To enhance Sri Lankan Capital Market:

SEC launches new initiatives

The Securities and Exchange Commission of Sri Lanka (SEC) will be launching several initiatives this year to uplift the standards of the Sri Lankan Capital Market to be on par with global trends.

Thus, the SEC fulfils its statutory obligations in two primary ways - through rule making and enforcement. However, the responsibility of the SEC is not confined to the above. The SEC spearheads many an effort to develop the Sri Lankan capital market. A few such endeavours are outlined below.

The proposal to introduce a Central Counter Party:

A Central Counter Party (CCP) is “an entity that interposes itself between counterparties to contracts in one or more financial markets, becoming the seller to the buyer and the buyer to the seller” (CPSS / IOSCO, Recommendations for Central Counterparties, November 2004).

A CCP helps facilitate the clearing and settlement process in financial markets. The role of a CCP comes into play after a trade is concluded. A CCP interposes itself between counterparties to financial transactions, becoming the buyer to the seller and the seller to the buyer. A well designed CCP with appropriate risk management arrangements reduces the risks faced by participants and contributes to the goal of financial stability.

Presently, at the Colombo Stock Exchange, without the existence of a CCP, both the seller and the buyer assume the counter party risk. There is no protection for market participants, in the event the other party defaults. With the introduction of a counterparty, it will act as a buyer for all sellers and as a seller for all buyers in all transactions. The CCP guarantees settlement through the use of collaterals and margins. The CCP settles the transaction with the affected party in the case of a default.

The introduction of trading in derivatives

The definition of “securities” in the SEC Act has been broadened so as to include derivatives. The establishment of a CCP will pave the way for such trading in derivatives to take place. Derivatives are financial products with value that stems from an underlying asset or set of assets. These can be stocks, debt issues, or almost anything. A derivative’s value is based on an asset, but ownership of a derivative does not mean ownership of the underlying asset. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

Future contracts, forward contracts, options and swaps are the most common types of derivatives.

Securitization

Securitization is a process by which an entity (“originator”) pools its interest in identifiable future cash flows and transfers the claim on those future cash flows to another entity that is specifically created for the sole purpose of holding them (i.e. Special Purpose Vehicle).

This process of securitization involves two steps. Firstly, a company which has receivables as assets in its balance sheet identifies certain receivables it wants to remove from the balance sheet and pools them together. Once the assets are pooled the company can sell such assets to the Special Purpose Vehicle (SPV). Secondly, the SPV finances the acquisition of the pool of assets by issuing tradable interest bearing securities to capital market investors, by way of private placement and public offering.

The SPV can structure the securities to be issued into different classes of securities. This is in order to allow investors with different risk appetites to invest in these securities. The SPV could get a rating agency to rate the securities. The securities will be issued at different interest rates depending on the risk attached to each class.

Since the assets transferred to the SPV are streams of future receivables it requires timely collection of such receivables. Although the assets are transferred to the SPV it does not have the required infrastructure to actually manage the collection of the receivables. The party doing so is called the “servicer” and the servicing functions generally include mailing monthly statements, collecting payments and remitting them to investors. Generally the servicing functions are carried out by the originator. The originator is best suited to carry out such functions due to the relationship it already has with its clients and the availability of the required infrastructure.

The securities issued by the SPV are referred to as “asset backed securities”. Investors of “asset backed securities” have a claim only over the pool of assets transferred to the SPV. Further, these investors are not affected by the financial position of the originator and hence would not be affected by the bankruptcy of the originator.

The main advantage of securitization is that it provides an avenue for originators to obtain funds for future investments without increasing the liabilities of the company. In contrast, borrowing money by way of a loan or by the issuance of debt instruments would increase the level of leverage of the company.

The proposed Act on “Regulation of asset - backed securitization” will ensure investor protection by requiring disclosure and by appointing the SEC as the regulator to regulate the securitization process.

The Act will introduce regulation to this sector on an “opt in” basis whereby originators may opt to come within the regulation of the Act. If they chose to do so, it will provide certainty to the transaction and in the long term it is expected that investors will require Originators to issue securities which come within the regulatory framework set out in the Act.

Demutualization of the Colombo Stock Exchange

Traditionally, stock exchanges have been organized as mutual associations controlled by their members. (Typically they limit their ownership to brokers and appoint a number of independent or public representatives to offset the self interest of their members) Thus, there is a close identity between owners of the organization and the direct users of its trading services and the members enjoy rights of ownership, decision making (one member one vote) and trading.

The Colombo Stock Exchange (CSE) is one such “mutual exchange”. It is a company limited by guarantee and is controlled by the member broker firms. These members, while benefiting from the use of the trading platform, do not have access to the assets or profits of the exchange.

Demutualization generally involves the conversion of an exchange from a “not for profit” member controlled organization to a “for profit”, shareholder owned, corporation. There is a change in the legal status of the exchange from a mutual association, with one vote per member, into a company limited by shares, with one vote per share ,making way for majority based decision making. Demutualization induces a change in the exchange’s objective from managing the interests of a closed member based organization (with the central focus of providing services for the benefit primarily of members), into a company (with the objective of maximizing the value of the equity shares) by focusing on generating profits.

Stated simply, demutualized exchanges operate as “for profit” entitles organized as corporations with a share capital which may even be listed and publicly traded. These exchanges comprise of three separate entities: owners, decision makers, and customers and can take many forms - some demutualize and become public listed companies (by listing on their own exchange as in Australia), some have demutualized but remained private corporations, while others have become subsidiaries of publicly traded holding companies (E.g. the Kuala Lumpur Stock Exchange, the United States Pacific Exchange).

This separation of membership, ownership and management is thought to bring about many benefits to the capital market, economy, investors, listed companies, market participants and to the exchange itself.

The Securities and Exchange Commission hopes to demutualize the Colombo Stock Exchange by way of a special Act of Parliament. This Act will convert the Colombo Stock Exchange from a company limited by guarantee to a public company limited by shares.

A new Takeovers and Mergers Code

The Code’s principal aim is to ensure fairness to shareholders during the course of takeovers. The Code also provides an orderly framework in which takeovers are conducted.

The Code was first introduced in 1987, and was revised in 1995 and 2003. It has now been over six years since the last revision, and the SEC believes a new Code is necessary.

The new Code envisaged not only proposes to address the shortcomings in and the difficulties posed by the existing Code, but also to provide the discretion to the SEC to determine the applicability of certain rules to the situation at hand.

Introduction of Exchange Traded Funds

An Exchange Traded Fund (or ETF) is an investment vehicle traded on the stock exchange. An ETF holds assets such as stocks and bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day.

ETFs are similar in many ways to traditional mutual funds, but the shares in an ETF can be bought and sold throughout the day on the exchange through a broker-dealer.

A change in the index value will be reflected in the price of the ETF.

The “authorized participant” or “participating dealer” will put together a corpus of securities (an index basket) with the asset management company and in turn will receive “creation units” or “ETF Units” from the asset management company. What is to be included in this index basket is determined by the asset management company. The participating dealer is free to dispose the ETF units on the stock exchange.

Technically, the deposited basket of securities is held by the trustee of the ETF, who will then create a specific number of creation units as determined by the asset management company.

The participating dealer can also redeem the ETF shares by delivering them, in ETF units, to the trustee, in return for a basket of securities, which is equivalent to the value of the redeemed ETF units.

There are many benefits of ETFs to retail investors. For instance, ETFs are easy to use, low risk and transparent, could be traded any time during trading hours and provide for dividend opportunities.