FIS Blog

Trading in Asia: Why the five percent rule is all about risk management


Chris Rojek | Monday, February 15, 2016

In most markets, if you want to buy a stock as a retail investor you have to have cash in your broker’s account before you place the order. But the Singapore and Malaysia markets practice contra trading, which means that retail investors can buy stock and deliver the cash later. As long as the cash is delivered before the stock transaction closes, this is completely acceptable – and it’s standard practice in these markets. (It’s also not dissimilar to margin trading, which is particularly popular in China)

But the penny stock crash in 2013 upset the status quo. In Singapore, there are plenty of stocks that trade below one cent, and there is a lot of turnover and volume. They are particularly popular among retail investors. In October 2013, some of the biggest penny stocks crashed. Three locally listed companies – Blumont Group, Asiasons Capital and LionGold Corp – were worth a combined S$2.34 billion at the beginning of 2013. On October 1, the combined value of the three companies had increased to S$10.53 billion following a series of acquisitions and a surge in interest in penny stocks. On October 4, their ascent abruptly ended. The shares nosedived, losing about S$5 billion in market value in the first hour of trading before the Singapore Exchange (SGX) stepped in to suspend trading. By the end of October 2013, the combined market value of the three companies was a mere S$842 million.

Another stock, Innopac Holdings, was trading at 14 cents and five minutes later was trading at 0.007 cents. Because they weren’t required to fund their transactions up front, a lot of retail clients simply walked away from the deals, leaving the brokerage industry to take a series of losses. SGX and the Monetary Authority of Singapore (MAS) found themselves under pressure to address the contra trading problem.

One obvious response might be to ban contra trading. It’s certainly not practiced in the vast majority of markets. But then, the majority of the market’s liquidity would disappear. So MAS and SGX proposed the Review of the Securities Market Structure and Practices – more commonly known as the five percent rule. The five percent rule is a margin-like premium that brokers collect from their clients. On the surface, it’s a simple concept. Retail investors may continue to purchase stock first and pay later provided they have at least five percent of the value of outstanding stocks as collateral with the broker at the end of the day.

But look beneath the surface, and you’ll discover a very significant effect that is only now becoming clear.

MAS’s own statement on the key objectives of the rule provides a big clue: “(i) mitigate the risk of substantial loss of investors from excessive trading on unsecured credit; (ii) strengthen credit risk practices in the industry by reducing reliance on remisiers to bear the credit risk of investors; and (iii) promote orderly trading and prudent investing among investors.”

What is the most important word in that statement? Risk.

MAS has explicitly said that it will have the power to impose higher collateral requirements on a broker – if it is not satisfied with the broker’s risk management practices and ability to manage exposures deriving from client trading activity.

This has fundamental implications for both the business processes and the IT infrastructures of brokers in Singapore – and potentially other, bigger markets. Contra trading is also practiced in Malaysia, whose regulator is watching the Singapore market very closely.

And on the other end of the spectrum of market size, contra trading is very similar to margin trading (also known as margin lending), where the broker lends the money for its clients to buy stocks. China is the biggest market for margin trading. Looking at the Chinese regulators and the size of the market, I wouldn’t be surprised if China takes a similar approach to margin lending practices, which have fueled the speculative bubble in the first half of 2015.

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