Licensing Policies for Brokers in Doha Securities Market
Research submitted to: Qatar Financial Market Authority
April 2008
Authors: Professor Ritab Al-Khouri Dr. Abdelgadir M. A. Abdullah Dr. Hicham Benjelloun Dr. Khalid Shams Corresponding author. Prof. Ritab Al-Khouri. Tel: 5400929; E-mail address: [email protected]
1
Acknowledgement
The researchers would like to extend their gratitude to Qatar Financial Market Authority for their support and for their help in providing valuable information. Also, our thanks are extended to Doha Stock Exchange for their help. We would like also to acknowledge all the people who offered us with their valuable comments.
2 TABLE OF CONTENTS Page Executive Summary 4
1- Introduction 6
2- Theories of Financial Intermediation
3- Capital Market and Institutional 8
4- Licensing Policies 11
4.1- Discussion of the Current Criteria of Licensing Brokers 13
and Suggested Changes
4.2- Advantages and Disadvantages of Open Door Policy for 19
Licensing Brokers
5- Fitting DSM into the Framework of the International Trend in 21
Brokerage Industry
6- Commissions and Charges of DSM 23
7- Brokers Commissions 26 8- Comparison Between Rules Governing Brokerage Activities 29
and Commissions in Different Markets
- Appendix1: The Development of the Major Stock Markets, and Lessons 35 to be Learned. Appendix2: DSM Licensing Rules 53 - Glossary 58
- References 59
3
Executive Summary
This report addresses two questions: 1. Should there be more brokers and what would be the optimal licensing policy? 2. Are the current commissions paid by investors appropriate? If not, what would be an appropriate commission scheme?
To give a policy recommendation and answer the above questions we consider the point of view of both investors and participants in the stock exchange. We attempt to provide recommendations that are fair to the investors and that take under consideration the institutional characteristics of Doha Securities Market (DSM henceforth) and the practices of international exchanges. We also emphasize in our analysis the issue of investor protection from abuse in their relationship with brokers, the cost of monitoring the activities of stock brokers by the Qatar Financial Markets Authority (QFMA henceforth), and the size of the market.
Based on our analysis we reach the following recommendations:
1. QFMA should allow big brokerage firms and banks to enter the business and limit the entrance of small firms. 2. QFMA should increase the capital required from QR5 million to QR15 million to limit the number of brokers and thus make it easier and less expensive to monitor brokers and protect investors. 3. Banks entering the industry should create a separate legal entity that is fully devoted to broking activities.
4 4. Corporations entering the brokerage industry should be allowed to engage in other businesses in order to diversify their activities and reduce risk. 5. QFMA should establish more stringent requirements toward the educational background and training of brokers. 6. QFMA should improve their control system to ensure that brokers act in the best interest of their clients and follow strictly its regulations. 7. QFMA should initially set a minimum for commissions on small trades and keep the upper level open. 8. QFMA should fully liberalize commissions for institutional investors. 9. The framework for regulating the brokerage industry in Qatar should not be conceived independently from the developments in international markets in general and the GCC countries in particular.
5 1. Introduction
The existence of a sound, transparent and efficient stock market is vital to achieve economic development in any country. To reach this goal, it is necessary to have an adequate regulatory framework to control the activities of the participants in the market. The aim of this report is to examine one of the main players, namely the brokers. More specifically the objectives are:
1. To discuss the current licensing policies. 2. To discuss the advantages and disadvantages of alternative licensing policies. 3. To provide recommendation on changing the current licensing policies. 4. To evaluate the current commission policy adopted by brokers. 5. To provide recommendation on changing the commission policies.
To put it in another way the report analyzes the current status of brokerage industry in DSM, and discusses some of the rules we think QFMA should give more attention to. The report will list the advantages and the disadvantages of allowing more brokers to enter the business. Then the report will look at the commission structure, and suggest a way to amend it. A comparison between different markets in terms of laws governing brokers and commissions will also be provided in the last section.
The report is composed of five sections. The second section gives a brief review of the main theories of financial intermediaries. Section 3 contains an overview of stock market development in Qatar and the major institutional
6 characteristics of its exchange. The third section discusses the current practices, status and rules governing the membership of brokers in the market. We lay out the major advantages and disadvantages of different policies that could be followed by the exchange. The fourth section discusses the licensing policies and in section five we try to fit DSM into the framework of the international trend in brokerage industry. In section five we discuss the commission and fees structure that prevails in DSM, and see its effect on revenues and costs. In sections 6 and 7 we suggest a commission and fees structure that might better serve the market. The final section looks at the similarities and differences between rules and regulations governing brokers’ activities, and commissions in different markets in the region.
2. Theories of Financial Intermediation Businesses, individuals, and government units often need to raise capital to fund investments. Funds are transferred between those who have funds to invest (savers) and those who need the funds (borrowers) either directly or indirectly though financial intermediaries (financial institutions like banks and insurance companies, and financial markets). According to the modern theory of financial intermediation, financial intermediaries are active because of the existence of market imperfections (mainly transaction costs and the asymmetry of information) which prevent savers and investors from trading directly with each other in an optimal way. The most important market imperfections are the informational asymmetries between savers and investors. Financial intermediaries, banks specifically, have a comparative informational advantage over ultimate savers and investors. They screen and monitor investors on behalf of savers. This is
7 their basic function, which justifies the transaction costs they charge to parties. They also bridge the maturity mismatch between savers and investors and facilitate payments between economic parties by providing a payment, settlement and clearing system. Consequently, they engage in qualitative asset transformation activities. To ensure the sustainability of financial intermediation, safety and soundness regulation has to be put in place. Regulation also provides the basis for the intermediaries to enact in the production of their monetary services. Financial intermediaries, the ones that mobilize savings, allocate capital, manage risk, ease transactions, and monitor firms, are essential for economic growth and development (see King and Levine, 1993). By increasing the fraction of resources society saves and/or by improving the ways in which society allocates savings, intermediaries can promote growth. Intermediaries can also diversify risks and exploit economies of scale. For example, large profitable projects might require high capital, an individual investor may have neither the resources to finance the entire project nor the desire to devote a disproportionate part of savings to a single investment. Thus profitable opportunities can go unexploited without intermediaries to mobilize and allocate savings. Intermediaries also provide payment, settlement, clearing and netting services. Modern economies, full with complex interactions, require secure mechanisms to settle transactions. Without these services, many activities would be impossible, and there would be less scope for specialization, with a corresponding loss in efficiency. In addition to improving resource allocation, financial intermediaries stimulate individuals to save more efficiently by offering attractive instruments. Intermediaries affect both the quantity and the quality of society’s output devoted to productive activities.
8 Innovations can also stimulate the development of financial services. Improvements in computers and communications have caused financial innovations over the past 20 years. Perhaps, more important for developing countries, growth can increase the demand for financial services, sparking their adoption. Financial markets also play a pivotal role in the growth of the economy by helping in transferring financial resources (savings) into the best companies in need for these resources. Financial markets have the ability to provide the necessary information to investors which help them in choosing the best investment opportunity. In addition, the financial markets help in providing liquidity. With the continuous trading, good information, and transparency efficient prices are determined. In the literature, there are different views on how the financial structure affects economic growth exactly (Levine, 2000). The bank-based view holds that bank-based systems – particularly at early stages of economic development – promote economic growth to a greater degree than market-based systems. The market-based view emphasizes that markets provide key financial services that stimulate innovation and long-run growth. The financial services view stresses the role of banks and markets in researching firms, exerting corporate control, creating risk management devices, and mobilizing society’s savings for the most productive endeavors in tandem. As such, it does regard banks and markets as complements rather than substitutes as it focuses on the quality of the financial services produced by the entire financial system.
9 The legal-based view rejects the analytical validity of the financial structure debate. It argues that the legal system shapes the quality of financial services. The legal-based view stresses that the component of financial development explained by the legal system critically influences long-run growth. Political factors have been introduced too, in order to explain the relationship between financial and economic development. From empirical research of the relationship between economic and financial development, it appears that history and path-dependency weigh very heavy in determining the growth and design of financial institutions and markets. It is important to realize that efficient financial intermediation confers two important benefits: it raises the level of investment and savings, and it increases the efficiency in the allocation of financial funds in the economic system.
3. Capital Market and Institutional Framework
Doha Securities Market is relatively new, with low liquidity due to the short history of its listed companies and the undeveloped state of the domestic institutional investor base. At the same time, DSM is affected by internationalization trends, and by competition from other stock exchanges in the Gulf area, and in the Middle Eastern Exchanges.
Law no. 33 of 2005 amended by Decree Law no. 14 of 2007 established Qatar Financial Market Authority, with a legal personality that enjoys financial and supervisory controlling and regulatory powers. The authority is
10 under the control of the Council of the Ministers with its head office in Doha. QFMA and policy-makers in Qatar became quickly aware of the challenges facing the market by strengthening listing and licensing standards, improving the trading systems, and enhancing corporate governance standards.
DSM started its trading activities in 1997 with 17 listed companies, and increased to 40 in the year 2007. Although macroeconomic developments have been favorable, the market is still small, both in absolute and in relative terms. Macroeconomic developments following the surge in cash flow from oil revenues have generally been favorable for stock market development in Qatar. The market capitalization of DSM represented around 254% of the country’s GDP in 2006.
DSM was established with the aim of consolidating the financial and the economics structure of the country. The main objectives of the market, as stated in the bylaws, among others, are to develop the market to serve economic development plans; help fulfill the government socio economic policies; enhance and organize the trading procedures; improve the investment climate in the state of Qatar; attract foreign investments; and help amend the legislations allowing non Qatari’s to invest in the local stock market. The amendment of Law issued in 2005, allows non Qatari's to invest in all companies listed at the DSM at a rate not exceeding 25%.
Table 1 summarizes the dynamics of Qatar’s stock market capitalization, which represent the market value of all listed companies over the period 1999 to 2006. The market capitalization has grown tremendously during this period. Equity market capitalization by the end of 1999 was around QR20
11 billion, and by the end of 2004 it reached QR 147.2 billion and increased to QR 199.6 billion in the year 2007. Market capitalization lost in the year 2006 around 30% of its value compared to that of the year 2005. The reduction in market capitalization was mainly due to the reduction of prices of most listed companies, and the decrease in liquidity due to the shift of liquidity into other sectors like the real estate sector, and the increase in interest rates.
In addition, the table shows that at the end of 2005, the ratio of stock market capitalization to GDP was 1300%. Additionally, over the years 1999-2005, stock market capitalization relative to GDP has increased, while it decreased relatively in 2006. Table 1 Market Indicators of Qatar Years market cap. Value traded GDP* mkt cap/GDP SPI** 1999 20 billion 1.2 b 12.3 b 1.63 2000 18.8 869 m 15.1 1.25 2001 26.7 1.5 b 16.3 1.64 2002 38.4 3.2b 17.2 2.23 2323.8 2003 97.2 11.7 b 17.54 5.54 3946.7 2004 147.2 23 19.49 7.55 6493.6 2005 317.2 102.8 24.46 13 11053 2006 221.7 74.9 26.05 8.17 7133.0 Sourse: DSM annual report 2006, DSM webpage, and the calculations of the writer *GDP: Gross Domestic Product **SPI: Stock Price Index
4. Licensing Policies
12 Stock brokers are not allowed to buy, sell or deal in securities unless they hold a certificate by the authority. At the end of 2007 there were 7 licensed brokers, between 2003 and 2006 the number of brokers was 9. This is due to the closure of 3 banks working as brokerage firms. Each entity wishing to carry brokerage activities is subject to a paid up capital of QR 5 million, and has to be a Qatari institution or a Qatari natural person. The security broker should also satisfy certain requirements, to provide a valid unconditional bank guarantee of QR 500,000, provide policy of insurance against trading risk of QR 5 m, and a reserve guarantee fund for QR 2000,000 (more details are shown in table 3 and the appendix at the end of the report).
The brokerage industry in Doha Stock Exchange is highly concentrated, in absolute value and relative to the world exchanges. Out of the 7 licensed brokers in DSM, and for the year 2005, the percentage of total deals handled by the most active broker was around 61% of the total deals in the market, which means that 61% of the market was handled by only one broker. At the same time around 74% of the market deals were handled by just two brokerage firms. In 2006 and 2007 the trading deals of the two most active brokers were 69% and 64% consecutively. These brokerage firms provide many facilities that the others do not provide. These facilities include, among others, multiple branches and internet trading.
However the phenomena of trading concentration are not unique to DSM. A survey conducted by the World Federation of Stock Exchanges in 2007 shows that the brokerage industry in the world is concentrated. For example, the survey found that the percentage of total trading volume of the five most active members in their sample (30 exchanges) was 46% at the
13 year 2006. The study also found that smaller markets are more concentrated than larger ones.
4.1. Discussion of the Current Criteria of Licensing Brokers and Suggested Changes
The criteria used by the authority to license brokerage entities are comparable to those of the other exchanges in this area, and to those of other emerging stock markets. We would like to point out however to some of the criteria that the commission should reconsider:
Article 56 paragraph A of terms of licensing the securities brokers states that “The applicant for the license shall be a Qatari institution or company, a bank licensed to operate in the State or any establishment or natural person whom the committee approves for carrying out the brokerage business”.
Our observation:
The authority does not license banks to deal with brokerage activities even though we see that banks are not excluded from the list of applicants. It is our opinion that QFMA should encourage large financial corporations and some financially sound and well governed financial institutions, mainly banks, to enter the brokerage business. These institutions would enjoy the trust of domestic and international investors and should be able to put together the human and technological capital required to run a large scale brokerage business. The entry of financial institutions would raise the standards in the brokerage industry, expand investor base from domestic and international markets, and might reduce the power of big brokers.
14
If banks enter the brokerage business, it will be feasible for them to use their existing branches to generate business for their broking subsidiaries. Support services from the banking system contribute significantly to the development of the stock market. Consequently, liquid inter-bank markets, largely supported by an efficient banking system, are important for the development of the stock market.
Initially Bank’s brokerage activities in Qatar were not separated from their original business as banks. We recommend that banks establish their brokerage business as a separate legal entity from the banking business. This gives more commitment by the bank to view brokerage activities as business and encourage them to employ people who are specialized in this business. The separation between the banking activities and the broking activities is important to control the conflict of interest between customers and investors. QFMA on the other hand would find easier to control the bank’s brokerage activities.
Empirically, researchers found that most stock market indicators are highly correlated with banking sector development. Countries with well-developed stock markets tend to have well developed financial intermediaries. Allowing banks to enter the broking industry is consistent with the goal of the stock exchange which is to improve the investment climate in the state of Qatar and to attract foreign investments to the country. To attract foreign investors it is more desirable to have well established and regulated institutions like banks because they are considered more trustworthy than small brokers.
15
In addition, QFMA should consider opening the door to foreign institutions to enter the brokerage activities. Foreign institutions would bring more experience to the market by creating more portfolio diversification and better market efficiency. However it is perhaps more urgent to concentrate at the moment on developing the market, encouraging firms to incorporate and educate people, and setting better rules and controls systems for governing the activities of the market.
Article 56 paragraph B states that “The paid-up capital shall not be less than QR5000, 000 (Qatari riyals Five million).
This opens the door for any person with this a small capital to start a brokerage firm. We think that requiring a larger capital would restrict the entry of small inexperienced brokers. We recommend the licensing of banks and corporations and suggest that the capital be increased to QR15 million. Of course this capital might differ based on the activities that the brokerage firm is dealing with, for example a full service broker (brokers that provide trading, research, portfolio management..) should have more stringent regulations in terms of capital requirement than a discount broker (broker that deals just with buying and selling).
Article 59 regarding representatives of brokers:
There should be more stringent requirements toward the educational background of brokers. A broker should possess a university degree and be subjected to a professional exam. The exchange on the other hand should provide workshops and educational seminars to keep up with international
16 developments in the brokerage industry. Any representative should take the educational seminar and be examined. In addition, the agent should have a practical experience, with an existing brokerage firm for at least 6 months. The workshops would have the added benefit of bringing additional revenues to the stock exchange.
Article 53 paragraph c states that “The business of the securities broker in the Market shall include the following matters: 1. Brokerage for commission 2. Brokerage in marketing of the new issues of securities 3. Brokerage by buying and selling in favor of the client (client’s portfolio) 4. Brokerage in underwriting of new securities 5. Any other business to be determined by the Committee.”
All brokerage firms licensed by the exchange are working as discount brokers. They are not allowed to provide full services for their clients. We believe that the door should be opened to full service brokers who can provide other services to their customers such as portfolio management, and trading advices. Local investors in Qatar are not experienced; their trading behavior is derived from rumors and by big investors influence. Full service brokers therefore are important to achieve the long term objective of market completion. But in order to reduce a potential conflict of interest between the full service broker and the client, the broker should not be allowed to use any information until after it has been used in a form of a recommendation to his clients.
If QFMA allows banks to enter the broking industry, we suggest that banks should separate the brokerage business from other activities. In
17 addition, it will be very desirable for corporations that decide to enter the broking industry to be allowed to do other businesses for diversification and risk reduction purposes. This would allow them to increase their growth potential as well. It should be enough for the entity engaging in brokerage activity not to be engaged in other businesses, in other words to be legally independent. This would help the authority to monitor and control the operations of the corporation.
Article 109: The broker’s employees whose names are shown in the list submitted to the Market in accordance with Article (61) of these regulations may not deal in securities for their own account or for the account of their wives and relatives up to the second degree other than through another securities broker. Article 110: In case of non-compliance with the provisions of this Article, the provisions of Article (115) of these regulations shall be applied against the defaulters. Article 111: Without prejudice to the provisions of Article (109), the broker may carry out sale or purchase of securities for the account of the Chairman of his company and members of the Board of Directors or its employees or the account of any entity with which they work provided that the Market shall be notified of any such sale or purchase transactions before the execution thereof and provided that the broker gives priority to any customer not falling under such Chairman, members and employees or the entity with which may authorize the broker and order him to execute atransaction of purchase/sale on the same terms.
QFMA, as the front line regulator, should stress the importance of these laws to the market participants, and show the capacity to enforce them. The legal system should have laws concerning financial issues, and specialized lawyers dealing with financial issues should be encouraged and recruited. We believe that a fundamental conflict of interest in broker-client relationship exists. Brokers often trade for their own account or those of
18 their preferred customers and relatives. This not only adds to the volatility in the market but is against investors’ protection. Although there are regulations governing proprietary trading in DSM, the system in place should be improved to distinguish the brokers trading for certain customers with preferences, from that done for other clients, and/or trading on inside information. In addition, there is no way to regulate those brokers engaging in churning – means encouraging people to sell and buy more continuously to get more commission.
The only way to enforce contracts is through legal actions of some kind which can be costly. One factor that features financial intermediation in developing countries is that the enforcement of contracts and, particularly, protecting investor rights, is very costly. Therefore, to improve investors’ protection and enforce contracts, the authority should concentrate on the following fields: The judicial process, as mentioned previously, should be ready to deal with financial issues by having specialized people in financial laws; A better supervision of the banking and financial sectors; More transparency; and more reliable information. In addition, QFMA should give more attention to corporate governance to ensure better transparency and supervision. Setting rules and regulations alone might not be effective without a good governance of the market, better transparency, better control and clear laws which are applied to all participants in the market.
4.2. Advantages and Disadvantages of Open Door Policy for Licensing Brokers:
A. Advantages of Open Policy for Licensing Brokers:
19
1- Encourages Competition between Brokers which leads to reducing transaction costs. Also through competition, brokers will tend to provide better services to attract more investors. In this market, however, commission is fixed, and brokers are not allowed to offer more services to customers. Therefore, to encourage competition, such restrictions should be removed. 2- If markets are without frictions (no transaction costs), and investors are rational (they take their investment decision based on expected return and risk only) then this might lead to an increase in market expansion, provide more liquidity and consequently lead to more efficiency (where prices reflect all available information in the market). However the market here is not frictionless and not deep enough (one powerful investor can affect the entire market); therefore efficiency cannot be reached with high competition at the moment.
B. Disadvantages of Open Policy of Licensing Brokers:
1- Having a large number of brokers is not necessarily consistent with expanding market access, and delivering services at competitive rates. If the market is efficient, with no market frictions and distortions and no fixed commission, which is not the case in this market, then competition works fine. Competition between brokers keeps commission rates low and leads to higher liquidity, market expansion and more efficiency.
20 DSM is a shallow market with many frictions, and fixed commissions. Even with few brokers, the market can be competitive. However the competition here is not on commission reduction, but on the market shares. As mentioned earlier two companies do most of the trading.
2- If the number of brokerage houses becomes large, it becomes more expensive and more difficult to effectively regulate them and to offer investors necessary protection from abuse. Brokerage houses, like banks, deal with public money and protecting public interest requires a strong regulatory regime.
3- Small brokerage houses would be slow in changing their way of doing business. These firms will not be able to cope with continuous changes in the industry partly because of cost, added risk and lack of expertise. These brokerage firms also might find it hard to cope with the international developments especially if the QFMA decided to expand the operations of DSM to the GCC markets or internationally. This might lead to closure of small brokerage houses which might come with a cost for these firms and for the society in general (i. e. there is an opportunity cost for the money invested in the brokerage firm which might go bankrupt or quitted the brokerage business).
5. Fitting DSM into the Framework of the International Trend in Brokerage Industry
21 Looking at the international trend, we see that consolidation is taking place in brokerage firms and not expansion. The Securities Commission in Malaysia for example has been pursuing consolidation in brokerage industry. The number of brokerage firms was reduced from 63 in the year 2000 to 32 in the year 2005. Consolidation is also taking place in India. In his published paper entitled “Broking Industry: 10 Years Hence” issued in 2004, the Chief General Manager of Securities and Exchange Board of India has forecasted that in the coming years the number of brokers in India would be reduced from 1000 to 100 at most.
The liberalization of commission, the expansion of bank’s activities to retail brokerage, and the competition from foreign brokerages and online trading lead to an increasing consolidation of the brokerage industry especially in Asian European markets. The great advancement in technology is also shaping the future of the brokerage industry. Due to automation, the marginal cost of executing trades is becoming insignificant.
Investors in Qatar need a small number of large brokers who are well regulated, work efficiently and enjoy trust of investors, both domestically and internationally. But the framework regulating financial intermediation in Qatar should not be conceived independently from the developments in GCC and the International markets and institutions. This applies to the design, reform, and management of regulations. The member countries in the GCC should adopt a common set of rules and standards in listing
22 companies, clearance and settlement processes and require listed companies and intermediaries such as brokerage firms to comply with them.
6. Commissions and Charges:
The fees and commissions are set by regulators. The brokerage commission, which is fixed, was initially set at 4.0 per thousand, and the market share of DSM from that commission was 30% before the year 2006. Since October 1, 2006, the brokerage commission was reduced from 4.0 per thousand to 2.75 per thousand and the Market’s share from that commission was reduced from 30% to 20%.
In a survey done by the researchers on 291 investors in DSM, around 57% of the respondents still believe that the commission charged is high and should be reduced further. In addition, 62% of the respondents believe that the high commission reduces their trading activity in the stock market.
To see whether the commission is high, we compare the revenues and costs at DSM with a group of exchanges belonging to the World Federation of Exchanges (WFOE). Table 2 shows the revenues and costs for DSM and a sample of 30 exchanges from the WFOE over the period 2003-2006. The exchanges in the review are from different parts of the world and include different sizes of exchanges.
The table shows that the net income of DSM over the whole period is relatively high. A closer look at the items which contributed to this high net
23 income, we found that trading revenues constituted the greatest proportion of income. Trading revenues fluctuated over time due to the amount of trading activity of the exchange. However, the percentage of trading revenue to total revenue is considered high. For the Federation of Exchanges, for example, the percent of trading revenue to total revenue was only 42% and 49% on average for the years 2005 and 2006. This is way below that of DSM. This shows that DSM depends on their revenue mainly on trading commission.
A general look at the ratio of cost to revenue for the sample exchanges in the federation we notice that costs represented around 70% of their revenues over the period 2003-2004, 79% in 2003 and 61% during 2006. For DSM, the figures also decreased from 59% in 2003 to 12% in 2005, and increased again to 20% in 2006. On average the cost of the DSM represents around 32% of their revenues, way below the other exchanges.
Table 2 Costs and Revenues (in billions of dollars) 2003 2004 2005 2006 Federation Revenue 9.57 10.66 11.23 15.75 Costs 7.82 7.85 7.67 9.59 Net Income (NI) 1.94 1.94 2.55 4.39 Trading Revenue/NI 42% 49% Cost/Revenue 79% 74% 68% 61% Qatar Revenue 8.5 21.1 81.4 61.9
24 Costs 5.0 7.6 9.45 12.2 Net Income (NI) 3.5 13.6 71.95 49.7
Trading revenue/NI 76% 79% 91% 76% Cost/Revenue 59% 36% 12% 20% Sourse: World Federation of Exchanges. “ Cost and Revenue Survey 2006”, October 2007. WFOE webpage. DSM annual reports, and the calculations of the author
The fees charged by the exchange must be reasonable and in the public interest. This implies that the rates have to be measured against the cost of providing the service.
The exchange must earn at least a “normal profit”. Normal profit is a return just equal to the opportunity costs of effort, investment and special skills. Determination of rate of return by regulators require resolution of what rate constitutes a fair rate to both the exchange and to the customer whose well being is sought. Establishing a rate structure which provides fairness and efficient incentives for all parties is not easy. We should note here that the fees charged by the exchange should cover the costs of DSM, QFMA, and the depository entities.
The objective of rate regulation is not necessarily to minimize costs to customers, since very low rates may affect the well being of the exchange and the quality of services it provides. In addition, minimizing rates may impact the incentive to innovate and the exchange may not be able to improve efficiency and thus to further lower rates over time.
25 The rule for assigning fees must be in such a way that the price of the service provided must cover the incremental cost of making this service available. The most that should be charged for the service is the stand alone cost of making that service available. The logic of this cap is that in a competitive market the most any individual or group can be charged is the cost of supplying that service to individual or group. If the supplier tries to charge more, the customer will go to other suppliers. Competition forces prices of the service to fall if and only if someone can produce it more cheaply. This happens if the price of the service exceeds its stand alone cost. If regulators would like to mimic the competitive market to reach efficiency, then they should follow the same conditions like those prevails in a competitive market (in other words, they should try to reduce frictions in the market like reducing fees, provide better and reliable information at a timely basis for all participants…).
Given that high commission leads to delay in market development, while low commissions are consistent with increasing market efficiency we suggest that fees should be reduced.
7- Brokers Commissions
To set commissions charged by brokers, there should be a balance between providing sufficient incentives for brokerage firms to take cost reducing actions, at the same time make sure that prices for customers are not excessive. Second, the issue should be addressed with respect to marginal and fixed costs for the brokerage firms. Since it is not easy to determine the
26 marginal and fixed cost for each firm, we suggest choosing between the following three methods:
1- Specifying the minimum commission charged by brokers for individual traders and keeping the upper level open. Setting minimum commission is necessary in order to prevent big brokerage firms from charging commissions less than their marginal cost, and subsidizing their losses from trade by offering their other services. However, commissions for institutional investors should be negotiable. In this way firms will set their commissions based on their marginal cost. This will lead to competition between brokers on big orders.
For example: The brokers should be allowed to charge the following
Trade Minimum Brokerage Rate
Institutional Fully negotiable
-Retail trades valued below
QR100,000 .0025
-Retail trade valued between
QR100,001-QR500,000 .0020
-Retail trade valued between
QR 500,001 – QR1000,000 .0015
-Above QR 1m .0010
27 Clearing fees:
0.15 of the commission rate with a maximum of QR 500.
This schedule might encourage investors to invest in big amounts rather than small amounts. This will discourage small investors from entering the market as gamblers.
2- The second method is to specify a lower and upper limit (a band) of commissions, and to specify different bands for different types of investors.
For example:
Specify the fees charged based on the market value of 0.0020.
Add lower and upper limits of brokerage firms’ commissions:
For shares lower limit 0.0020 – upper limit 0.0040
This gives a limited amount of freedom to compete by brokers to provide the service with less commission.
3- Liberalizing Commissions:
The liberalization of commissions is more suitable if banks are allowed to enter brokerage activities. This might lead to consolidation of brokerage industry. The liberalization also might lead to the reduction in transaction costs and high competition.
28 We believe that liberalizing commissions might be the best for the market; however, it should not be implemented immediately. It might be more prudent in the meantime to follow a two stage approach in the liberalization of commissions, to allow the brokerage industry to adapt to these changes. For example, the first method can be used then when the market is ready, fully liberalizing commissions. If banks are allowed to enter and commissions are liberalized small brokerage firms might not be able to cope individually with the competition. This will more than likely lead to consolidation.
8. Comparison between Rules Governing Brokerage Activities and Commissions in Different Markets.
The table at the end of this section displays a brief comparison of DSM with some of the regional exchanges in terms of the number of brokers, activities, paid up capital, contribution to the guarantee fund and insurance, the commission charged by the brokerage firms as well as the fees received by the exchanges. It appears from the table that:
1-The number of brokers operating in the exchanges differs significantly depending on the size of the market as well as the activities performed by the brokers. While Doha Security marker has only seven brokers at the present time, Abu Dhabi has almost 100 brokers and the number exceeds 140 in the case of Cairo stock exchange.
29 2- With the exception of Bahrain Stock Market, the activities of exchanges are limited to buying and selling. In the case of Bahrain, brokers are allowed to offer custodianship and research services.
3- In terms of paid up capital required from the brokerage firms to be licensed the comparison revealed wide diversity. In case of Doha Security market the required paid up capital is QR 5 million ($1.4 million). In Bahrain the paid up is about $ 500000, in Abu Dhabi Stock Exchange is about $ 8 million and in Dubai is AED. 5 million ($1.4 million).
4- Most brokers in the stock exchanges are required to contribute to the guarantee fund and to provide insurance against risks that investors may be exposed to. The amount to be set aside also differs among these exchanges. In DSM QAR 2 million is required as a contribution to the guarantee fund in addition to QAR 5 million as insurance. In Bahrain the contribution must not be less than BHD 100000 ($300000), in Muscat Stock exchange the amount is RO 1.35 million while in Dubai EAD. 10 million bank guarantees must be submitted.
5- As for the fees charges by the brokers to their clients, there is no standard formula and the practice differs among exchanges. In DSM and Bahrain the commission represents 0.275% of the total value of buy and sells transactions for each investor. In Muscat the commission ranges from an upper limit of 0.70% to 0.40% as a lower limit of the market value of each order for any amount from RO 1 to RO 100000. In Cairo Stock Exchange the commission differs depending on whether the company is listed or not. For listed company the commission is 0.012% of the value of every
30 transaction from each party up to the maximum of 5000 pounds. For unlisted companies the commission is 0.10%. In Abu Dhabi Stock Exchange the overall commission is 0.275% of the total value of the transaction and the commission of the broker is 0.15% in addition to AED 10 from each side of the transaction. However, if the commission is less than 65 AED the broker’s commission is 30 AED plus AED 10 from each party. In Dubai the total commission is fixed at 75 Dirham for each transaction of value less than 15000 and the broker gets 45. If the value of the transaction is more than 15000 the overall commission is 0.50% of the excess amount and the broker gets 0.30%.
6- The way fees are charged and the amount taken from brokers differ among the exchanges. In DSM and Bahrain the commission of the exchange is 20% of the broker’s total commission in addition to annual fee. In Muscat the commission of the exchange is 20% of the maximum limit. If the market value of the order is more than RO 100000 the market charges are 20% of the 0.50% of the excess amount. In Abu Dhabi the commission of the exchange is 0.055 of the value of the transaction and 0.075% goes to CSD and Authority Commission. In Dubai, the market charges AED 15. If the value of the transaction is less than AED 15000 , AED 7.5 go to the Authority and an equal amount goes to the Clearing. If the value of the transaction is more than AED 15000 the overall commission is 0.5% of the excess amount and the market gets 0.10% of that percentage while the Authority and the Clearing receive 0.05% each.
31 Table (3) Comparison of Status of Brokers in Selected Regional Stock Exchanges
Exchan No of brokers Activities audit Cash deposits Broker’s Broker’s capital Guarantee Fund Fees to exchange ge commission Doha 7 Its activity is restricted QR 5001 thousands 0.0025 of the QR 2 million + QR 5 20% of the commission of to Brokerage business total value of QR 5 million million as insurance the broker the transaction Bahrain 14 Trade in securities 0.275% from Not less than BD Not less than BD 20% of the broker’s total locally, regionally and the total value 30000 for limited 100000 commission of the broker internationally, trade on of buy and sell liability companies behalf of their clients transactions and BD 200000 for and for their own for each joint stock account investor and companies Offer custodianship and issue within research services the same trading day with a minimum of BD23 Muscat 20 Its activity is restricted Between RO 1.35 million 20% of the maximum limit. to Brokerage business 0.75% to If the market value of the 0.40% of the order is more than RO market value 100000, the market charges of each order shall be 20% of 0.5% of the for any amount excess amount from RO 1 to RO 1000003. Cairo 145 Its activity is restricted For listed 10000 pounds paid once to Brokerage business companies: Semi annual fee= 1% from 0.012% from the paid up capital of the the value of broker up to 5000 pounds.
1 QAR= $ 0.275 2 BHD = $ 2.638 3 OMR = $ 2.598
32 every transaction from each party up to the maximum of 5000 pounds4. For unlisted companies: 0.10% from the value of every transaction from each party up to the maximum of 5000 pounds. Abu 86 Not carry on any other Provide a of AED 1,250,000; Overall At least DED At least AED 20000000 0.05% of the value of each Dhabi business other than certificate commission is 300000005 transaction + 0.075% to approved brokerage and from an 0.275% of the CSD and Authority those activities which approved value of the Commission are normally ancillary auditor that transaction. thereto the firm has 0.15% goes to in place the the broker plus systems and AED 10 from processes to each side of ensure the transaction compliance If the overall with ADSM commission is Rules, less than 65 including AED the the Code of broker’s Conduct and commission is Customer 30AED plus Agreement AED 10 from
4 EGP = $ 0.18186 5 AED = $0.2724.
33 each party. Dubai 99 Its activity is restricted A Broker A fixed The company's It submits a bank 1- for each transaction of a to Brokerage business. shall submit amount of 75 paid-up capital is guarantee issued by a value of less than 15,000 final AED for each not less than five bank operating in the AED accounts and transaction of million AED. State in an amount of - 15 AED to the Market. an annual a value of less not less than ten million - 7.50 AED to the balance than 15,000 AED Authority. sheet duly AED, and a - 7.50 AED to the Clearing audited by broker gets 45 2- An overall commission of an AED 0.5 % of the value of each accredited 2 - An overall transaction in excess of auditor commission of 15,000 within one 0.5 % of the - 0.1% to the Market. month from value of each c - 0.05% to the Authority. the end of transaction in d - 0.05% to the Clearing the financial excess of year, and 15,000 AED, also submit and broker a quarterly gets 0.3 % statement on . its financial circumstanc es, and notification to the Market in the event of there being any deficit affecting the soundness of its financial position.
34 Appendix 1 The Development of the Major Stock Markets, and Lessons to be Learned.*
Stock exchanges, as institutions, started during the 12th century in Paris and spreaded to the other trading centers of the world during the 16th and 17th centuries (such as, Amsterdam, Great Britain, Denmark, Germany and France). The growth of trade, combined with expanding activities and the shortage of capital stimulated the issuance of securities by different institutions like governments, banks, insurance and trading companies. By the 19th century, trading in securities on a formal basis was common in industrial nations. Today, trading is conducted on over 120 stock markets worldwide.
Stock exchanges might be classified into either incorporated institutions or voluntary associations of members. Regardless of how they are organized, they include a legal framework, a constitution, a charter, by-laws, and rules and regulations that govern their membership, listing, trading and other organizational and practical matters. Exchanges provide the facility for trading. They facilitate marketability in their listed securities. This is done by providing trading facilities, requiring timely and proper standard of information by their listed companies, which leads eventually to enhancing the confidence of the investor in the stock market (Glenn 1984, p.893).
* This review was mainly based on the paper by Lance Davis, Larry Neal , and Eugene White “Membership Rules and the Long Run Performance of Stock Exchanges: Lessons from Emerging Markets, Past and Present”
35
Additionally, the stock exchange offers the opportunity for companies to raise capital to expand their business. This capital comes from the savings of individuals which should be protected by the exchange. It is therefore essential, both for fairness and economic efficiency, that all exchange functions, including the setting of stock prices, be determined in a transparent way. Therefore, the central functions of stock exchanges revolve around adapting the conventional roles of stock exchanges to the challenges posed by technology and the globalization and institutionalization of markets
Most stock exchanges are self-regulating organizations. Their rules are determined by its members. However, experiences for its members can differ. The number of members, the range of their interests outside the stock exchange, and the financial capacity of each member are established by the rules that govern membership. These factors, in turn, can affect the behaviors of members for self-regulation, or innovation as their response to endogenous forces (for example, the interaction of traders with their customer base and the array of products available) and exogenous constraints (foreign investors demands and domestic government regulations).
In order to give some idea about rules governing brokers, we will give an overview of the largest and most successful of the first emerging markets of London, New York and Paris over the period 1800 and 1914. The incentives for innovations on these earlier stock exchanges were based in part on the
36 sources of income available to the traders. Traders could increase their incomes by raising their prices and collecting monopoly rents; by enlarging the number of trades on which they charged commissions; or by providing a large variety of services for their clients. The three exchanges varied widely in this respect.
The rules of the London Stock Exchange largely banned almost all its members from offering other financial services, and they also limited the size of member firms. Their income was limited to commissions. Therefore, brokers try to increase their revenues by increasing the variety and the number of securities they dealt with. As of the fee schedule, until 1912, commissions were set individually by each broker and were scaled to the needs of each client and to the abilities of each broker.
The New York Stock Exchange allowed its members to do whatever other businesses they chose and at whatever scale they wished. This prevailed until the restrictions were imposed by the Securities and Exchange Acts in 1933 and 1934. The no restriction on brokers gave the traders the ability to expand the scale of their trading operations and the scope of their financial services. So New York Firms established branch offices nationally and internationally and started offering advice on portfolio management to its customers. Fixed minimum commissions were set by the exchange, therefore, limiting the scope of competition between brokers. Also, there were rules about sharing commissions among brokers, and between brokers and clients. Rules that placed restrictions on these practices increased the transaction costs of intermarket arbitrage, and, sometimes, limited market integration and increased transaction costs. The absence of these restrictions
37 could, however, have slowed innovation by other financial intermediaries and, perhaps, delayed the modernization of the financial sector.
However, members of the Paris Bourse were strictly forbidden from doing anything except their brokering business at the Bourse, and their firms were strictly regulated in terms of size and organization. Because of the monopoly power by the government, the agents of Paris Borse tried to urge their governments to enlarge the scope of the monopoly and to increase the size of their firms. Similar to NYSE, the scope of competition was limited by a common agreement that set minimum levels and a fixed schedule of commissions
The London Stock Exchange London Stock Exchange dated back to1762, when 150 of the stockbrokers formed a club and, in return for paying a rent of £1,200 a year. They raised this money by charging each member £8. No one was allowed to enter this club until non-member brokers filed a law suit against the members. In 1773, more reputable brokers formed the Committee of Proprietors acquired a “stock exchange” building in Threadneedle Street, close by the Bank of England. They allowed anyone to use their facilities and charged a daily admission of 6d. In 1801, the Committee of Proprietors decided to convert the “Stock Exchange” into a “Subscription Room”, along with the Committee for General Purposes they formed a United Committee, set up rules for the election of members, determined the number of proprietors to be 21 should be admitted without ballot, and fixed the subscription at ten guineas a year, essentially doubling the access fee for full-time brokers.
38 In 1812, all members had to be admitted annually by the Committee and were required to pay the subscription rate fixed by the Proprietors. New members had to be recommended by two established members, and their names posted in the House eight days before the ballot so that any objections to them could be sent in writing to the Committee. New members could not be engaged in any other business, although clerks of the Bank of England, East India Company, and South Sea Company might be admitted if their employers gave explicit approval. Dealing with non-members was discouraged. The first Rule Book had recommended that members should not deal with illegal practices that dishonor the Exchange.
The structure of London Stock Exchange changed slowly over the course of the nineteenth century. The Exchange itself was owned by a joint-stock corporation owned and controlled by the Proprietors, who set the terms for use of the building by subscribing Members. These, members in turn, were the active traders, divided into the distinct categories of Jobbers and Brokers. A candidate for membership had to pay an entrance fee of £525, find three members who would each put up £500 bond against his possible failure over the next four years, buy three shares in the Stock Exchange – shares costing close to £600 – and purchase a nomination from a retiring member. Such nominations varied widely in price, from £40 to as high as £700. Alternatively, if one had served as a clerk for four years, the entrance fee was reduced to £262.5, the number of surety bonds reduced to two, and the number of shares required reduced to one.
39 The number of members required to put up a bond and the necessary purchase of shares in the Exchange, as well as the minimum experience as a clerk, for candidates applying for membership in the London Stock Exchange had gradually increased over the years. Before 1871, only two surety bonds were required and a clerk only had to serve two years. Candidates could be blackballed, however, by existing members and, starting in 1871, members were given 14 instead of 8 days to register their objections. Over the years, the qualifications for members were gradually raised to ensure their maturity (originally clerks as young as 16 could be admitted as members), their competence (Rule 23 was amended in 1871 to read “required to have such personal knowledge” in place of “expected”), and their financial backing. There was however, one relaxing of the restrictions in 1871. Members were required merely to be British subjects, not Britishborn.
In London Stock Exchange there were brokers and jobbers. This led to a conflict of interest between the two. The efforts of the brokers to discourage off-site trading by the jobbers ended with the passage of two rules – a 1909 ban on any trader acting in the dual capacity of broker and jobber and a 1912 order that established minimum commission rates.
One feature of the British market was a heavy government stamp fee levied on each transfer of title to shares in joint stock. By 1910, the government stamp tax was ½ percent on the cash value of the transfer, and it had been as high as 1½ percent early in the 19th century, far exceeding the normal brokerage charges of 1/8 percent on each side.
40 The New York Stock Exchange The New York Stock exchange was structured as an association for more than the first century and a half of its existence. It was organized as a club and, because of its structure; it was able to exercise a level control over its members. From the moment a broker became a member, he placed all his business affairs in the hands of the organization. Therefore, the stock exchange was a private organization. It was able to inspect any member's books at any moment. If it suspects him of wrongdoing it can terminate his membership. Until 1971, the members of the Exchange had refused to incorporate. Thus, from its birth, the NYSE operated its own miniature legal system, with its own rules governing security trading, and its own mechanism for settling trade-related disputes.
By 1842 the list of officers included the president, secretary, a roll keeper, and a sergeant-at-arms. By 1868, membership had grown and the problems faced by the Exchange had become much more complex. Thus, a new constitution called for the election of a Governing Committee - a committee endowed with the power to control and manage the Exchange. The full Committee consisted of the president and treasurer and the forty elected members. The Committee, together with the secretary, were designated the officers of the Exchange. he 1938 constitution set the membership of the Governing Committee at thirty-two: the chairman and the president of the Exchange, and fifteen members of the exchange.
Unlike the London Stock Exchange, the number of members has been constrained not only by the "price" of membership, but also, by the unwillingness of the governing body to admit new members. The admission
41 and annual fees were relatively low (as late as 1900 annual dues were only $100). As the demand for seats expanded in the years before 1868, the "total costs" of obtaining membership gradually became above the initiation fee and annual dues. In 1820 the initiation fee was set at $25, in 1822 it was raised to $100, and in 1833 to $150. In 1840 it was again increased to $400, in 1858 to $1,000 and in 1864 to $3,000. However, the total cost of membership - a cost that included the "price" of a seat, although owners of seats were still not vested with property rights, had reached $3,000 in 1862 and $10,000 in 1866. After 1868, those "extra" costs were absorbed in the price of seats. In 1905, the initiation fee was only $2,000; it was later increased only twice - to $4,000 in 1920 and to $7,500 in 1962.
There were also non-financial constraints on membership: membership required a year's experience as a broker in 1817and was increased to two years in 1818, before being cut back to a single year in 1820. By 1900 a prospective member, having insured himself that he could meet the requirements of the Committee of Admissions, and having provided himself with two sponsors, entered into negotiations with the secretary of the Exchange for the purchase of a seat. Once having completed those negotiations and paid the $2,000 initiation fee, he and his sponsors presented themselves before the Committee of Admissions. "This committee first calls his proposer and his seconder, and they are subjected to a careful inquiry about the applicant. If the answers to their questions prove satisfactory, the candidate himself is put through a similar examination." He was then, of course, still subject to election by the membership.
42 However, until seats became property and the exchange moved to officially limit the total number, it was the black ball that most effectively constrained membership. Its effectiveness can be seen in the very slow growth in membership: from 27 in 1817, to 39 in 1820, to 50 in 1836, to 75 in 1848. Thereafter, growth was somewhat more rapid, but the blackball still restricted membership. There were around 209 members in 1853, a figure that had reached 533 by 1869. Still, in 1861, for example, twenty-nine candidates were proposed; and, while seventy-six ballots were taken, only seven new members were elected. Membership rose to 1,065 with the merger with the Open and Government Boards. From that time on, however, there have been only three further changes – the increase of 40 in 1879, the "seat" dividend of 275 seats between 1929 and 1932, and the reduction of 9 seats in 1953.
The impact of those constraints was reflected in the trend in "average" prices of seats on the exchange. Between 1870-79, that figure was $5,800, $24,000, $21,000, $70,000, $63,000, $190,000, $146,000, $50,000, $76,000, and $252,000. While participation in a cartel can increase profits, however, cartel behavior indicates that, in the absence of some coercive power to prevent defections or some other major benefits from continued membership, the optimal strategy for each member involves convincing others to agree to the price fixing arrangement and, then, for them to defect. By charging lower than the agreed price, the defector increases his profits by greatly expanding his sales. Since it is in the interest of each participant to defect, historically, the life of effective cartels has tended to be very short. To keep them from defection, the Exchange must have offered other major benefits to its members. A review of the literature suggests that the
43 Exchange membership offered such benefits – benefits that were not readily available to non–members. Among others, the Exchange provided a relatively efficient market place and, thus, kept transactions costs low. Over its history, the Exchange developed a reputation for moving quickly and effectively to protect investors who chose to use its services. For a member, although costly, such protection greatly expanded the number of potential customers – customers who were willing to pay cartel commission rates to obtain those benefits.
The first discount brokers emerged in the late 1970s as a result of deregulation in the U.S. securities industry. From 1792, the year in which the New York Stock Exchange (NYSE) was established, to 1975, NYSE members charged for their services on the basis of a minimum commission schedule. The NYSE had the authority, subject to permission from the Securities & Exchange Commission (SEC), to set minimum commission rates on stock transactions. This fixed commission regime limited price competition among brokers. Consequently, fixed commissions led to high rates, market fragmentation, and an oversupply of additional services.
The SEC eliminated fixed commissions on May 1, 1975 – now referred to simply as “May Day.” The effect of deregulation on prices was dramatic. As brokers started to compete on price, rates fell sharply. At first, however, the new structure benefited mostly major institutional investors. For example, Schwartz notes that the commission rate for large institutional orders (orders larger than 10,000 shares) fell to 0.31% of principal in December 1978, from 0.57% in April 1975 – a 45% reduction. In 1970s also discount brokers
44 emerged and provided inexpensive trading commissions, which was essential for individual investors. Aggressive marketing and attractive pricing allowed them to create a new market niche and drove the sector’s growth through the early 1990s.
The Paris Bourse In contrast to the London and New York markets, the stock market in Paris was a tightly regulated creation of the government. In spite of efforts of various reformers, the architecture of the market reflected its history more than any reasoned design. Restrictions on entry created substantial rents for brokers who struggled to maintain their monopoly in the face of expanding securities markets and competition from the curb market.
The Paris Bourse was created by Napoleon on the model of the pre- revolutionary bourse. The bourse of ancien régime was established by decree in 1724 and functioned until it was shut down by the Revolution in 1791. The Crown created a monopoly of all secondary transactions in listed securities for a fixed number of brokers who were forbidden to trade on their own account. They received a commission of 0.25 percent on each trade, half to be paid by the buyer and half by the seller. The market was an agency/auction market where the professional on the floor of the exchange, the agent de change, acted solely as agents or brokers for their customers.
Customers were required to deliver their securities or money to their agent before the open of the bourse, effecting a consolidation of the orders, and the brokers then negotiated trades on their behalf. Brokers were thus barred from making a market: these rules were designed to prevent the brokers
45 from benefiting from any superior information. The agents de change were officers of the Crown, required purchasing their office from the Crown for security bond that paid a fixed rate of interest. The fixed number of brokers fluctuated over time; it was set at 40 in 1733, raised to 50 in 1775 when the market began to boom, then reduced to 40 in 1781, before it was finally raised to 60 in 1786.38 Agents were required to 25 years old, French, Catholic and of a good reputation, with a minimum of five years experience with a bank, commercial house, or notary.
Revolution broke the agents’ monopoly. In 1791, the profession was opened to any individual who could pay the patente tax of 300 francs and take an oath of personal integrity. The number of brokers jumped from 57 in 1791 to 132 in 1792.
As part of his general reordering of government finances and the financial system, Napoleon looked back to the model of the ancien régime. Three laws, the law of 28 Ventose IX (March 19, 1801), the decree of 27 Prairial X (June 16, 1802) and the Code de Commerce of 1807 determined the structure of the new bourse. Based on these laws, Brokers were paid a fixed commission and were forbidden to trade on their own account. Penalties were assessed on interlopers. This agency-auction market had rules governing the consolidation of orders – rules that required customers to deliver orders to brokers in advance of the opening of the market. Separate agents for the buyer and seller made the trade on the floor of the exchange and announced the price to their fellow brokers. The prices of the trades were recorded in brokers' journals and were publicly released in the côte officielle only after the close of the market. The intent of the law was to
46 ensure that the public had perfect confidence in the agents de changes and to guarantee that they not "expose themselves to the danger of compromising the interest of their clients by compromising their own fortune in a risky or unfortunate enterprise."
Initially, in 1801, Napoleon appointed 71 agents, a decline from the 106 reported practicing the previous year. The surety bond required was a hefty 60,000 francs, a figure that was raised to 100,000 francs in 1805. This high price and the modest volume of trade led the number of agents to drop to 41 in 1814.
In 1816, the officers of the Crown, including the agents de change were given the right to select a successor. They were given the property right to the office, to sell it freely to anyone who met the minimum qualifications of office. The number of brokers was fixed at 60. The compagnie des agents de change was reconstituted in the same year and served as the self- regulating association of the brokers. Its general assembly set the rules and handled the budgetary affairs of the bourse. The compagnie was presided over by an elected syndic and an assistant, who also handled its day to day management. A chamber syndicale of 6 brokers assisted the syndic in his duties.
Until 1823, foreign government securities were also excluded from the exchange; and even afterwards, the securities of foreign private companies were barred until 1859. This latter inclusion occurred only after the market for foreign securities had emerged, and the foreign firm’s ability to avoid French taxes imposed such an unequal burden on domestic firms’ securities,
47 that the exclusion became an embarrassment. Two events occurred that began to force the French to accept freer incorporation. The British Company Act of 1856 led some French firms to migrate across the channel to incorporate with limited liability in Britain under the relatively easy terms granted by the act. Meanwhile, a Franco-Belgian treaty had been negotiated to circumvent the 1849 Belgian decision that French sociétés anonymes could not exist as legal personalities under Belgian Law; the treaty required that France allow foreign companies to freely operate.
The capital of a broker was comprised of the required security bond, the purchase price of the office, and the personal reserve funds. In 1818, it was originally set at 125,000 francs; in 1863 the minimum bond was raised to 250,000 francs. Beginning in the Second Empire, this bond at the Treasury was supplemented by a required reserve to be used by the compagnie des agents de change to assist members in crises. The minimum reserve was set at 75,000 francs, a figure that was gradually increased to 100,000 francs. The broker's personal reserve fund was used to cover losses when clients proved to be insolvent. Between 1850 and 1876, this reserve varied from 250,000 to 300,000 francs; and it rose again and fluctuated to between 350,000 to 450,000 francs over the remainder of the century.
The largest component of a broker’s capital was the price of his office. In 1816, the price of an office was 30,000 francs. Before the Revolution of 1830, it had risen to 850,000 francs, falling in its aftermath to 250,000. A new peak of 950,000 francs was reached in 1848, only to decline to 400,000 during the new period of revolution. Again in the 1850s, following the subsequent growth of the market, the purchase price of the office began to
48 soar. The price rose from 800,000 francs in 1853 to 2 million by 1856 which represented the peak of prices during the late nineteenth century. Between 1860 and 1898, prices hovered between 1.6 and 1.7 million francs. The creation of 10 new offices and the growth of the coulisse combined to cap the price at this level.
The rising price in the 1850s, however, had made entry difficult for any potential broker, who was dependent on his own capital. In response, in 1862 the government permitted agents de change to form partnerships. In these partnerships, the broker provided the cautionnement plus a minimum of one quarter of the capital. The broker was paid a fixed salary and a share of the profits, with the remainder accruing to the partners. In Verley's large sample of brokers, the return on investing in the office of an agent de change was high. The return averaged 27 percent in the 1850s and 1860s; it rose to 30 percent in the 1870s and 1880s, before reached 39 percent in the 1890s, and 57 percent in 1911-1912. By the late nineteenth century, much of the securities market had slipped away from the control of the agents de change to the traders on the largely unregulated coulisse.
How current emerging markets benefited from the Past?
How relevant the historical experience of first emerging markets the new markets’ efforts to limit membership and control the activities of their members.
Hungary, in seeking foreign investment, reestablished the Budapest Stock Exchange on June 21, 1990, with 41 founding members, consisted mainly of
49 Hungarian banks and insurance companies. The number of members now is 65; also include a number of foreign banks and investment companies. Foreigners hold around 75 percent of Hungarian shares. Also, around 70% of the turnover on the Budapest Stock Exchange comes from commissions by foreign investors. The strength of the BUX could be attributed, partly to, the confidence foreign investors have had in dealing with members of the Budapest Stock Exchange.
In the Czech Republic, foreign banks as well as investment firms are also allowed among the 57 members of the Prague Stock Exchange. Their law permits the Czech National Bank, to hold membership in the exchange. Membership of new entrants to the PSE has to be approved by the Exchange Chamber after an applicant has been recommended by two existing members and met the various legal requirements imposed by the state on all members of the exchange (by the Stock Exchange Act of 1992). In 1999, the exchange allows branches of foreign banks to become members of the stock exchange. This was a reaction to the Investment Services Directive of the European Union and the need for the Czech Republic to harmonize its laws with those of the European Union, if it is to be admitted as a member. The original restrictions on membership and the constant interventions of the state in matters, usually left internal to an exchange, have affected the market negatively.
In 1991, Poland established the Warsaw Stock Exchange as a joint stock company under the oversight of the State Treasury and adopted the French system. The Warsaw Stock Exchange is a self-regulated organization; however, its rules and statues must be approved by the Polish Securities
50 Commission. In 1998, a new Securities Act designed to settle Polish practice with regulations of the OECD and the European Union was passed. There are 36 firms licensed brokers on the exchange, which include a number of the international firms – a list that encompasses, among others, the firms that were listed as operating in Hungary. In common with the other transition economies, in Poland the majority of the members of the official exchange have been drawn from among the domestic banks and insurance companies. The domestic members control the operations on the exchanges; however, the representatives of the foreign firms provide much needed expertise and access to greater liquidity than would be available locally.
The reliance upon banks and insurance companies as the self-interested regulators of the exchanges, for example, reflects only German experience. The more successful exchanges of London, New York, and Paris in the nineteenth century all excluded banks and insurance companies from membership.
Similarly, the emerging economies of Asia also attempted to deregulate the financial sector between 1980 and 1995, so their securities markets became somewhat more competitive. In Korea, for example, there was a general easing of the controls on foreign investment: international trust funds were established; foreign brokers were allowed to open branches and establish joint ventures; and, in 1992, the government allowed foreign brokers, firms, and individuals to invest in the local market. The government also turned its attention to the formal securities markets; some of the restrictive economic regulations were removed; and some rules designed to increase disclosure and augment investor protections were strengthened.
51
The Singapore government deregulated the stock exchange in 1987. The Stock Exchange of Singapore permitted foreign financial institutions and securities brokers to acquire forty-nine percent of local brokers and the Monetary Authority opened the government securities market to foreigners. Three years later, further reforms included scrapping the overlapping listing system at the Singapore Securities Exchange Market and the Malaysian Securities Exchange Market.
In Indonesia, the Philippines, Taiwan, and Thailand, too, the governments moved to encourage the expansion of the formal securities markets by removing some of the restrictive regulations. There remained, however, not only significant inter-country differences in the relative importance of securities markets and the degree of foreign participation that was permitted, but also in the extent of government control.
The structure chosen by Asian and transition economies are similar to that of Paris Bourse, the government controlled entry, established trading rules, and determined the composition of the securities traded. In Paris, those screenings were most often based on a political rather than an economic situation; the monopolistic characteristics of the market kept costs high; and the exchange played only a limited role in both capital accumulation and mobilization in the private sector. The success of the Paris market owes more to the initiatives of the bankers operating the informal market outside the regulated monopoly of the formal market.
52 Appendix2: DSM Licensing Rules Section 1: Business of the Securities Brokers Article 53: Para a: Every entity intending to carry out the business of securities brokerage in the Market shall submit an application to the Committee for obtaining the requisite license provided that the Committee shall issue a decision with its approval or refusal
Para b: The number of securities brokers and the type of business to be carried out by every securities broker shall be determined by a decision of the Committee.
Para c: The business of the securities broker in the Market shall include the following matters: 1. Brokerage for commission 2. Brokerage in marketing of the new issues of securities 3. Brokerage by buying and selling in favour of the client (client’s portfolio) 4. Brokerage in underwriting of new securities 5. Any other business to be determined by the Committee.
Article 54: The business of brokerage may not be carried out in the Market except after obtaining a license from the Market’s Committee. An entity intending to carry out brokerage business in the Market shall fulfill the requisite
53 conditions and pay the applicable fee and contributions for admission thereof as a securities broker in the Market.
Article 55: All trading activities shall be confined to the agents approved for representing the securities broker licensed by the Market and their assistants. These persons shall undertake to bear the professional cards provided to them by the Market.
Section 2:
Terms of Licensing the Securities Brokers and their agents Article 56: The Committee shall specify the procedures and fees for granting the licenses to the entities intending to carry out the brokerage business in the Market and it is stipulated for granting the license that: A. The applicant for the license shall be a Qatari institution or company, a bank licensed to operate in the State or any establishment or natural person whom the committee approves for carrying out the brokerage business.
B. The paid-up capital shall not be less than QR5000, 000 (Qatari riyals Five Million). C. The expertise and capabilities necessary for carrying out the brokerage business shall be stratified in respect of the persons assuming the management of the broker. D. The manager in charge of the brokerage business shall have a university degree or equivalent qualifications, and shall have carried out business in financial or banking institutions for a period of not less than three years.
54 E. The securities broker shall undertake to submit when requested, a summary of the financial lists and statements approved by the financial controller for the last consecutive three years or the period from the date of incorporation, whichever is shorter. Article 57: The securities broker shall, when requested by the Market, undertake to carry out the following: A. Provide a valid unconditional bank guarantee, for unlimited period for an amount of not less than QR500,000 (Qatari riyals five hundred thousand) . This guarantee shall be payable on the first demand. B. Open a settlement account with the payment bank and manage the same in accordance with the procedures and regulations of the Market. C. Provide a policy of insurance against trading risks, mismanagement and the inability to discharge financial obligations, for an amount which should not be less than QR5,00,0000 (Qatari riyals five million) provided that the market shall be the first beneficiary under the policy. D. Provide another bank guarantee of the same description, for an amount of not less than two million) Qatari riyals to be deposited with the Market for being used in establishing the reserve guarantee fund. E. The Committee may add any other terms or requirements. Article 58: The securities brokers who are licensed to carry out brokerage business in the Market shall be registered in a special record to be prepared by the Market for this purpose. Every securities broker shall be given a serial number. The record shall also contain all the information submitted by the broker to the Market on submitting the license application. Article 59: The securities brokers who are licensed to carry out brokerage business in the Market shall nominate specified persons from amongst their
55 employees for acting as their agents in the Market provided that these agents shall satisfy the following conditions and requirements: A. Be of a Qatari nationality. B. Enjoying full legal capacity C. Not convicted for a criminal offence or sentenced for issuing a cheque without adequate bank balance unless he has been rehabilitated. D. Having at least secondary school qualifications or their equivalent. E. Bears good conduct and reputation. F. Is devoted to the business and does not work in any manner and in any capacity for another securities broker. G. Fulfill any other conditions to be specified and published by the market in its publication. The persons so nominated by the licensed securities brokers shall not be Chairman, member of the board of Directors or employees of a company whose shares are traded in the Market. Article 60: The approval of any persons satisfying the conditions stated in the preceding Article as an agent and the delivery of the professional card thereto shall be subject to his successfully qualifying an examination regarding professional awareness. The Market shall determine the subjects, regulation and procedures of such examination. Article 61: A securities broker licensed to carry out the brokerage business in the Market shall submit to the Management of the market a list of the names of all his employees, specimens of their signatures, names of their wives and relatives up to the second degree, on an annual basis or on the occurrence of any change therein during a year together with a written undertaking wherein the broker undertakes to assume the responsibility for the behavior of his employees related to their business in the Market.
56 Article 62: The brokerage license granted to the natural persons representing the brokers (Agents) in the Market is not transferable either through sale or inheritance and the brokers or agents may not sell the license to carry out brokerage business in the Market. Article 63 In case there is an amendment in the Trading System in the Market in a material form, the Market shall prepare a new examination format for all the agents approved by it. These agents shall have to qualify the examination in order to continue as agents to carry out the trading business. Article 64: The Committee reserves the right to determine and amend at any time the conditions of granting the licenses to the securities brokers and their agents.
57 Glossary Churning: means encouraging people to sell and buy more continuously to get more commission. Market Efficiency: The extent to which the market prices securities so as to reflect available information pertaining to their valuation. There are three forms of market efficiency. A weak form: whether prices reflect historical information of prices and volume. Semi-strong: the extent to which the market prices securities so as to reflect publicly available information relating to their valuation. Strong form: The extent to which the market prices securities so as to reflect all public and private information pertaining to stock valuation.
58 REFERENCES Asian Development Bank Institute, Seminar on Securities Market Regulation,” Executive Summary,” Tokyo, April 1998.
Haque, Nadeem (2002), “Developing of Financial Markets in Developing Economies” Given at Financial Reform Conference, Colombo, Sri Lanka.
Demirguc-Kunt, Asli and Ross. Levine, 1996, “Stock Market Development and Financial Intermediaries: Stylized Facts,” The World Bank Economic Review, Vol. 10 (2), pp. 291- 232.
Doha Security Market. ”Internal Regulations” 16/07/2007. DSM webpage
Doha Securities Market “Annual Reports” Different Issues 3004-2006.
Farhi E., Golosov M. and Aleh Tsyvinski. “A Theory of Liquidity and Regulation of Financial Intermediation” February 23, 2007.
Glenn G. Munn, Revised by Garcia, F. L. 1984, Encyclopaedia of Banking and Finance, 8th Edition, Bankers Publishing Company, Boston, pp.892-3.
Lance Davis, Larry Neal, and Eugene White. “Membership Rules and the Long Run Performance of Stock Exchanges: Lessons from Emerging Markets, Past and Present”
Michie, Ranald C. The London and New York Stock Exchanges, 1850- 1914. London: Allen and Unwin, 1987.
World Federation of Exchanges. “ Cost and Revenue Survey 2006”, October 2007. WFOE webpage. http://www.world-exchanges.org.
Schwartz, Robert A., Equity Markets: Structure, Trading and Performance (New York, 1988).
59