Apollo Asia Fund

The cons & cons of Malaysian settlement
"It's not the economy, stupid; it's the settlement system."
A foreign broker's view, by Gerry Ambrose

Since the 1997 Asian Crisis, Malaysian GDP growth has recovered, inflation remains mild, corporate & private balance sheets are strong, the domestic savings rate is 33% of GDP, private sector investment & consumption have recovered, bank loans are accelerating, and loan quality is improving. Yet stockmarket activity is lagging, while neighbouring markets have surged ahead. Malaysia's relative weighting in an Asia ex-Japan portfolio has shrunk to the extent that regional investors need not bother.

What is the reason for Malaysia falling off foreign investors’ radar screens when ten years ago it was the cornerstone of any ASEAN equity portfolio? [Stockmarket turnover on several days of 1993 was higher in Kuala Lumpur than on the New York Stock Exchange. CB] Capital controls have been relaxed, and economic and political developments are widely viewed as positive. However, Bursa Malaysia (BM) continues to operate under a complex & cumbersome settlement system devised after the imposition of capital controls. This system operates with the apparent overriding aim of deterring foreign manipulation, whereas other regional stockmarkets after the crisis improved accessiblity to foreign investors. BM's policy of limiting foreign investors' ability to manipulate the market is punishing 'innocent' foreign investors who wish to invest long-term in Malaysian equities, and depressing liquidity to the detriment of all investors and of local companies.

Major problems experienced by foreign investors include the following:

The need for BM to know the 'beneficial ownership' of every share bought/sold requires every individual sub-account belonging to an investor to have a CDS number. Officially, share sales/purchases cannot be made by an 'omnibus' account during the day, for allocation into different sub-accounts after the market closes. A foreign institutional investor may wish to allocate the trade at the end of the day, depending on the total volume transacted: this normal practice is prevented.

Foreign banks might wish to pass an order to a local broker to buy/sell Malaysian shares, amalgamating hundreds of retail orders. This now involves hundreds of CDS accounts. A broker without a BM seat has to open in advance a separate clearing account with a local broker for each and every one of his clients’ sub-accounts/CDS numbers. As some clients have literally hundreds of different sub-accounts (one for each individual fund) this can be (a) time consuming and (b) fraught with danger: one small error in writing an account name or number (eg using the abbreviation 'Ltd' instead of 'Limited') can result in a failed trade. In neighbouring markets, just one omnibus account need be opened between the foreign & local broker.

This requirement also makes local brokers privy to information which neither the end-client nor the foreign broker might wish to divulge. Investors renowned for their size and/or acumen, which might otherwise have accumulated shares over a period of months, might be deterred from trying.

The inability of brokers to warehouse small purchases is a further deterrent to attempting purchase of illiquid shares. Very small purchases may not be economic to settle, so it is common in other markets for brokers not to book out small amounts but to accumulate them over a few days and book out in larger quantities (or facilitate an orderly decision to give up and offload if the volume is minimal). If the cost of trying to deal in thinly-traded shares is too great, they will be even less liquid than they might have been - a vicious circle.

The sheer complexity of the settlement system in a relatively small market acts as a barrier to investment. BM trades are settled in two different ways:
- The Fixed Delivery Settlement System (FDSS) requires the client’s custodian bank to deliver shares to the local broker on T+2 midday. The local broker will then deliver the shares to the BM’s clearing house (SCANS) by 0900 on T+3. The custodian bank is credited with sale proceeds some time after 1000 on T+3.
- The Institutional Settlement System (ISS) requires the local broker and custodian bank to 'pre-match' a trade on T+2 and then carry out 'virtual' delivery versus payment on T+3. In the case of ISS, the custodian bank delivers the shares to SCANS at 0900 on T+3 and the custodian bank is credited with sale proceeds some time after 1000 on T+3.

Most foreign institutional investors prefer to settle using ISS: many are prohibited from delivering shares free of payment. Indeed, ISS was created to enable these institutions to deal in Malaysian equities. However, ISS only achieves 'virtual' DVP (delivery versus payment), as SCANS handles the scrip delivery side of the transaction and insists on an 0900 value time on T+3, whereas the financial side of the transaction is operated through the banking system, which does not accept transactions before 1000.

Crossings and placings can only be settled through FDSS. This disqualifies many investors from participating.

There may also be a requirement that placement shares when resold must also be settled through FDSS: it is not clear why this would be.

The complexity of account opening leads foreign investors to 'stick to the devil they know', rather than distributing orders on brokers' merit, discouraging the competition and dynamism associated with healthy markets. Before the creation of ISS, a few large brokers financed their institutional clients' purchases for the 24 hour period between T+2 & T+3. Many institutions have directed all orders through these brokers ever since.

Foreign shareholding limits are cumbersome compared to Thailand. In Thailand, if the foreign ownership limit has not been reached, shares may be bought from local investors and immediately registered as foreign, with no additional steps required. In Malaysia, it is not so easy. MISC’s foreign ownership level is currently about 15%, well below the 25% limit. However, if a foreign investor wishes to buy and register, he must first settle the trade as locally-registered shares, then apply to MISC’s registrar in writing to convert to foreign-registered. Approval will take a minimum of four working days, provided all paperwork is in order. This problem arises because the broker in Malaysia has no authority to apply on the client’s behalf to register local shares as foreign; only the foreign client can do so, through his custodian bank, which has to complete special forms & send them to one of about thirty share registrars in KL. The registrar then has to apply to SCANS to authorize the conversion, etc etc etc. In Thailand, the broker has the authority to register shares immediately as foreign if there is room on the foreign board.

Foreign shares cannot be sold on the local board, so a foreign investor wishing to exit must either seek a foreign buyer or attempt to convert the shares back to local. [It is not clear whether this can usually be done or is at the discretion of the company: the only time we tried, the registrar said it was impossible and the foreign bid plummeted to a huge discount - with insiders, who could be confident in the reverse conversion, the gleeful and only buyers. This was however a few years ago. If foreign-to-local conversion is now possible, it still flags the vendor's intention and size very clearly - and one cannot of course tell whether there will be liquidity to transact after all the hoops have been jumped, or whether one would have to convert back and forth in an endless paperchase. CB]

Failure to settle Malaysian trades on the due date results in immediate buy-in with no quarter, at ten spreads above/below the market price – far harsher than other neighbouring markets.

Many Malaysiaphiles like myself have had to convert back to being regional brokers and leave the country in order to make a decent living. Malaysia's economy has rebounded to pre-crisis levels, yet the authorities seem mystified as to why the equity market is not enjoying a similar recovery. Stultifying red tape and systemic bias are prime suspects.

Gerry Ambrose, 6 Jan 2005

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