosed as annexure A to this report.

2.2 Case Studies

2.2.1 India The regulator of the capital markets– Securities and Exchange Board of India (SEBI)

- has adopted a phased approach for development of debt market and for

establishment of a trading platform with acceptance from all market segments.

The efforts for promoting trading of debt securities in India date back to 2003 when

SEBI released the basic norms for the development of Debt Market. SEBI also

formulated a committee to deliberate on the development of corporate debt market of

India, which suggested that in order to develop this market; a trading platform was

required that would cater specifically to the institutional buyers and sellers, as

globally, this market has been functioning as an OTC market.


In December 2006, SEBI introduced the first phase of creation of a unified trading platform by launching a system to capture all information related to trading in corporate bonds as accurately and as close to execution as possible through an authorized reporting platform. BSE was initially mandated to provide a corporate bond reporting platform. All issuers, intermediaries and contracting parties were granted access to the reporting platform for reporting of trades. The non-members of the exchange were also granted access through Virtual Private Network (VPN). All transactions in corporate bonds of the value of Rs. 100,000 or more were required to be reported on this platform within 30 minutes of the closing of the deal. The information on settlement was to be reported within 1 trading day from completion of settlement. Subsequently in March 2007, NSE was also instructed to launch a similar reporting platform.

In April 2007, the second phase was introduced and both BSE and NSE were permitted to have in place corporate bond trading platforms to enable efficient price discovery and reliable clearing and settlement in a gradual manner. To begin with, the trade matching platform was to be order driven with essential features of OTC market. Eventually, a system of anonymous order matching was to be established. All trades on the exchanges were to be carried out through the registered stock brokers. Participants were also provided with the options of undertaking OTC trades which were to be reported to the exchanges. Initially the parties were provided the option of bilateral settlement. Subsequently, the settlement of trades between specified institutions was made mandatory through the Indian Clearing Corporation Limited.

Today trading in corporate debt securities is carried out at the Whole Sale Debt Segment (WDM). The trades on the WDM segment can be executed in the Continuous or Negotiated market.

In the continuous market, orders entered by the trading members are matched by the trading system. For each order entering the trading system, the system scans for a probable match in the order books. On finding a match, a trade takes place.

In the negotiated market deals are negotiated outside the exchange between the two counter parties and are reported on the trading system for disclosure to the market.

Trades in the WDM segment are directly between the participants on the Delivery Vs Payment basis (DVP), who take exposure to the settlement risks attached to any unknown counter party. For every trade, it is necessary to specify the number of settlement days and the trade type. On the scheduled settlement date, the Exchange provides data/information to the respective member/participant regarding trades to be settled on that day with details like security, counter party and consideration. The Exchange closely monitors the settlement of transactions through the reporting of settlement details by members and participants.


For trading in continuous market, every participant can set up counter party exposure limits to ensure that all his trades are within the exposure limits set up for the respective counter party. This provision enables the participants to minimize the counter party risk associated with any counter party.

In the negotiated market, since the buyers and sellers are identified, no counter party exposure limits need to be invoked.

However, despite repeated efforts by SEBI, NSE and BSE, anonymous automated order matching system for the debt market could not gain momentum primarily because the debt market players are not comfortable with an order matching system where they do not know the counterparty to the trade. SEBI understands the market sentiments and has therefore been cautious in aggressively pursuing shifting of corporate debt trading market to anonymous trading system.

2.2.2 Thailand

The Bond Electronic Exchange (BEX) is a subsidiary of Stock Exchange of Thailand (SET) and was established in 2003 to support Thailand’s secondary bond market. It provides trading platform for government and corporate issues for both wholesale and retail segments. Prior to BEX, bonds were traded in the OTC market, which was mainly the institutional investors’ arena. Small investors were unable to get into that particular market due to its size and its ambiguity or simply the lack of information. Currently only publicly listed companies’ bonds are allowed to trade on BEX, non-listed companies will soon be able to have their bonds traded on the exchange as well.

Automatic Order Matching (AOM)

Investors can place orders through BEX member firms or through brokerage companies who in turn, enter the order into BEX’s trading platform. Orders follow are prioritized based on price then the time the order is received. If the bid or offer price and volume match, the orders are done automatically.

Put Through (PT)

When the trading value crosses over 10,000 units, which is equivalent roughly to 10 million Baht, an alternative method provided by BEX called “Put Through” must be selected. The counterparties can negotiate off the exchange. Once the deal is concluded, the seller can initiate the put through transaction, which then needs to be verified by the buyer. Once the confirmation process is completed, the buyer will allow that transaction to go to the next process of clearing and settlement.


2.2.3 Malaysia

Bursa Malaysia introduced the Electronic Trading Platform (ETP) in 2008 for the Malaysian bond market. This new platform was introduced to boost transparency and liquidity as well as increase efficiency in bond trading.

ETP was developed and customized based on the Korea Exchange's bond trading

system and allows dealers to match bids with offers, negotiate deals and access

historical data through a common computerized network. ETP offers investors a real-

time price quotation and facilitates the trading and reporting of all secondary market

activities.

Member Participants can carry out transaction through 3 types of functions, namely:

a. Order Matching

Order matching refers to the matching of identical orders placed by the buyer

and seller into the pool that will automatically match the order in the pool

according to the matching mechanism with a set of predefined matching

principles. Once matched, an acknowledgement will automatically be sent to

both parties.

b. Trade Negotiation It is a process whereby the trader advertises the quotes to selected participants.

The respective parties may respond to the quotes advertised and negotiate

electronically with the initiator to reach a favorable and agreeable price/volume.

c. Trade Reporting A function to report any trade concluded between buyer and seller that has been

trade outside the system. The system shall allow the parties involved in off

market trades to report all transactions immediately regardless whether one or

both of the parties to the transaction is a member participant, whether for own or

clients’ account.

2.3 Conclusion:

The above analysis lead the Committee to conclude that in order to promote the debt market

and provide market participants with an efficient trading platform, a hybrid structure will be

required which provides an automated order-driven trading interface together with the

flexibility embedded to facilitate the negotiation between market participants. However, it was

also observed that as long as the off-market transactions are continued to be permitted by

SECP, market participants will not prefer to actively participate on the BATS due to inherent


ease of trading on OTC market and the lack of transparency which facilitates the transactions

between identified parties with specific motive to manipulate the prices.

While agreeing to the need of discontinuing the off-market trades, the Committee also

concludes that the transition from OTC to a purely exchange based undisclosed automated

system should be accomplished in a phased manner and a complete switch to the

anonymous trading will be a significant deviation from the international practices.

Consequently Committee feels that the BATS model should be equipped with features that

also facilitate the negotiation between counter parties in light of small number of market

participants and the existing low level of liquidity in order to provide impedes to the developing

market. It is noted with satisfaction that reporting of all trades carried out in the listed TFCs

has already been made mandatory and the second phase of market development should

focus on restricting the off-market trades by discontinuing the relaxation being granted by

SECP, at the same time revamping the BATS model to provide the required degree of

flexibility. Following are the recommendations in this regard:

2.3.1 All or None Option

It is recommended to add a new order type in BATS called “All or None” which shall be

used by sellers to fill the order completely or not at all. If there is insufficient supply to

meet the quantity requested by the order then it is canceled at the close of the market.

This feature is being added considering the dynamics of debt market where the buyers

and sellers prefer to trade in pre-defined lots and the fear of partial execution of orders

can hamper the active participation in the market. Although the option of All or None

orders is currently available for buyers, similar option may be provide for sellers so that

partial orders cannot be executed.

2.3.2 Request For Quotation (RFQ)

Request for Quotation is recommended whereby an interested party can ask for quotes from the market or selected participants. This feature will facilitate the system based negotiation between the parties and assist in efficient price discovery.

2.3.3 Indicative quotes

Considering the existing small number of market participants and low level of liquidity, it is recommended that market participants should be able to provide indicative quotes which will encourage the online negotiation without the fear of having committed oneself to an inefficient price. The role of market maker has importance in debt market and this functionality will equally fulfill the needs of market maker.

2.3.4 Disclosed Trading

The committee recommends buyer and seller member codes should be displayed on the TWS on optional basis to facilitate the negotiations between the parties considering the


revised risk management regime which places greater emphasis on the counter party risk as discussed below.

2.4 Review of BATS model

Committee also reviewed the existing BATS model and aimed to identify the practical issues which can hinder the active participation from the market. Following improvements are suggested:

2.4.1 Circuit Breakers:

Price Discovery is the key element for the development of secondary market, which gets

impeded by Circuit Breakers (CBs). Yet, they protect clearing-house, investors and

intermediaries from large defaults caused by extreme market movements and provide

time-outs to the market when they get overheated and investors are unlikely to act

rationally.

Committee debated in detail the current level of circuit breakers which restrict the

maximum price movement in a TFC to Rs.5. It was observed that that the current

MUFAP prices are not indicative of true market value in all cases and therefore do not

provide an adequate basis for opening prices on which CBs can be levied. In this regard,

the practice adopted for the equity segment was also discussed in detail whereby no

CBs are imposed on the first day of trading in order to facilitate the price discovery. It

was noted that due to illiquid nature of the debt market, extended period will have to be

allowed for price discovery. It was also noted that due to the low level of liquidity, the

price of TFCs can fluctuate beyond the corridors of CBs. It was also noted that the

current system will update the price on the basis of weighted average of bid and offers

after three days which may prevent market participants, specially mutual funds, from

taking timely exit and meeting their liquidity demands.

One of the key reasons for imposing the CBs is the risk management system (RMS)

which requires CBs in order to ensure the sufficiency of collaterals collected by the

clearing company. Since the Committee has proposed a revised RMS regime which will

close out the deal in case of default and will use the margins as a penalty, it is felt that at

the initial stage, the system should operate without CBs in order to facilitate efficient

price discovery and prevent any adverse impact on the market participants.

2.4.2 Enhancing BATS trading interface The committee revisited the BATS interface and noted some shortcomings, which are

annexed as Annexure B; the exchanges are requested to make the said changes in their

BATS interfaces, in order to make BATS interface in line with practices and terms

applicable and suited to debt market.


2.4.3 CVT Anomaly Currently 0.02% Capital Value Tax (“CVT”) is still charged on purchase of TFC along

with 0.01% Withholding Tax (“WHT”) whereas CVT has been waived on equity segment

through Finance Act 2010 and only federal excise duty is applicable on trades of equity

segment. This double taxation discourages investors from investing in TFC. The

committee recommends abolishing CVT on TFC.

2.4.4 Cross Listing One of the problems associated with the trading of TFCs on BATS is the fact that

TFCs are not listed on all exchanges. As a result, investors of one city face difficulties

in trading through BATS in a TFC which is listed in a different city. It is observed that

if off-market transactions are completely restricted, only those brokers which have

dual membership of more than one exchange will be able to trade in TFCs listed at

different exchanges. To resolve this issue, it is imperative that innovative solutions

are provided to enable the listing of TFCs across all exchanges. It must be noted that

the issuers of existing TFCs have already completed the capital raising process and

therefore have no incentive in getting listed on different exchanges. Exchanges

therefore need to come forward and facilitate cross-listing by providing relaxations in

the listing fees and sharing the documents submitted by the issuer.

Currently 1/20th of 1% is the usual annual listing fee charged by the exchanges.

Exchanges are requested to devise mechanisms and procedures as such that once

listed with one Exchange, the TFC is deemed listed at all exchanges and the listing fee

are divided amongst all the three exchange. The committee requests that such practice

may be adopted for at least five years or till such time deemed appropriate by the all

exchanges.

2.4.5 Market Maker Clause XIII of Chapter IV- 12 of SECP guidelines for TFC state that “In order to make

the TFCs more liquid, the issuers are encouraged to appoint a Market Maker. The

Market Maker shall give the offer and bid prices of TFCs daily in the secondary market.

A market maker may be a Brokerage House or an Investment Bank.”

The committee observed that since launch of BATS, no official market maker has been

designated. Therefore the committee recommends all exchanges to enforce issuers to

appointment at least one market maker amongst brokers for each listed TFC.


2.4.6 Availability of BATS with all NBCMS

Trades can only be entered into BATS through brokers of the exchanges. In order to provide institutions with direct access to the market, it is recommended that BATS terminals should be provided by the brokers to the Non-Broker Clearing Members (NBCMs) of the exchanges and trades executed from these terminals should be auto-initiated for IDS transactions. NCCPL should coordinate with the exchanges and NBCMS in this regard.

2.4.7 Market awareness

Committee noted that one of the key issues underlying the performance of BATS is the level of market awareness particularly form the banking industry. It is recommended that extensive efforts should be concentrated in this area by exchanges and NCCPL by holding presentation and workshops to explain the modalities and features of BATS to the market participants. It is also recommended that effective reference material is developed and made available with all brokers to facilitate and educate general investors regarding the TFC market.


3. REVIEW OF RISK MANAGEMENT 3.1 Currently a slab based margining regime is applicable on BATS with normal default

management procedures which largely rely on the selling/ purchasing of the underlying

security in the event of default through square up market and allocation of losses to all market

participants in case the collaterals are not sufficient. It is noted that the low level of liquidity in

the market and the absence of VaR figures can lead to large losses. There is also the general

misconception regarding the NCCPL’s role which does not act as a central counter party or

the “guarantor of every trade” and only acts as a facilitation agent. It is also noted that large

margin percentages will hamper the trading activities due to liquidity constraints. Taking these

factors into account, considering the practical example of India where the settlement are

based on counter party risk, the Committee recommends that the RMS of BATS should be

revamped in the following manner with a view to facilitate the market development process:

The margin slabs should be changed in the following manner:

3.1.1 Existing:

Description Exposure Margin

Par Premium Margin Total Margin

TFC (having minimum credit rating of A) > par premium

2.5% of the Exposure amount

50% amount of the excess market value

2.5% of the Exposure amount + 50% amount of the excess market value

TFC (having minimum short term credit rating of A) < par (discount)

2.5% of the Exposure amount

25% of the amount of discount with par value

2.5% of the Exposure amount+25% of the amount of discount with par value

TFC (having minimum short term credit rating below of A) > par premium

5% of the Exposure amount

100% amount of the excess market value

5% of the Exposure amount + 100% amount of the excess market value

TFC (having minimum short term credit rating below of A) < par (discount)

5% of the Exposure amount

25% of the amount of discount with par value

5% of the Exposure amount+25% of the amount of discount with par value


3.1.2 Proposed margin slabs:

Issue size Margin % Upto Rs.1 billion 1% Between Rs.1 billion and Rs.3 billion 1.5% Above Rs. 3 billion 2%

The margins are recommended to be strictly in cash. In future, when stock exchanges have developed the valuation methodology for T-bills, the same may accepted as collateral. The option of pre-settlement delivery is also recommended which will enable a seller to deposit the underlying shares with the NCCPL before the settlement date and all margin requirements shall be waived.

3.1.3 Close out process

On the occurrence of a failure by a Debt Market Clearing Member (“DMCM”) to fulfill

his settlement obligation, the Closed-out process shall be initiated by NCCPL on

Counter-Party basis as follows:

• In case of default by buyer DMCM i.e. failure in payment of its money obligation,

such trade shall be closed-out at the trade price and the delivered TFC’s shall be

returned to the seller DMCM along with the margins so collected from the

defaulted buyer DMCM at the time of trade.

• In case of default by seller DMCM i.e. failure in its delivery obligation, such trade

shall also be closed-out at the trade price and paid amount shall be returned to

the buyer DMCM along with the margins so collected from the defaulted seller

DMCM at the time of trade.

3.1.4 Blacklisting

It is recommended that any defaulting investor should be suspended from the debt market for a period of six months. In case of multiple defaults from a same broker, the broker must also be suspended for a period of six months.


4. REVIEW OF CURRENT PRICING METHODOLOGY

4.1 The committee reviewed in detail the existing pricing methodology which stipulates that:

“For Debt Market, the closing price shall mean the volume weighted average price of the trades during whole day. In case of no trading in that particular security for three continuous Business Days, then, in such case, the closing price shall be updated on the basis of bid and offer mechanism whereby Bid/Offer must be better than last traded price and satisfy the following conditions: (i) Bid/Offer is available for trade at the time of closure of the market. (ii) Bid/Offer remains un-changed during this time For the purpose of above, the volume weighted average of bid and offer of last three days on which the bid and offer are available shall be considered” The Committee discussed that due to low level of liquidity and frequency of trades, the above policy is not appropriate and system must have a reasonable look-back period for calculating the closing price. Furthermore, there must be a threshold for selecting the transactions that can affect the closing price in order to prevent the manipulation of prices on the basis of small transactions.

4.2 Recommendations

The Committee recommends Pricing of listed TFCs based on the following rules: • If the issue size of TFC is below Rs. 1 Billion, then the maximum cut-off threshold

considered for price calculation shall be Rs. 15 million • If the issue size of TFC is above Rs. 1 Billion, then the maximum cut-off threshold

considered for price calculation shall be Rs. 25 million • The volume weighted average price of the trades during last thirty days shall be

considered for each TFC within the above thresholds. • In case of no trading in that particular TFC or trades below the above mentioned

thresholds during last 30 days, the last reported trade price or the weighted average of offers made by sellers, whichever is lower, shall be considered for calculating the price. Provided that only those offers with a minimum volume of Rs.10 million shall be considered for this purpose.

• The system should clearly identify whether the closing price is calculated on the basis of weighted average of trades or is reflecting the last reported trade.

Committee also recommends that there must be an effective mechanism for surveillance of debt market trades by Exchanges and SECP in order to detect any manipulative trades which have been carried out with a view to inflate or decrease the price. Currently the debt market is infected with such trades which are effected between parties for an agreed period of time and are subsequently reversed with an objective to affect the net asset value of mutual funds. It is recommended that such trades should be identified on a prompt basis, investigated and excluded form the calculation of closing price.


5. UNLISTED TFCS

5.1 A major portion of the corporate debt is constituted by unlisted TFCs which are currently traded

at OTC market or off-market as a result of direct negotiation between the parties. In order to

ensure efficient price discovery and transparency, it is important that a centralized platform is

provided for trading or reporting of trades carried out in such securities. While the most easy

solution appears to recommend the mandatory listing or technical listing of all these TFCs, it is

noted that there are several considerations underlying such approach. Many of the unlisted TFCs

are represented by re-structured loans. Further, as per the current legal framework, listing of any

security of a company grants that company status of a listed entity. It must be appreciated that

there are many privileges and responsibilities associated with this status such as corporate

governance, increased public disclosures and tax advantages/ consequences. Accordingly, care

is required while providing the listing status to any company especially in case of privately placed

TFCs of small sizes. Committee has noted with satisfaction that KSE has already launched a

platform which facilitates listing by providing a much simplified process and trading is limited to

Qualified Institutional Buyers in that platform.

5.2 Many stock exchanges around the world provide trading facilities for unlisted debt securities also. However, the requirements of section 8 of the Securities and Exchange Ordinance, 1969 prohibits the trading of any unlisted security at the exchanges.

5.3 In view of the above, it is recommended that reporting of trades of unlisted TFCs to stock exchanges should be made mandatory on a real time basis. Such trades should be disseminated to market on the BATS alongside the trades of listed TFCs with appropriate identification.

5.4 Restrictions should be imposed upon the transfers of unlisted TFCs in the CDS and only those transfers should be allowed which are represented by trades reported to stock exchanges. Another useful option would be the mandatory settlement of unlisted TFCs through the NCCPL. If that option is exercised, the reporting of trades to stock exchanges will also be facilitated since the reporting function can be performed by NCCPL. It is felt that complete reporting of all trades in unlisted TFCs at a centralized platform will lead to more efficient price discovery.

5.5 In addition to above, the Committee recommends that for unlisted TFCs that meet the eligibility criteria for listing on normal counter or the OTC counter, an incentive scheme should be launched by the stock exchanges by providing waivers/ relaxation in the listing fees and providing a speedy process to encourage listing of such instruments. Committee also recommends that exchanges and SECP should conduct a thorough review of the listing process with an aim to curtail the unnecessary formalities or documentations and reduce the timeframe for the listing process.


6. ROADMAP

6.1 In order to ensure the development of debt market, it is essential that a long term road map is

developed which is augmented by appropriate policies and milestones. Committee therefore

recommends that a review is conducted after six months with following milestones:

• The features for negotiated deals should be reviewed and if considered appropriate,

monetary thresholds should be defined above which negotiated trades would be

allowed. For trades below such thresholds, the automated order matching system

must be used.

• The RMS must be reviewed with a view to introduce a VaR based model or any

another model based on international best practices and applying a robust margining

regime

• The appropriate level of circuit breakers should be decided

• The pricing methodology should be reviewed and suggestion be provided for

improvements

• The reporting of trades in unlisted TFCs should be reviewed and recommendations

should be provided for improvements


ANNEXURE A International Bond Markets Jurisdictions

Country Trading Venue Earliest year of

Operation Execution

Methodology Direct Participants Electronic or by

phone OTC Market 1980’s Bilateral Dealer

Institutions Electronic by Phone

Australian Stock Exchange 1999 Cross Matching Order Driven

ASX Broker Participants Electronic

Australia

Yield Broker 2001 Bilateral Dealers Electronic BovespaFix(Sao Paulo Stock

Exchange) 2001 Cross Matching

Order Driven

Dealer to Dealer Electronic or by PhoneBrazil

CETIP(OTC market) 1986 Bilateral Dealers By Phone Inter- dealer Bond

Brokers(4IDBs) 1975 Bilateral

Order- Driven Dealer to Dealer Electronic or by Phone

ATS (3 systems)

2001

(i) Cross-matching (ii) Request for Quote -

dealers acting as liquidity

providers (iii) Order-driven,

anonymous trading

Dealer -to –Institution Institution-to-institution

Retail Investors Can access One system indirectly

through dealers

Electronic

OTC market

Bilateral Principal market

Dealers Institutional investors

Retail investors

By phone Fax

Electronic (dealer systems)

Canada

Toronto Stock Exchange

1987 (first trades of corporate bonds on the exchange)

Cross-matching Continuous auction

market

Participating organizations (dealers)

Institutions and retail investors access the

exchange indirectly through dealers

Electronic access to the

exchange Orders may be called

in to the dealer

Euronext

1990

(first year of electronic bond

trading)

Cross-matching Auto-matching Order-driven

Exchange members

Electronic

France

OTC market

Bilateral

Dealers Institutions

Electronic or by phone

Frankfurt Stock Exchange

Frankfurter Wertpapierbörse: 1585; Deutsche

Börse AG (operator holding):

1993

Order-driven

Exchange participants

Floor trading and electronic

Germany

OTC market Bilateral

Dealer-to-dealer

By phone

Stock Exchange of Hong Kong

1986

Cross-matching Auto-matching Order-driven

Dealers (exchange participants)

Electronic

Hong Kong

Bloomberg

1999

Multi--dealer auction

Dealer-to-dealer

Electronic

Italian Stock Exchange

1994

Cross-matching Order-driven

Dealer-to-dealer Retain investors can access

indirectly through dealers

Electronic

MITS

1988

Quote-driven



Electronic

TLX

2003




Electronic

ATS

Cross-matching Multi-dealer Order-driven

Dealer-to-dealer Retail investors can access indirectly through dealers

Electronic

Italy

OTC Market

Bilateral

Dealers

By phone

Japan Stock Exchanges 1966 Auction Authorized intermediaries Electronic


OTC market

ATS(2

1948

Bilateral Multi-dealer

Dealer-to-client Multi-dealer


Malaysia

OTC market

1989

Bilateral

Dealers

Electronic and By phone

Kuala Lumpur

Stock Exchange (KLSE)

1989

Order-driven

Exchange members

Electronic

Mexico

BMV(3) (Mexican Stock Exchange)

1975


Dealer-to-dealer

Electronic

Brokers

1998

Dealer-to-dealer


Singapore Singapore Exchange

Securities Trading Limited (SGX-ST)

1998 Cross matching Order-driven

Dealer-to- Dealer Institutions and retail investors access the

exchange indirectly through dealers

Electronic

OTC market

Bilateral

Dealers Institutional investors

Retail investors


AIAF market

1991

Bilateral

Dealer-to-client Dealer-to-dealer

By phone

Madrid Stock Exchange

1993


Electronic

Spain

1993

Bilateral

Electronic

Switzerland

Swiss Exchange

1996

Cross-matching Auto-matching,

Order-driven but also offer

order books such as bilateral trade

matching

London Stock Exchange

Market maker

Exchange members


ATS i) Multi-dealer ii) Order-driven

Dealers, fund manager and other investment firms

Electronic Electronic

United Kingdom

OTC Market

Bilateral

Dealer-to-institution Dealer-to-dealer


Multi-dealer alternative trading

systems (2 systems)

1999


Electronic

Inter-dealer broker alternative trading

systems (2 systems)

2000

Order-driven

Dealer-to-dealer Dealer-to- institutions

By phone

Single dealer trading system

1999

Automated limit orderbook


Electronic

Alternative trading systems (3 systems)

2000

Cross-matching

Dealer-to-institution Retail and institutions

through dealers

Electronic

Auction – alternative trading

system

2000

One-sided Bids-wanted


Electronic

United States

New York Stock Exchange’s

Automated Bond System System

1977


NYSE members

Electronic

In order to study the corporate debt market of other jurisdictions, the committee studied over a dozen different markets ranging from underdeveloped, developing and developed markets


from Asia/Asia-Pacific, Europe, and North-America etc. The Debt Market Development process in various markets has been a very old phenomena dating back to as long as from mid-1970’s. Amongst the markets studied by the committee, fourteen markets had Order Driven systems and a dozen had bilateral system. The market participants in around ten markets were Dealer to Dealer, three had Dealer to Client access and around four had Dealer to Institutions linkage. Four markets had retail investor’s access to Exchange, nine had Electronic and Phone based order matching system, a dozen Exchanges have Electronic and about half a dozen had Phone based system.


ANNEXURE B


DEAL TICKET Deal Ticket requires adding of price entry mechanism input as to obtain yield when price is entered. Current Value should be named as unredeemed value. Benchmark rate is to be termed as Current Coupon Rate. Coupon rate should be named as Base Rate. Total Amount should be named as Purchased Value. In calculating Accrued Interest the number of day’s convention is taken as 365 days currently.


YIELD CALCULATOR Rate to IRR should be changed with price to yield. IRR to rate should be changed to yield to price. 6 Month KIBOR should be used for the 6 Month TFC and for 3 month TFC 3 month KIBOR should be used.


bonds automated trading system (bats)

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