When it comes to stock marker reforms, the behaviour of brokers appears puzzling at first.

After all, brokers themselves were the driving force behind certain reforms such as introduction of electronic trading, ‘dematerialisation’ of shares through creation of CDC, switching from ‘quote driven’ trading to ‘order driven’ trading, and replacing periodic settlements with rolling settlements.

Without any doubt, all these reforms have made trading more transparent and safer by reducing opportunities of manipulation by brokers and by reducing systematic risk. It must be emphasised that these reforms were primarily broker-driven with regulators taking the back seat.

However, there are other reforms (regulator-driven), such as eliminating badla (CFS is a variation of badla) and the demutualisation of stock exchanges, which the brokers are stalling. These other reforms are also aimed at improving transparency and reducing the systematic risk. If both sets of reforms have the same objective, how come brokers forcefully argue for one and stall the other?

It is also a common perception among participants and commentators that most of the benefits of market manipulation go to big brokers who are not more than a dozen in number. However, the reputational costs are shared by the entire broker community. There are 200 brokers in the Karachi Stock Exchange alone. If most of the gains go to only a dozen and the costs go to all, why don’t the other brokers out-vote the manipulating bloc and elect directors who would check such manipulation?

In this short note, I will argue that both the questions raised above have a common answer. The answer lies in understanding the interactions between announced formal rules and historically developed informal rules. If we consider the process of reforms as a mere transplantation of formal rules from developed markets to our markets, the questions remain unanswered. But, if we consider the interactions of these transplanted rules with existing informal rules underlying our markets then things appear to fall into place and coherent answers to the questions raised above are found. Along the way, we will see that the underlying ‘rent structure’ that shapes the informal rules is very different from what one typically sees in developing countries.

Normally, rent-seekers aim to gain privileged positions through favourable government interventions. The “SRO culture” in our industrial sector is a case in point. But in the case of the stock market, the privileged positions have arisen endogenously through market interactions. Hence, the rent-seekers of the stock market do not want government interference in their affairs. Consequently, the politics of rent-seeking is very different in the stock market.

Before answering the above questions, one myth perpetuated by brokers needs to be debunked. Brokers often argue that badla has been eliminated and now we have a new system called ‘Continuous Funding System’ or CFS. In reality, CFS is just another form of badla. In fact, it is an even stronger form of badla since it not only makes funds available for a longer period but also operates in parallel with the ready market. As will become clear shortly, it increases the defacto power of ‘badla kings’ by strengthening the informal ties among brokers.

I will begin by addressing the second question first. Consider two games, one with formal rules and another with informal rules. Initially, assume that the two games are not linked. The formal game has legally spelled out procedures for election of five- member directors. There are about 200 brokers who can vote. The informal game is one in which few large brokers decide how to allocate badla funds to other brokers. Badla is lucrative to all brokers since it magnifies their trading volumes and consequently their incomes.

Of course, large brokers with badla funds have complete freedom to decide who gets badla. If the two games are separate, it is optimal for the majority of small brokers to unseat member directors who favour large brokers in the formal game. But, by strategically linking the two games, that is, by making badla availability in the second game conditional on cooperative voting in the first game, few powerful brokers can manipulate the outcome of elections.

The first question is now fairly easy to answer. Broker-driven reforms are exactly those that increase the component of the informal game in the pooled incentive constraint across the two games. “Dematerialisation of shares”, “badla market operating in parallel with the spot market” and “rolling settlements”, all increase the efficiency with which the badla funds can be employed along with some mitigation of systematic risk. Both outcomes favourable to badla financiers. Broker-driven reforms are exactly those that increase the defacto power of already powerful brokers.

In contrast, regulator-driven reforms are those that, if implemented, will weaken the component of the informal game in the pooled incentive constraint across the two games. No wonder such reforms are stalled. Hence, the brokers’ response to the two sets of reforms is entirely consistent. Consequently, regulators cannot negotiate their way to success with the brokers who already have defacto power due to the privileged position that the market has bestowed on them due to badla financing. Note that the market has endogenously given them this privileged position and no government action was involved. Hence, this type of rent is very different from the rent associated with the SRO culture.

Also, another intriguing development is brokers entering into the commercial banking sector. Some of the brokers are now operating their own commercial banks. Serious conflicts of interests have been created here along with substantial increase in the defacto power of some brokers. There must be a strong regulatory response here. The consequences of repealing the Glass-Steagall act in the US are in front of us in the form of this global financial crisis. We need a Glass-Steagall act of our own to avoid our own localized financial crises.

So, what’s the way forward? It is clear that policy makers cannot win this battle with the brokers as long as the powerful brokers are on their own turf. The battlefield needs to change. I suggest that a new stock exchange called the “National Stock Exchange of Pakistan” be created. That new exchange should start out with all the reforms in place. Most importantly, the new exchange must have a totally separate spot and derivatives market and not an amalgamation of the two in a strange mixture of CFS and spot. Investors with speculative appetite and short-term horizons should be deflected to the derivatives market. Spot market should only have transactions for delivery. The transparency of the new market will first attract investors, and then firms will follow. This will create strong competitive pressures on the existing stock markets and powerful brokers will have no choice but to accept the reforms.

The writer is a faculty member in the department of economics at Lahore University of Management Sciences.