June 2015

This report was produced for review by the United Agency for International Development by the USAID BRCP Project implemented by The Pragma Corporation. The views expressed in this report do not necessarily reflect those of the United States Agency for International Development or the United States Government.

 

USAID PakistanFinancial Market Development (FMD) Activity

Quarterly Progress Report

Oct-Dec 2016

Jan 15, 2017 This publication was produced for the United States Agency for International Development by the Pragma Corporation.

Prepared for the United States Agency for International Development, USAID Order # SOL-391-15-000013

BY

The Pragma Corporation Principal Contact: Paul Davis 116 East Broad Street Falls Church, Virginia 22046

DISCLAIMER

The authors’ views expressed in this publication do not necessarily reflect the views of the United States Agency for International Development or the United States Government.

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Table of Contents

LIST OF SELECTED ACRONYMS ............................................................................................... 3

1. PROJECT HIGHLIGHTS AND ACCOMPLISHMENTS........................................................... 5

1.1. TASK 1: SUPPORTING GOP IN CREATING AN IMPROVED ENABLING ENVIRONMENT FOR THE ROBUST DEVELOPMENT OF DEBT, ISLAMIC, COMMODITY AND SME MARKETS.......................... 5

1.1.1. Enhanced SME Funding............................................................................................................................. 5

1.1.2. Commodity Warehouses Receipt Financing Mechanism Framework ................................................... 6

1.1.3. Review of Public Offering Framework .................................................................................................... 6

1.1.4. Development of Sukuk/Islamic Financial Products Framework ............................................................. 7

1.1.5. Availability of Credit Enhancement Guarantees for the NBFI Sector ................................................... 8

1.2. TASK-II: SUPPORTING GOP INSTITUTIONS IN IMPROVING SOVEREIGN DEBT ISSUANCE/MANAGEMENT, AND HELP DEVELOP THE INSTITUTIONAL ARCHITECTURE REQUIRED FOR THE COMPETITIVE AND INNOVATIVE OPERATIONS OF DOMESTIC CAPITAL MARKETS .......... 9

1.2.1. Reforms for National Savings Scheme..................................................................................................... 9

1.2.2. Institution Building Support for State Bank of Pakistan ........................................................................ 10

1.2.3. Institution Building Support for NCCPL/Establishment of Central Counterparty Framework at NCCPL/Operational Guidelines for Know Your Client Functionality .............................................................. 10

1.2.4. Fixed Income Training Program for the Institute of Financial Markets ............................................... 10

1.3. TASK-III: SUPPORTING EXPANSION OF SME LENDING WITH DEVELOPMENT CREDIT AUTHORITY (DCA) INSTITUTIONAL PARTNERS ........................................................................................ 11

1.3.1. KHUSHHALI BANK & FIRST MICRO FINANCE BANK .................................................................... 11

1.3.2. JS BANK & BANK ALFALAH ................................................................................................................ 13

Monitoring and Evaluation ................................................................................................................................... 14

2. PROBLEMS AND OBSTACLES .......................................................................................... 14

3. SUCCESS STORIES ........................................................................................................... 15

Annexures: .............................................................................................................................. 16

Annex 1: FMD Quarterly Financial Report.................................................................................. 16

Annex 2: National Clearing Company of Pakistan Limited (NCCPL) Observance to Recommendations for Central Counterparties (CCPs) ................................................................ 17

Annex 3: IOSCO Compliant Central Counterparty (CCP) Gap Implementation Plan.....................34

IOSCO Compliant Central Counterparty (CCP) - Gap Implementation Plan................................. 34

Annex 4: National Clearing Company Pakistan ltd. Evolving Role As a Centralized Know Your Customer Organization ............................................................................................................ 37

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LIST OF SELECTED ACRONYMS

ATCI Access to Credit Initiative ADB Asian Development Bank CCN Cooperating Country National CDC Central Depository Company CDNS Central Directorate of National Savings CKO Central KYC Organization COP Chief of Party COR Contracting Officer's Representative CPEC China Pakistan Economic Corridor DMFAS Debt Management and Financial Analysis System DMWG Debt Management Working Group DPCO Debt Policy Coordination Office DFID Department for International Development, United Kingdom DCOP Deputy Chief of Party DCA Development Credit Authority DMMMD Domestic Markets and Monetary Management Department EAD Economic Affairs Division EBND Electronic Bond Trading Platform eWRS Electronic Warehouse Receipt System EFF Extended Fund Facility EFPW External Finance Policy Wing EFW External Finance Wing FMD Financial Market Development FSI Financial Sector Initiative GOP Government of Pakistan GDP Gross Domestic Product HICD Human and Institutional Capacity Development IT Information Technology IFM Institute of Financial Markets IFC International Finance Corporation IOSCO International Organisation of Securities Commissions KYC Know Your Client LOP Life of Project MIS Management Information System MTB Market Treasury Bills MTDS Medium Term Debt Strategy MOF Ministry of Finance M&E Monitoring and Evaluation MEP Monitoring and Evaluation Plan NCCPL National Clearing Company of Pakistan Limited NSS National Savings Scheme NBFI Non-Banking Financial Institution NGO Non-Governmental Organization OCAT Organizational Capacity Assessment Tool PACRA Pakistan Credit Ratings Agency

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PE Private Equity PIB Pakistan Investment Bond PMEX Pakistan Mercantile Exchange PSX Pakistan Stock Exchange PKR Pakistani Rupees PD Primary Dealer PPII Pakistan Private Investment Initiative SECP Securities and Exchange Commission of Pakistan STTA Short-Term Technical Assistance SME Small and Medium Enterprise SOP Standard Operating Procedure SBP State Bank of Pakistan TFC Term Finance Certificates TBD To Be Determined UNCTAD United Nations Conference on Trade and Development USAID United States Agency for International Development USD United States Dollars USG United States Government

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1. PROJECT HIGHLIGHTS AND ACCOMPLISHMENTS

1.1. TASK 1: SUPPORTING GOP IN CREATING AN IMPROVED ENABLING ENVIRONMENT FOR THE ROBUST DEVELOPMENT OF DEBT, ISLAMIC, COMMODITY AND SME MARKETS

Under this component, FMD aims to improve the regulatory framework and implement policy level interventions consistent with international best practices.

1.1.1. Enhanced SME Funding

FMD began work with Pakistan Stock Exchange (“PSX”) on PSX’s Small and Medium Enterprise Development Plan. In a sign of the strong cooperation of PSX and MFD, FMD’s Senior Policy Advisor was named Vice Chairman of PSX’s Small Business Committee. The Committee aims to make it easier for small businesses to raise capital on the PSX, and presently intends to have two meetings during the next quarter.

Christopher Johnson, FMD’s SME Listing Expert, began his first mission to Pakistan on 5 December. He and the FMD team immediately met with Nadeed Naqvi, CEO of the “PSX”. With the support of Mr. Naqvi, Mr. Johnson and the FMD team met with a broad cross section of PSX staff in order develop to improvement recommendations for PSX.

Mr. Johnson completed a review of the relevant legal and regulatory framework. Based upon his review, he recommend improvements to the following areas of the legal framework in his report:

• Structure & Governance • Listing Requirements • Defining the target investor and associated regulatory inputs • Listing Fees • Tax & Investment Incentives.

Johnson also met with relevant USAID personnel for his “in-brief,” as well as with two top brokers in Pakistan (Kamran Nasir of JS Global and Nadir Rehman of BMA), and with PSX’s Chief Regulatory Officer. These meetings produced the following, all of which are consistent with Johnson’s TOR:

• Johnson will work from the PSX offices from 9 AM to 5 PM each day to stimulate hands-on-training, coordination, feedback and interaction.

• Johnson will produce an "SME Platform Business Plan" that provides the background, status, and recommended road map for the SME Platform.

• One Outreach event would be conducted in Karachi for targeted SMEs. This event would be created and delivered by Johnson and other stakeholders. FMD intends to conduct the event in the final week of December.

Johnson’s first report will be delivered in the first half of January.

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1.1.2. Commodity Warehouses Receipt Financing Mechanism Framework

Dr. Andre van der Vyver completed the first phase of his three-phase intervention regarding FMD’s ongoing work in the area of electronic warehouse receipts. Dr. van der Vyver met with producers, warehouse operators, quality control service providers, the Central Depository Company, Pakistan Mercantile Exchange, and SECP.

Dr. van der Vyver prepared detailed recommendations, which include commentary on the draft Collateral Management and Warehousing Regulation, the spot trading platform, the eWRS depository, and collateral management companies. His report also contains recommendations on the creation of industry product committees, staple crops from the pilot project, depository software needs, as well as warehouse inspection and certification standards. He visited Punjab and Sindh and met with warehouse operators and others who are active in the eWRS eco-system.

He is scheduled to return to Pakistan on or about 15 January 2017.

1.1.3. Review of Public Offering Framework

During the course of October, FMD drafted comments and recommendations on Final Revised Draft Public Offering Regulations, 2016, as well as Underwriters Regulations, 2016. These were delivered on October 18, and were discussed with SECP in a meeting on November 14. They delineate the obligations and limitations on the various parties (issuer, consultant, underwriters, bankers and investment agents) to a public offering. The comments are summarized below.

Public Offering Regulations Chapter II 3 (11)

The exchange is to determine the suitability of the Issuer or security. This is an inefficiency in that ordinarily this is a judgement made by the investor or investment advisor. The general rule of thumb is that the role of regulations of new issues is disclosure. If disclosure is satisfactory, then market participants or their advisors can make informed decisions on suitability.

Public Offering Regulations Chapter II 3 (12)

This is a form of redundancy. The exchange and the consultant to the issuer will have already approved the prospectus to their satisfaction and subject to liability. SECP probably must retain the right to reject a filing, but perhaps could notify the market that, as a matter of practice it will broadly accept and post filings automatically. SECP, in any event, already publicly disclaims liability.

Public Offering Regulations Chapter VII 13 (3)

This is an even better opportunity for efficiency “outsourcing” (which is what Chapter II 3 (12), supra attempts to accomplish), but with the addition of an objective risk based algorithm. Issuance already requires a credit rating from a regulated agency. Therefore, SECP could consider a “non-objection” approval for bonds that attain a specific rating or higher (say, “A,” for example). As the issuer and consultant to the issuer still have a full disclosure obligation, the SECP could automatically approve (so long as it has not published an objection) bond issues with such a rating.

Public Offering Regulations Chapter IX 19 (2)

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Here, the draft empowers the SECP to determine the suitability of the issue or the security. Again, best practice empowers the Consultant to the Issuer to determine the suitability of the Issuer or security. This part of the draft is an inefficiency in that ordinarily this is a judgement made by the investor or investment advisor. The general rule of thumb is that the role of regulations of new issues is disclosure. If disclosure is satisfactory, then market participants or their advisors can make informed decisions on suitability. This standard is satisfied by Public Offering Regulations Chapter IX 20 (ii).

Public Offering Regulations, First Schedule, Section 1, 5

This section correctly affirms that SECP is not responsible for the quality of the issue and therefore justifies more reliance on disclosure by the issuer and consultant to the issue.

Public Offering Regulations, First Schedule, Section 2, Second schedule, 4 (x)

Generally, the requirements for the abridged prospectus represent information that a reasonable investor would require for an informed decision. However, the issuer is asked to spell out the “potential return for investors.” This is essentially marketing and would actually be forbidden under securities law of many countries. This adds to the burden of the issuer without enhancing the disclosure and could be the source of stock touting.

During the November 14 meeting, SECP was amenable to FMD’s recommendations. FMD’s recommendation of an algorithm for risk based approval of debt securities was very interesting to SECP.

FMD and relevant SECP personnel met several more times regarding the comments that FMD provided to SECP on the Final Revised Draft Public Offering Regulations, 2016 (and three related documents). This parallels FMD’s work on trustees, sukuk taxation and securitization. Insofar as most of these comments are directed at reducing redundant activities by SECP and various of its regulated entities (exchanges, consultants, and rating agencies), the meetings concerned related practicalities. SECP showed particular interest in FMD’s recommendation on Section VII 13 (3) for a risk-based approval system for Term Finance Certificates and sukuks. SECP and FMD aim to reduce friction in the public offering process of both equities and fixed income securities. If adopted, these amendments could make issuance of securities somewhat more efficient and therefore broaden the capital markets that are heavily skewed to government securities.

1.1.4. Development of Sukuk/Islamic Financial Products Framework

During the quarter, FMD advanced its recommendations on various regulations that underpin sukuks and securitization. The key recommendations are summarized below:

Market participants have expressed the view that the overall relationship between banks as trustees and the issuers has caused trustees to be lax. There should be some restriction on the trustee holding enough securities of an issue on which it is trustee to influence a restructuring, but ownership of 10% should be permitted to allow inventory as a market maker.

Currently to restructure/reschedule a security requires a simple majority of holders to vote in favor. FMD suggested that, in order to ensure that a broader pool of investors is satisfied, the threshold should be 75%.

Trustees should be aggressive in pursuing the rights of creditors; the trustee should be required to initiate proceedings against a defaulting issuer immediately after any grace period in the debenture at its own cost (to be the first reimbursement from cash flow proceeds from

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the security). Naturally, this “kneejerk” reaction could be overruled by 75% of holders as in the above restructuring vote.

On November 5, SECP incorporated FMD’s recommendations and posted a new draft trustee regulation for the required public comment period.

FMD also met with SECP to recommend modernization of the asset backed securities (securitization) rules. FMD’s recommendations on securitization can be summarized as follows:

Securitization is an important vehicle to provide financing to households and SME businesses (via the finance companies that serve them). Continued flow of finance to banks and NBFIs via this structure will be possible with a sound structure.

Section 10 of the existing rules requires independence of originator and SPV in a securitization. Current global practice is moving toward requiring that the originator hold the most junior securities of an SPV (the first loss tranche). This acts to give the originator an incentive to maintain appropriate credit standards in collecting the underlying receivables for securitizations.

SPVs should have a full menu of financing structures available to them, including Sukuks and commercial paper, and even multiple tranches of equity. This allows for broader fund raising and better terms for the SPVs and therefore for the underlying debtors. In particular, the Islamic market is liquid and yields would be expected to be more attractive if the securitization can be structured to match that liquidity.

SECP has been hesitant about FMD’s independence recommendation (Section 10 of the rules). However, SECP clearly understands the benefit to investors for the originator to be at risk. On November 14, in a meeting with SECP, and with a follow up email, SECP has indicated serious consideration of FMD’s view.

1.1.5. Availability of Credit Enhancement Guarantees for the NBFI Sector

In October and November, FMD developed a dynamic pro forma modelling tool for a securitization guarantee candidate, Orix Leasing. This tool allows an analysis of various securitization structures and assumptions for consideration in designing a facility to allow the originator to expand its financing utilizing an efficient off-balance sheet vehicle.

The pro forma includes a summary of the existing originator balance sheet, all pro forma adjustments for each proposal, and a sample post securitization balance sheet. It also provides an income statement for the originator both before and after the mooted securitization, with all adjustments spelled out for review and discussion. It includes an income statement for the securitization trust to indicate the interest coverage and cash flow available to investors. Finally, the model includes a measurement of key profit and leverage ratios that are the important justification for the structure proposed.

On November 2, FMD met with Orix executives to present the dynamic pro forma modelling tool and to answer questions on the structure, assumptions and advantages of the structure we proposed. The outcome was both interest in the structure and an agreement for FMD to amend the model to base it solely on data points available in the public domain from Orix’s securities filings in order to permit its use in marketing to outsiders.

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On November 10, FMD met with investment bankers at Allied Bank, the main bank relationship for Orix. FMD explained the structure of a securitization and discussed with them the benefits for all parties. On that basis, Allied agreed to cooperate on a marketing road show for a securitization when all the structural elements become known.

On November 11, FMD delivered the updated dynamic pro forma modelling tool for a securitization, reflecting only publicly available data. In addition, FMD delivered to Orix a draft term sheet for a securitization of PKR 1 billion. The term sheet spells out the proposed overcollateralization, the underlying assets to be bought, the broad waterfall of cash flows, the hypothecation arrangement and proposed covenants. Importantly, it also includes a requirement for the originator to hold a first loss tranche for appropriate risk sharing and allocation.

On November 17, FMD delivered the primary analysis and concept paper called for in the work plan. The paper provides a description of securitization, the process of development and the advantages. It also summarizes our work in identifying candidates in the Pakistan market that could create a securitization structure and issue securities. The paper spells out the key elements of the structure in terms of underlying assets, overcollateralization and asset selection and management. FMD proposes possible solutions to respond to market uncertainty about the structures and the current regulatory environment. FMD summarized its due diligence on the candidates for a securitization based on international experience. Finally, FMD provided recommendations for a route forward and proposed next steps to achieve a sound credit enhancement guarantee.

1.2. TASK-II: SUPPORTING GOP INSTITUTIONS IN IMPROVING SOVEREIGN DEBT ISSUANCE/MANAGEMENT, AND HELP DEVELOP THE INSTITUTIONAL ARCHITECTURE REQUIRED FOR THE COMPETITIVE AND INNOVATIVE OPERATIONS OF DOMESTIC CAPITAL MARKETS

1.2.1. Reforms for National Savings Scheme

FMD’s State Debt Management Advisor and its Senior Policy advisor met several times with the Director General of the Central Directorate of National Savings (“CDNS”), Mr. Zafar Masud, to further refine CNDS’s understanding of what assistance FMD can provide, and how that assistance might best be delivered.

FMD agreed with Mr. Masud that key support interventions should be shaped in the direction of rationalizing the National Savings Scheme within the context of Pakistan’s overall state debt management program. Mr. Masud agreed that, at this point, key focus should be on FMD’s provision of legal/regulatory assistance related to CDNS organizational autonomy, as well as product audit and design assistance.

On 15 November, FMD and USAID-Pakistan met with Mr. Masud. FMD stressed that any intervention that it can provide must address, ultimately, support for debt markets and rationalization of National Savings Scheme-related obligations in the context of Pakistan’s debt portfolio. Mr. Masud agreed, and then presented to USAID-Pakistan a request for a series of interventions.

Thereafter, USAID-Pakistan instructed FMD to compose a proposal setting forth a general description of work to be performed under each of the three general areas regarding which USAID-Pakistan believes FMD can be impactive. FMD submitted the said proposal (largely composed by

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FMD’s State Debt Management Expert) on 18 November, and USAID-Pakistan approved the proposal.

FMD’s Senior Debt Management Specialist and its Capital and Money Market Expert, in anticipation of USAID-Pakistan’s approval of FMD’s proposal regarding its work with the Central Directorate on National Savings, prepared a draft strategy regarding such work.

The strategy covers FMD interventions, under the rubric of “product design,” regarding NSS’s Retail Debt Programs. This includes a history of retail debt programs in Pakistan, the role that they are intended to play, the cost-effectiveness thereof, and the degree to which the programs actually achieve their intended goals. This strategy will form the basis of any product adjustments that FMD recommends, once the collaboration between FMD and NSS is formalized. FMD discussed this strategy in detail with USAID-Pakistan prior to FMD’s sharing with CDNS counterparts.

1.2.2. Institution Building Support for State Bank of Pakistan

FMD completed analyses related to Pakistan’s government debt securities market, including assessments, recommendations and proposed actions related to work plan subtasks 2.1.1 (new prospectus design), 2.1.3 (analysis and improvement of primary issuance structure) and 2.1.4 (recommendations for improvements to the primary dealer system).

The ultimate purpose of FMD’s preparation of the foregoing is the implementation of a strategy, through appropriate measures that lead:

• to an increase of funds available to meet financing needs of the private sector, through an increased supply of loanable funds of the banking industry, increased investors' demand for privately issued debt capital instruments and a further increase in equity finance;

• to a reduction of the dominance and the resulting crowding out the effect of the high share of government debt securities within the debt capital market (>95%) and of the high share of banks as holders of marketable government securities within the financial sector (>80%) and finally;

• to more efficient government securities primary issuance arrangements, resulting in lower financing costs (interest rate expenditure currently being at 22% of budget outlays), in widening the investor base and, in a more vibrant secondary market, eventually turning investors’ demand to a greater extend into the private capital market.

The full-text document will be submitted to USAID-Pakistan early in the next reporting period.

1.2.3. Institution Building Support for NCCPL/Establishment of Central Counterparty Framework at NCCPL/Operational Guidelines for Know Your Client Functionality

During the reporting period, FMD provided technical support to the country’s only securities settlement agency, the NCCPL. The reports of the two relevant experts are attached hereto as Annexes 2-4.

1.2.4. Fixed Income Training Program for the Institute of Financial Markets

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As a result of the comprehensive course on Fixed Income Basics and Trading, FMD received requests for additional presentations of the course. In a meeting on November 4, State Life Insurance Company requested a tailored course for its investment executives.

Institute of Financial Markets of Pakistan (IFMP), the sponsor of the original course, also requested additional delivery of the course during the first quarter of 2017.

FMD has extensively refined and updated the Fixed Income syllabus to reflect the specific needs of IFMP, State Life and, and the Institute of Business Administration. The courses are to be delivered in Karachi from 16-25 January 2017.

1.3. TASK-III: SUPPORTING EXPANSION OF SME LENDING WITH DEVELOPMENT CREDIT AUTHORITY (DCA) INSTITUTIONAL PARTNERS

1.3.1. KHUSHHALI BANK & FIRST MICRO FINANCE BANK

In mid-August, FMD recruited an international SME consultant to work with two microfinance banks–Khushhali Microfinance Bank (“KB”) and First Microfinance Bank–Pakistan (“FMFB-P”). She completed a two-month mission (21st August–21st October).

During the portion of her mission that occurred during this quarter, she and relevant FMD personnel conducted a 3-day training course for KB. This training course was divided into session designed around the following areas:

o Introduction to SME Finance and New SME Products o SME Credit Analysis: Collecting & Understanding Information o SME Credit Analysis: Verifying Information o SME Analysis: Cash Flow Analysis o Loan Portfolio Management & Monitoring o Segment Management

This training course was conducted at National Institute of Banking & Finance (NIBAF), Islamabad. It was attended by MSME Area Coordinators, MSME Team Lead Trainers, Country MSME Manager, and Product Manager.

Additionally during the quarter, the FMD banking team:

• Conducted meetings with the Product & Business Teams at KB and agreed to develop two Agri Financing Products (i.e. Agri Implements Financing; Tractor Financing) within the MSME segment.

• Prepared a Product Development Project Plan and shared it with KB. The following timelines were shared with KB, after discussion with the KB Product Head: o Agri Implements Financing – Last week of January 2017 o Tractor Financing – Last week of February 2017

• Developed survey tool for Focus Group sessions to identify the market needs. • Held 6 Focus Group Sessions, in collaboration with KB Product Team, at 3 locations (i.e. Sahiwal,

Vehari and Bahawalpur). • Made a field visit, along with the KB Product Team, to Okara to get a sense of the Agri

Equipment/Implements’ variety and prices.

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• Presented the findings to the KB Leadership Team (including the CEO). • Ran a market insights exercise to understand the delivery model used by commercial banks for

“Tractor Financing.” Met a local bank’s Agri Finance Head. Also, composed a “Competitor Analysis.”

• Collaborated with the KB Product Team to put together the bank’s “Product Approval Document.”

• FMFB asked FMD to defer engagement activities until January 2017, as it has reprioritized its core banking implementation. The following task was completed in December 2016:

• Held a meeting with the FMFB Product Team and proposed “Agri Equipment” financing as a potential product to collaborate for product development in January 2017.

I. Implementation Status: The implementation for the work plan areas for the two microfinance banks are outlined below:

Activity No.

Activity Implementation Status

3.1 Action plan development

Action plan development with the timeline for the two MF banks were completed on the following days: FMFB-P: Completed on July 1, 2016 KB: Completed on August 17, 2016

3.2 Product refinement and design, and lending methodology

It has been completed with a presentation, a report to the respective banks and followed by training in October.

3.3 Training of branch personnel

Training needs assessment was conducted with the respective banks during the branch visits.

Training materials developed. Loan officers, TOT trainers, relationship officers

and credit officers were trained in the week of October 17 2016 (KB).

3.4 Piloting of innovative SME lending products and methodology

KB: A work plan with a timeline was completed and agreed upon by Head of Retail Banking, Head of SME, Head of Marketing, product management and credit risk. The plan is to pilot the products potentially as early as January ’17 and February ’17.

FMFB-P: While the bank agreed in principle on developing new SME products, they requested to delay implementation until at least January ‘2017.

3.5 Implementation of the Pilot (6 - 10 months from approval of the work plan)

This will be completed after piloting the program in three of the respective banks’ branches.

II. Implementation Challenges FMFB redefined their priorities and preponed the core banking implementation; hence, the engagement would resume potentially in January/February 2017.

III. Stakeholder Participation and Involvement

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The SME Advisory Team has been engaged with the two banks’ senior management, their branches and SME clients.

IV. Lessons Learned Project success so far has been due to the engagement and commitment of the banks. Additionally, FMFB’s engagement has slowed down because of organizational changes within the bank and limited ongoing engagement of STTA resources.

V. Planned Activities for next quarter Pilots for new products will be rolled out for KB. Training & Orientation session will be held at the respective branches. Also, marketing material will be put together. Discussion will be resumed with FMFB for Product Development and Capacity Building of MSME Staff.

1.3.2. JS BANK & BANK ALFALAH

In mid-August, FMD recruited an international SME consultant to work with two commercial banks: JS Bank and Bank Alfalah. The consultant completed his first mission on 21 September, and will be in Pakistan in January 2017 for his second mission to complete his terms of reference.

During this quarter, the local resident SME advisor achieved the following:

• Made a visit to Lahore and met the Agri Head at Bank Alfalah to seek its feedback on the proposal submitted by the short-term consultant (i.e. Luc Vaillancourt). Subsequently, followed up with the SME Team (i.e. SME Head, Product Head and Agri Head) to seek their feedback. Bank Alfalah, asked that additional items be built into the proposal, and sought to resume the discussion in January 2017.

• In the last week of October 2016, held a meeting with JS Bank Team (i.e. Retail and Corporate Group Head, Product Head, SME Head) to review collaboration status, and review related follow-up proposals submitted by the short-term consultant, Luc Vaillancourt. Also, met with the JS Bank CEO and discussed progress and next steps. Subsequently, followed up with the SME Head and Product Head to seek their formal written approval based on a request from USAID.

• Drafted TORs for the short-term consultant in line with latest updated requirements.

I. Priority FMD Interventions for the reporting period II. Activity Title Status

JS Bank Bank Alfalah 3.1 Action Plan Development – v1.0 Completed Completed 3.1.1 Action Plan Development – v2.0 In progress In progress

3.2 Product Refinement and Design, and Lending Methodology

In progress In progress

3.2.1 Product Refinement/Design N/A Conceptualized 3.2.2 Innovative Lending Methodology In progress In progress

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Monitoring and Evaluation

The final version of FMD ME&L plan envisages a monitoring, evaluation and learning system that helps identify promising interventions in advance so that they can effectively be implemented during the Activity to generate approved anticipated results. Having data available about how well an intervention or policy works will provide useful information for formulating and justifying resource requests. This will facilitate judicious allocation of resources to undertake interventions that will provide the strongest impact. Furthermore, it provides clear indicators against which FMD is working and being measured; it ensures that information for the outputs being measured is available and verifiable.

FMD has already initiated the development of monitoring instruments/checklists in accordance with the approved ME&L plan. As soon as the performance indicators reference sheets (PIRS) for a few indicators are agreed the team will start collecting data utilizing the monitoring instruments and subsequently the data will be reported in the following quarterly reports.

2.PROBLEMS AND OBSTACLES

Until 20 December 2016, FMD was not permitted (by USAID) to work with the Ministry of Finance. This negatively impacted FMD’s ability to perform much of the “State Debt Management” portion of the work plan.

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3.SUCCESS STORIES

Pakistan’s Securities Market Moves Towards International Compliance

The Development of an IOSCO Compliant CCP Framework Adds Another Safety Benchmark to Pakistani Securities

The Pakistani financial securities market is one step closer to compliance with international benchmarks, thanks to the development of a new central counterparty (CCP) framework.

The framework was developed with support from the Financial Markets Development (FMD) program, an initiative of the U.S. Agency for International Development (USAID). Its creation makes it possible for Pakistan to achieve full compliance with the CCP benchmarks set by the International Organizations of Securities Commissions (IOSCO).

“With the implementation of a modern CCP framework, NCCPL has given an added confidence to the market participants that there will be no delivery failure in our market,” said Mr. Mohammad Lukman, who is the CEO of NCCPL. The framework will also allow NCCPL to act as a settlement guarantee obligor for each trade, Mr. Lukman said.

For years Pakistan’s financial markets offered inadequate protection to participants, and failed to meet basic, but critical compliance standards set by IOSCO. To add, the markets remained out of step with a decision made by G20 leaders requiring the mandatory clearance and settlement of all over-the-counter trading through the central counterparty (CCP) channel.

The new framework stands to improve Pakistan’s overall compliance ratio with IOSCO, and comes against the backdrop of the country’s inclusion in the MSCI Emerging Market Index— a move that is likely to bring substantial foreign investment inflow to the country’s market next spring.

“CCP implementation before Pakistan’s reclassification in the MSCI Emerging Market Index shall give a very positive signal to foreign investors about the added safety of the country’s market for the global participants,” said Mr. Kamran Nasir, CEO of JS Global.

One important benchmark of market stability is how a country implements an effective CCP framework for its securities settlement system. Despite having an automated and centralized securities clearing and settlement process, Pakistan had not yet adopted the critical CCP framework, which can be seen as providing assurance for the completion of the securities settlement process.

Coinciding with FMD’s CCP work, USAID also collaborated with NCCPL to deliver a technical workshop demystifying the IOSCO complaint CCP framework. The workshop, delivered by FMD’s internationally certified CCP expert, targeted key capital market stakeholders including foreign custodian banks.

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Annexures:

Annex 1: FMD Quarterly Financial Report

The Pragma Corporation Project: AID-391-C-15-00013 (Financial Market Development Activity-Pakistan "FMD")

Report Period: 03/01/16-12/31/16 Total Obligated Amount: $3,718,750

Budget Item Budget Amount

Actual Spent

Through Qtr

09/30/16

Estimated Amount for

Qtr 10/01/16-12/31/16

Total Estimated Amount

Spent Through 12/31/16

Budget Amount Balance

Labor 5,121,452 428,487 219,069 647,556 4,473,896

Fringe Benefits 1,773,919 163,168 75,569 238,737 1,535,182

Expatriate Allowances 1,485,176 166,295 98,900 265,195 1,219,981

Travel 835,070 68,358 37,351 105,709 729,361

Other Direct Costs 4,169,154 261,493 97,376 358,869 3,810,285

Subcontracts 836,870 74,509 30,549 105,058 731,812

Indirect Costs 3,374,424 281,290 138,250 419,540 2,954,884

Fixed Fee 754,164 76,634 32,843 109,478 644,686

Total Cost 18,350,229 1,520,235 729,907 2,250,142 16,100,088

Estimated Obligated Amount Balance $1,468,608

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Annex 2: National Clearing Company of Pakistan Limited (NCCPL) Observance to Recommendations for Central Counterparties (CCPs)

National Clearing Company of Pakistan Limited (NCCPL) Observance to Recommendations for Central Counterparties (CCPs) (Assessment of Compliance to the CPMI-IOSCO “Recommendations for Central Counterparties’)

1. Introduction 1.1 Objectives of the report

This report addresses the results of an independent assessment by Pragma Corporation as part of its commitment to the USAID Financial Market Development Project (FMDP) of the National Clearing Company of Pakistan Limited (NCCPL) Central Counterparty (CCP) functionality and its observance of the Recommendations for Central Counterparties issued by the Bank for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO) November 2004.

The assessment identifies gaps and shortfalls from the aforementioned recommendations and outlines a time-framed implementation plan covering all regulatory and operational areas in a manner designed to ensure full compliance with the relevant IOSCO principles and best regional practice.

1.2 Background

CCPs have attracted considerable attention in the aftermath of the financial crisis. One explanation is that CCPs contribute to reducing risk between market participants and to ensuring market transparency. The CCP positions itself between the buyer and seller from the transaction date until the transaction is finally executed and settled. If either of the parties to the transaction defaults within this period, the CCP still has an obligation to the other party. This entails that risk is concentrated in the CCP, and therefore the CCP is subject to a number of regulatory requirements to ensure the completion of the transaction.

Central clearing fundamentally alters the linkages and exposures in the financial system. It replaces bilateral trading exposure between market participants with a centralised network of exposures between clearing members and the CCP. This implies that:

The CCP combines the exposure of all clearing members on its balance sheet. If all clearing members can meet their obligations, the CCP runs regularly matched books. But if a participant defaults, it assumes the rights and obligations of the failing clearing member; and

Instead of being subject to multiple exposures to a range of counterparties, each market participant maintains just a single trading exposure to the CCP. Because of multilateral netting, the size of this exposure is equivalent to the net position vis-a¬vis all other clearing members.

Global standard setters have devoted considerable effort to strengthening the reliance of individual CCPs. They have required more stringent CCP risk management, with a focus on stress events. And they have adjusted the relative levels of capital and margin requirements for centrally cleared products so as to ensure that capital and liquidity requirements appropriately cover the risks associated with exposures to the CCP while maintaining incentives for central clearing.

The NCCPL is responsible for providing the clearing and settlement services for all trades and transactions that have been executed at PSX. In line with the NCCPLs key role within the overall capital markets infrastructure the SECP has taken various steps to enhance and align its role in line with international best practices and measures. To these ends the following measures have been adopted:

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The SECP included comprehensive provisions within the Securities Act 2015 (ACT) covering all major aspects to ensure that a well-founded statutory framework is provided to the clearinghouse to operate. The SECP had further enhanced the regulatory frame work by issuing the Clearing House (Licencing and Operations) Regulations 2016, which establishes the criteria for licencing, roles and responsibilities, shareholding and governance structure, audit and reporting requirements, etc. These provisions will add to the transparency and efficiency of the role of NCCPL.

The Act also mandated NCCPL to assume the role of a Central Counterparty (CCP) whereby the NCCPL imposes itself as a buyer to every seller and visa versa to guarantee the settlement of all trades and transactions executed at PSX. Globally major clearing houses have assumed the role of a CCP which has required the development and implementation of a reliable and effective risk management framework and the maintenance of adequate liquid financial resources to guarantee the settlement of trades. As a result complete risk management functions were entrusted to NCCPL from May 2, 2016. To ensure the availability of adequate financial resources, significant funds (PKR 2.7bn) were transferred from the "Clearing House Protection Fund” maintained by PSX to the Settlement Guarantee Fund (SGF) maintained by NCCPL.

The NCCPL is currently in the process of thoroughly reviewing and renewing their existing risk management model and where necessary aligning it with the requirements of international standards. These include and focus on the latest and reliable

technology infrastructure for risk management, margin requirements, collateral, valuation mechanisms for the SGF and mechanisms to independently perform stress tests for all elements on a regular basis.

It is envisaged the NCCPL and its CCP capacity will not only add to the confidence of the capital market investors but will also serve to attract the foreign investor community.

It is evident that the Pakistani capital markets regulators and infrastructure organisations have made positive progress in terms of improving capital market regulations, efficiency, and operations while launching new concepts for ease of doing business and more importantly investor protection.

NCCPL provided the fullest cooperation in the carrying out of the assessment.

Trade National Clearing Company of Pakistan Limited Date of 3-Jul-01 Paid-up PKR 300,000,000 - June 30, 2105. PKR 600,000,000 - March 31,2016 (un-audited)

Shareholde rs

Pakistan Stock Exchange Limited (PSX) 47.06% LSE Financial Services Limited 23.53% Pakistan Kuwait Investment Company (Private) Limited 17.65% ISE Towers REIT Management Company Limited 11.76%

Board 13 Directors

Scope of coverage

Clearing and Settlement Services, Risk Management System, Unique Identification Number (UIN), Margin Trading System (MTS), Margin Financing System (MFS), Securities & Lending & Borrowing (SLB), National Custodian Services (NCS)

Daily PKR 5,808,965,714 - March 31,2016 Clearing Broker Clearing Members: 346, Non-Broker Clearing Members: 168, Custodian Other Market information, Circulars & Notices, Knowledge Base & Investor Education Regulatory Securities and Exchange Commission of Pakistan (SECP)

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NCCPL Regulations NCSS Procedures

Governing legislation

Clearing House Companies (Registration and Regulations) Rules 2005 Companies Ordinance 1984 Income Tax Ordinance 2001 Securities Act 2015 Leveraged Market and pledging Rules 2011 Income Tax Rules 2001

1.3 Equity Market Foreign investment accounts for approximately 10 per cent of the total market capitalisation

(30% of free-float). The retail investor base is small compared to other regional markets. The major players are open-ended and close-ended state-owned mutual funds, commercial

banks, investment banks and development finance institutions. Due to the size of the Pakistani stock market and the concentration of trading in a few

companies (volume leaders) large volumes can cause significant price volatility. Presently about 98 per cent of the securities listed on the PSX are registered on the CDC. Unique Identification Number (UIN) applies to this market. The purpose of the UIN is to

establish a traceable link between every order entered into the trading system of stock exchanges and the person placing the order. All investors, whether local or foreign, are required to obtain a Registration Number (UIN).

1.4 Secondary Market The PSX operates under the T+2 settlement system. Book entry transfers are affected on a real-time basis. Securities transfers can be extended till

15:30, but cut-off timings are determined by the cash-processing deadline, i.e. 12:30pm. Under the PSX regulations, the delivering broker is required to replace securities with the

defective title if the claim is submitted within the stipulated deadline. Payment or securities are only released upon receipt of counter value. Effective 1 July 2008, The State Bank of Pakistan (SBP) implemented a Real Time Gross

Settlement (RTGS) system in order to automate cash settlement on real time basis. The Central Depository Company of Pakistan Limited (CDC) offers DVP facility under which

simultaneous exchange of cash and securities takes place. However, the DVP facility is not utilized by market participants due to its failure to provide same day cash settlement.

1.5 Organizational Structure

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1.6 Market Interactions

1.7 Executive summary of the recommendation assessment

NCCPL is fully compliant with 8 of the 15 Recommendations, broad compliance with 4 and partially compliant with 4 of the Recommendations. (Reference: Assessment of Compliance (Summary)).

In order to achieve full observance, NCCPL should assess the risks and identify the actions needed to ensure a complete track record of the interventions, with account also taken of the likely increase in

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the number of financial instruments dealt with by the clearing system. Moreover, NCCPL should also carefully assess the quantitative adequacy of the human resources dedicated to its key processes.

1.8 Assessment of Compliance (Summary)

Assessment Category Applicable Recommendations Compliance 3, 4, 6, 8, 11, 13 and 14 Broad compliance 2, 7, 10 and 15 Partial compliance 1, 5, 9 and 12 Non-compliance NA Not applicable NA

2. Abbreviations:

ACT Securities Act 2015 BCP Business Continuity Planning BIS Bank for International Settlements CCP Central Counterparty CDC Central Depository Company of Pakistan Limited CPMI Committee DVP Deliver versus Payment IOSCO International Organisation of Securities Commissions NCCPL National Clearing Company of Pakistan Limited NCS National Custodial Services NCSS National Clearing & Settlement System PMEX Pakistan Mercantile Exchange Limited PSX Pakistan Stock Exchange Limited RTGS Real Time Gross Settlement SECP Securities and Exchange Commission of Pakistan SGF Settlement Guarantee Fund SLB Securities Lending & Borrowing UIN Unique Identification Number VaR Value at Risk

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Recommendation 1: Legal risk

Key criteria Observations

1. Clarity, coherence and availability of laws and regulations

NCCPL is subject to regulations stipulated under the provisions of the ACT as well as the Clearing House (Licencing and Operations) Regulations 2016.

NCCPL maintains appropriate provisions with respect to the contractual provisions for its clearing members. These are governed by NCCPL’s business rules. However, it is recommended the actual legal documentation should be revisited to remove any ambiguity with respect to its ultimate legal obligations (amending the term "agreement” to "terms and conditions”).

NCCPLs detailed operational procedures are defined in its rules. In terms of clarity and internal coherence, no difficulty has been identified to date for any part of the overall legal and regulatory framework.

Market participants receive comprehensive documentation covering NCCPLs rules, requirements, policies and procedures. Access to which is available via the participant’s on-line interface with NCCPL. PSX also assists in the distribution of relevant documentation.

All available documentation is available on request.

2. Effectiveness of laws and regulations

The SECPs legal framework provides a sound legal basis that supports novation, netting, default procedures, collateral, clearing arrangements, enforcement of a CCPs rules vis-a-vis its participants, finality of transfers of funds and the insolvency of a CCP. All the above-mentioned aspects are also clearly stated in CCP Rules, issued and approved by the supervisory authorities (SECP).

However, it was noted that the term "Custodian” was not defined in any of the current laws, rules and regulations. For the avoidance of any doubt in the future, it is recommended that the

3. Enforceability of rules, procedures and contracts on participant default

The current legal framework ensures the enforceability of CCP rules, procedures and contracts/agreements, should a CCP participant default or become insolvent, the actions taken under such default rules are final and may not be stayed, avoided or

4. Conflicts of laws, rules and regulations

Current SECP rules dictate that (new) Clearing Houses’ must have at least PKR 1bn paid-up capital. NCCPLs current objective is to mirror this obligation.

It is recommended that NCCPL’s participation contracts (Clearing Members Application Form) establishes that only Pakistan jurisdiction applies to all the obligations arising from their participation in the National Clearing and Settlement System (NCSS).

It is recommended that detailed care and attention be given to the current inordinate number of notices, rules and recommendations being issued by SECP as a result of the

t t f th ACT Hi t i ll h l l f di i ti Assessment: Partial compliance

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Recommendation 2: Participation requirements A CCP should require participants to have sufficient financial resources and robust operational capacity to meet obligations arising from participation in the CCP. A CCP should have procedures in place to monitor that participation requirements are met on an on¬going basis. A CCP’s participation requirements should be objective, publicly disclosed, and permit fair and open access.

Key criteria Observations

1. Financial and operational requirements

NCCPL will eventually have a tiered membership structure, based on the following categories: i) Trading only, ii) trading and self-clearing and iii) trading and clearing.

The SECP Notification of June 24, 2016 has established minimum requirements for its participants’ financial resources, which depend on the type of membership. In addition NCCPLs updated regulations May 17, 2016 requires entities have established technological and organisational requirements.

When examining participant qualifications, it was noted on a number of occasions a shortfall of "financial literacy” and the apparent lack of formal qualification requirements compared to those required by the State Bank of Pakistan (SBP). Consideration should be given to launch a formal certified

2. Monitoring of requirements

NCCPL monitors membership requirements on an on-going basis. Participants must in fact communicate their supervisory capital periodically.

Furthermore, members must promptly inform NCCPL of any significant change in their ownership structure and operational activity.

It is recommended NCCPL conducts a review process of the contact data maintained on it’s core contact database as investigations identified principal participant contact personnel details were out of date.

3. Objectivity and disclosure of participation requirements

The NCCPL participation requirements do not limit access on grounds other than risks, are objective and permit fair and open access to the CCP system; they are set out in the NCCPL Rules which are distributed and published on the NCCPL website.

The Management Committee, including the CEO, CFO, Chief Compliance and Risk Officer, Head of Operations and Head of PD & CSS evaluate applications. In the event of refusal of access, NCCPL explains in written form the reasons for the denial of access.

Members’ suspension and exclusion and the arrangements for d l i l l d l i h i ifi i i f h Assessment: Broad compliance

Recommendation 3: Measurement and management of credit exposure A CCP should measure its credit exposures to its participants at least once a day. Through margin requirements, other risk control mechanisms or a combination of both, a CCP should limit its exposures to potential losses from defaults by its participants in normal market conditions so that the operations of the CCP would not be disrupted and non-defaulting participants would not be exposed to losses that they cannot anticipate or control.

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Key criteria Observations

1. Measurement of exposure

NCCPL monitors its exposure towards its participants on an on-going basis.

Reports on open positions are available in real-time. Margins are determined on members’ end-of-day open positions

(marked to market). Moreover, NCCPL routinely calculates intraday margins at least

once during the trading day, based on real-time positions and prices and using the same margining methodologies. If the uncovered exposures vis-a-vis NCCPL (stemming from large variations of prices and/or net positions) exceeding pre-set thresholds intraday margins are requested and collected

2. Limitation of exposure

NCCPL limits its exposures to potential losses from defaults by its participants through margin requirements, calculated and collected at least daily.

NCCPL observes Recommendation 4, therefore this Key question is not applicable

Assessment: Compliance

Recommendation 4: Margin requirements If a CCP relies on margin requirements to limit its credit exposures to participants, those requirements should be sufficient to cover potential exposures in normal market conditions. The models and parameters used in setting margin requirements should be risk- based and reviewed regularly.

Key criteria Observations

1. Sufficiency of margin coverage

Margin requirements are applied for every type of financial instrument settled by NCCPL and are generally aimed at covering the potential losses stemming from the closure of an insolvent member’s open positions in all but extreme market conditions.

Different levels of margin requirements are used, depending on the nature and level of liquidity of the financial instruments.

The margin parameters are recalculated on a regular basis and reviewed at any time, whenever deemed appropriate on the basis of market circumstances. In general, margin parameters are recalculated by NCCPLs Risk Dept., compared against the intended coverage, and reviewed by the Risk Committee.

2. Ability to make intraday margin calls

As indicated above in the answer to Recommendation 3/Key Question 1 NCCPL routinely calculates intraday margins, based on real-time positions and prices at least once during the trading day. In case of relevant uncovered exposures (stemming from large variations of prices and/or members’ net positions), the rules governing CCP activities provide for intraday margins to be collected.

It is NCCPLs policy to calculate and collect intraday margins routinely.

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NCCPL accepts the following as margin: cash, equities (limited to approximately 130 top-tier liquid companies, these are regularly assessed), State Bank of Pakistan T-bills and guarantees issued by banks in favour of clearing members. The current percentage split of the collateral position is as follows: Cash 35% Equities 55% T-bills and bank guarantees 30%

A conservative haircut is applied to all equities covering extreme declines in asset value over a multi-day period.

3. Collateral acceptability For all book-entry securities having a formal listing history of and haircuts more than 6 months

Haircut applicable on daily VaR based Margin Buckets closing rate in the ready

00.00%< VaR <12.50% 15.00% 12.50%< VaR <15.00% 17.50% 15.00%< VaR <20.00% 22.50% 20.00%< VaR <25.00% 27.50% 25.00%< VaR <30.00% 32.50% 30.00%< VaR <40.00% 42.50% 40.00%> VaR 60.00%

Assessment: Compliance

Recommendation 5: Financial resources A CCP should maintain sufficient financial resources to withstand, at a minimum, a default by the participant to which it has the largest exposure in extreme but plausible market conditions.

Key criteria Observations

1. Stress testing scenarios and default procedures

In addition to margin requirements, NCCPL has access to the Settlement Guarantee Fund (SGF), which was recently transferred from PSX.

NCCPL currently outsources the running of SGF stress tests to Akhtar & Hasan Actuaries Pvt Ltd. However, the SECP Systemic Risk Unit is currently considering an alternative model, which will be established in-house at NCCPL. The estimated time frame for inclusion is expected to be between six to nine months.

After inclusion it is proposed stress testing of the SGF will be performed daily.

The results are reviewed by the NCCPL risk department; the models, parameters and scenarios adopted are frequently re-discussed and re-examined.

Currently, stress testing assumes the concurrent default of the two largest broker’s net settled transactions that could result in maximum excess loss.

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2. Financial resources in the event of a default

In order to manage defaults in the unlikely event of losses exceeding margins, the SGF (as of June 30th, 2016, PKR2.7bn (US$27.5million)), whose sizes are gauged on the basis of stress test results, are aimed at guaranteeing the proper functioning of the system under extreme circumstances, including the occurrence of multiple defaults.

NCCPL’s paid-up capital was PKR 600,000,000 - March 31,2016 (un-audited).

Current untested SECP Systemic Risk Unit assumptions estimate that total exposure of the SGF could exceed PKR6.8bn.

The SGF is overseen by a Trust and managed by independent Trustees.

NCCPL Regulation 29.8.1 limited the liability of NCCPL to the size of the SGF

Furthermore, NCCPL rules establish that under no circumstance may the SGF be used to cover losses arising from a market segment it does not guarantee including operational losses.

Consideration should be given to the re-naming of the term SGF, as this is principally only used in Bangladesh, Egypt, India and Iran. The recommended international acceptable name should be "Default Fund”.

3. Any financial resources not immediately available

All guarantees accepted by NCCPL are required to be immediately available. However, depending upon the timing of a default, accessibility to liquidity may be restricted.

Although it takes a certain number of days to sell equity collateral/SFG assets under the current settlement cycle T+2, these may be converted into cash on the same day by means of cash-collateralized securities lending. However, Securities Lending and Borrowing (SLB) is currently under utilized in the Pakistan capital markets.

NCCPL is currently in discussions with a number of Settling Banks to obtain credit facilities should the need arise as only 35% of the current collateral portfolio is in cash.

Assessment: Partial compliance

Recommendation 6: Default procedures A CCP’s default procedures should be clearly stated, and they should ensure that the CCP can take timely action to contain losses and liquidity pressures and to continue meeting its obligations. Key aspects of the default procedures should be publicly available.

Key criteria Observations

1. Default procedures

NCCPL Rules states clearly what constitutes a default. NCCPL Rules state clearly the circumstances in which it has the

authority to close out the positions of a participant in default, using its collateral and - if necessary - the SGF to cover losses.

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2. Enforceability of default procedures

Collateral posted with NCCPL may not be subject to enforcement proceedings or preventive measures initiated by the creditors of individual participants or by the body that administers the CCP itself. The legal framework permits the identification and separate treatment of client and proprietary assets; as a further guarantee for customers, client account assets may not be used to cover NCCPL

3. Internal plans for default management

NCCPL has formalised procedures for managing defaults. The procedure explicitly focuses on limiting market impact in

liquidating the defaulter’s positions and foresees a sufficient level of flexibility and coordination with other entities involved.

The procedures are reviewed at least once a year and whenever changes occur in laws, regulations or the internal operational system, that could affect the default procedure.

Market stakeholders (SECP, PSX and CDC) are immediately informed of a default and of any relevant information pertinent to i 4. Default procedures All the key aspects of the default procedure are described in detail

Assessment: Compliance

Recommendation 7: Custody and investment risk A CCP should hold assets in a manner whereby risk of loss or of delay in its access to them is minimized. Assets invested by a CCP should be held in instruments with minimal credit, market and liquidity risks.

Key criteria Observations

1. Custody risk

The equity collateral collected by NCCPL is deposited with CDC. The collateral is deposited on client accounts owned by NCCPL,

which therefore has prompt access to the deposited securities in the event of a participant’s default.

It is recommended an annual due-diligence be conducted by NCCPL on the finances and operations capacity of CDC.

2. Investment security

Most of CC&G’s capital and cash margins are held on cash accounts with leading Settling Banks; cash deposits are therefore not subject to market or liquidity risks.

The tri-party contract signed by NCCPL, the clearing participant and Settling Bank mention that the sums deposited are margins with the resulting protection.

3. Overall exposure of obligors

NCCPL holds cash accounts with several Settling Banks. The main criteria of the treasury policy are: diversification (no more than a certain amount of the cash margin may be deposited at a single bank, even though the actual deposits at individual banks have been constantly and significantly below the pre-defined thresholds), creditworthiness (banks or bank groups with a rating equal to at least A-1 as rated by Pakistan Credit Rating Agency (PACRA) and JCR-VIS Credit Rating Company Limited).

Assessment: Broad compliance

Recommendation 8: Operational risk A CCP should identify sources of operational risk and minimise them through the development of appropriate systems, controls and procedures. Systems should be reliable and secure, and have

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adequate, scalable capacity. Business continuity plans should allow for timely recovery of operations and fulfilment of a CCP’s obligations.

Key criteria Observations

1. Procedures to identify operational risk

NCCPL has a clear risk map that identifies the risks related to its core activities as well as its accountability for monitoring and managing the risks. The risk map is validated by Senior Management Committee and by the internal auditors.

2. Business continuity plans

NCCPL has developed continuity and contingency plans to cover the failure (temporary or prolonged) of its key systems. These plans cover both the handling of contingencies, emergencies and a major hardware failure (Disaster Recovery Plan).

The Business Continuity Plan (BCP) states the policies and procedures for maintaining business continuity both from prevention and from a remedial point of view. It establishes the timing and the manner of addressing contingency situations and responsibilities if and when they emerge.

The BCP contains a methodology for identifying and analyzing operational risk.

The BCP is tested on a mandatory annual basis with the last test being conducted in June 2016.

In preparation for the continuation of business in the event of disruptions, data is stored both at the primary location and the backup center to allow for a prompt switchover to the back up center in the event of failure at the primary location.

3. Adequate controls and staff

In general, senior and middle management monitor the operational reliability and adequacy of controls. In particular, any operational error causing problems for NCCPL or participants is reported to senior management for the adoption of appropriate remedies.

During the assessment NCCPL personnel always proved to be well qualified and to have a good knowledge of the operational, technical and organizational environment.

NCCPL monitors and permanently records all contingencies and interventions.

NCCPL has an independent internal audit department that conducts i l di h f i l i k d h i k

4. Availability of key systems

NCCPL has not experienced a key system failure in recent years. System capacity and the actual number of transactions processed

are constantly monitored. NCCPL staff is available for production support on a 24/7 basis. Processing is resumed in less than 2 hours. All incidents are fully

documented in dedicated reports. No transactions or data have ever been lost. The planning and control of information systems is managed by a capacity planning process. (Current system capacity thresholds are set at 30%).

Assessment: Compliance

Recommendation 9: Money settlement

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A CCP should employ money settlement arrangements that eliminate or strictly limit its settlement bank risks, that is, its credit and liquidity risks from the use of banks to effect money settlements with its participants. Funds transfers to a CCP should be final when effected.

Key criteria Observations 1. Does the CCP use the central bank model or the private settlement bank model?

NCCPL uses the private settlement bank model. They currently utilise 20 settling banks with 32 branches in Karachi, Islamabad and Lahore.

2. If the private settlement bank model is As already highlighted (Recommendation 7 Key criteria 3) NCCPL used, does the CCP utilises 20 settling banks and review their credit ratings on a regular establish and monitor basis. strict criteria for the Should the credit rating fall below the pre-approved criteria (A-1), banks used that participants are instructed to change their designated settling bank addresses their to one that satisfies the current criteria. creditworthiness, access 3. If the private settlement bank model is used, does the CCP monitor the NCCPL currently relies on the reporting and assessments published

concentration of by the two afore mentioned credit rating agencies.

exposures among the It is recommended to establish a risk monitoring process to settling banks and measure the impact of the settling bank concentration risk routinely asses its potential losses and liquidity pressures from Assessment: Partial compliance

Recommendation 10: Physical deliveries A CCP should clearly state its obligations with respect to physical deliveries. The risks from these obligations should be identified and managed.

Key criteria Observations

1. Clarity of NCCPL’s obligations with respect to physical deliveries

Market rules dictate that physical securities cannot be traded or settled via PSX and NCCPL and requires the physical security to be formally dematerialized by CDC prior to trading.

NCCPL currently has no regulatory or operational provisions with respect to physical securities and relies solely on those enacted by PSX and CDC.

It is recommended that NCCPL establish rules and regulations that clearly state its position with respect to physical securities.

2. Principal risk Not applicable 3. Liquidity, storage and Not applicable

Assessment: Broad compliance

Recommendation 11: Risks in links between CCPs CCPs that establish links either cross-border or domestically to clear trades should evaluate the potential sources of risks that can arise, and ensure that the risks are managed prudently on an on-going basis. There should be a framework for cooperation and coordination between the relevant regulators and overseers.

Key criteria Observations

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1. What kind of links are in operation?

PMEX also act as CCP within the capital market infrastructure NCCPL acts as the central UIN repository for Pakistan and PMEX

accesses the NCCPL UIN database to facilitate their participants

2. Rules governing the link

Access to NCPPLs core UIN database is protected by utilising a secondary data file which is accessed directly by PMEX for the retrieval of UINs of their respecting participants

NCCPL Regulations, 2015 (24.2.10) states: "The information of the UINs Database provided, to the PMEX by the Company, on the condition that the PMEX will ensure confidentiality of such information of the UINs Database and will use it only for the purpose for which the information was required."

Accordingly, NCCPL has entered a non-disclosure agreement with PMEX for maintaining confidentiality of all the information (technical, non-technical or operational) shared with PMEX.

3. Operational, credit Not applicable 4. Regulation and Not applicable

Assessment: Compliance

Recommendation 12: Efficiency While maintaining safe and secure operations, CCPs should be cost-effective in meeting the requirements of participants

Key criteria Observations

1. Review of costs and pricing

NCCPL has procedures in place to control its costs; however it is not possible to benchmark Cc&G’s costs against those of other CCP’s as these are not publicly available.

NCCPLs cost-control includes accounting procedures that produce periodic economic status reports, which are compared with the yearly and periodic budgets (budget variances, monitoring of the main performance indicators) and management accounting procedures that allow the authorisations pertinent expenditure to be controlled at every stage of the workflow.

NCCPL has procedures in place to review its pricing levels against its operating costs at least once a year.

Consideration should be given to changing the current fees scales as the current structure is based on transaction value to one based on transaction volume in-line with international best practice "Volume versus Value” principle.

2. Review of service levels and operational reliability

NCCPL reviews its service levels with participants through its dedicated Product Development & Customer Support Services Dept., which is in charge of fine tuning the service level and developing new functions to satisfy clients’ and market needs.

Operational reliability is actively monitored by senior and middle management.

Assessment: Partial compliance

Recommendation 13: Governance Governance arrangements for a CCP should be clear and transparent to fulfil public interest requirements and to support the objectives of owners and participants. In particular, they should promote the effectiveness of a CCP’s risk management procedures.

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Key criteria Observations

1. Clarity and transparency of governance arrangements

NCCPL is subject to governance-related regulation under the Companies Ordinance 1984 as well as governance-related regulation under the ACT as a CCP

One of the fundamental management policies of NCCPL is to provide user- orientated high quality services.

The shareholders of NCCPL are as follows: - Pakistan Stock Exchange Limited (PSX) 47.06% - LSE Financial Services Limited 23.53% - Pakistan Kuwait Investment Company (Private) Limited 17.65% - ISE Towers REIT Management Company Limited 11.76%

The Board of Directors of NCCPL is currently composed of thirteen members.

The management policies of NCCPL, along with lists of shareholders and board members are available on the NCCPL website

2. Separation of reporting lines for risk management

NCCPL has a Risk Management Dept. that reports directly to the CEO and is independent from the operational units.

A Risk Management Committee has been established which makes decisions and holds discussions related to the execution of the business operations

3. Skills and accountability of management and Board

The CEO is appointed by the Board, which evaluates his/her skills in order to help NCCPL deliver sound and effective services and meet related public interest requirements, one of the most significant objectives given to the CEO and the management is to ensure full compliance with all applicable laws, rules and regulations issued by a national authority and a complete lack of complaints by the authorities.

With reference to public interests, it must be noted that - as indicated on its website - NCCPL is committed to promoting and offering its services in an equitable, transparent and non-discriminatory manner and on the basis of criteria and procedures aimed at assuring interoperability, security and equal treatment among market infrastructures. C

4. Disclosure of objectives, responsibilities and deliveries

NCCPLs objectives are focused on its CCP functionalities and the quality of its clearing services. With reference to the CCP functionalities, the main objectives are anonymity, elimination of counterparty risk and sound risk management.

With reference to clearing services, the focus is on the netting process, position keeping, collateral management, and STP post-trading functionalities. These objectives are clearly indicated in the CC&G R l d C i i d hi hli h d h

Assessment: Compliance

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Comments: In order to take account of all relevant interests, the governance structure should be improved by the introduction of standing user committees to be consulted in the event of major changes; their decisions/suggestions should be reported to the Board.

Recommendation 14: Transparency A CCP should provide market participants with sufficient information for them to identify and evaluate accurately the risks and costs associated with using its services.

Key criteria Observations

1. Disclosure of risks

The rights and obligations of participants and the relevant laws are part of the contractual agreements signed by participants. The rules of the counterparty service, the circumstances in which NCCPL assumes counterparty exposure and the default procedure are clearly stated in the system rules and regulations. The aforementioned documents are also available on the company website.

NCCPL publicly discloses the following information on its website: the price list; a description of the steps taken to mitigate risks (kind of margins requested, methodology for their calculation, collateral accepted; default fund).

2. Accessibility of All pertinent information is made available on the website. 3. Review of information The key criteria are regularly reviewed as services and the business

Assessment: Compliance

Recommendation 15: Regulation and oversight A CCP should be subject to transparent and effective regulation and oversight. In both a domestic and an international context, central banks and securities regulators should cooperate with each other and with other relevant authorities.

Key criteria Observations

1. Ability and resources of regulator and overseer

SECPs supervise the central counterparty systems and NCCPL, which manages them.

As the supervisory authorities, they may require system managers and participants to provide data and information concerning the clearing and settlement of transactions; they may also carry out on-site inspections.

2. Clarity and transparency of objectives, roles and policies of authorities

The tasks and role of SECP with respect to securities clearing and settlement activities are clearly defined in the legislative texts and respective rules and regulations, which are published on the regulators’ and NCCPLs websites.

SECP is responsible for transparency and the protection of investors.

3. CCP reporting requirements

SECP may ask the system managers and participants of NCCPL for any document, data, and information concerning the clearing and settlement of transactions.

Outsourced arrangements/contracts must ensure that NCCPL meets its regulatory obligations and the competent authorities can exercise their regulatory powers.

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NCCPL and SECP maintain close contact with each other, routinely 4. Cooperation between exchanging information and opinions on current, proposed orauthorities changes to current rules and regulations.

Assessment: Compliance

Gap Implementation Plan

No: Gap Responsibility Proposed timeline

(Western C l d )

1

Address and rectify corrupt website data links. NCCPL Q4 ‘16 Ensure all the rules, regulations, policies and

procedures published on the NCCPL website are current.

NCCPL Q4 ‘16

Draft and enact a formal definition for the term "Custodian”.

SECP Q1 ‘17

Revision of NCCPL participation contracts to ensure that Pakistan jurisdiction applies to all obligations arising from their participation in the National Clearing and Settlement System (NCSS).

NCCPL Q1 ‘17

2 Consideration should be given to the establishment or SECP Q3 ‘17 NCCPL should conduct an exercise whereby it

verifies and updates principal contact information maintained on its participant databases.

NCCPL Q4 ‘16

5

Facilitate the transition of the current outsourced SGF stress testing from Akhtar & Hasan Actuaries Pvt Ltd. NCCPL/SECP Q3 ‘17

On-going re-evaluation of maximum exposure of the SGF in line with anticipated default scenarios

NCCPL Q2 ‘17

Consideration to be given to the re-naming of the SGF to the Default Fund in line with international practices.

SECP Q2 ‘17

7 NCCPL should undertake an annual due-diligence

review of the inancial and operational capabilities of their custodian CDC.

NCCPL Q1 ‘17

9 Establish a formalised monitoring process to measure

the impact of the settling banks exposure to concentration risk.

NCCPL Q1 ‘17

10 Redraft current NCCPL rules, regulations, policies

and procedures to address their policy with respect to settling of physical securities without relying on

NCCPL Q4 ‘16

12

Review current fee scales in line with comparative regional and international organizations.

NCCPL Q1 ‘17

Analyze the revenue impact with resect to changing the core fee criteria from a value based model to transaction/volume based model.

NCCPL Q1 ‘17

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Annex 3: IOSCO Compliant Central Counterparty (CCP) Gap Implementation Plan

IOSCO Compliant Central Counterparty (CCP) - Gap Implementation Plan Recommended implementation plan to attain full IOSCO CCP Recommendation compliance

Proposed Implementation time-lines

• Time sensitivity

• Majority to be in place prior to Pakistan’s re-admittance to the MSCI Emerging Markets Index (May 2017)

• Dedicated lines of responsibility

• Predominantly NCCPL policy, procedures, rules and regulation focus

• Minimal impact for regulatory intervention/clarification

• Establishment of concrete foundations for future assets class integration and servicing in line with PSX product development

• Recommendation compliance

CPMI-IOSCO CCP Recommendations Legal risk Recommendation 1: A CCP should have a well-founded and enforceable legal framework for each aspect of its activities in all relevant jurisdictions.

• Laws and regulations governing the operations of a CCP and the rules, procedures and contractual provisions for its participants, clearly stated, coherent and readily accessible to participants and the public

• Legal framework demonstrates a high degree of comfort that there is a clear and effective legal basis for: - The CCP to act as central counterparty - Assumption of liabilities as a CCP - Netting arrangements - Default procedures - CCPs interest in collateral (including margin) that a participant pledges or transfers to the

CCP

• Address and rectify corrupt website data links.

• Ensure all the rules, regulations, policies and procedures published on the NCCPL website are current.

• Draft and enact a formal definition for the term “Custodian”.

• Revision of NCCPL participation contracts to ensure that Pakistan jurisdiction applies to all obligations arising from their participation in the National Clearing and Settlement System (NCSS).

Participation requirements Recommendation 2: A CCP should require participants to have sufficient financial resources and robust operational capacity to meet obligations arising from participation in the CCP. A CCP should have procedures in place to monitor that participation requirements are met on an on-going basis. A

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CCP’s participation requirements should be objective, publicly disclosed, and permit fair and open access.

• Established requirements for participants’ financial resources and creditworthiness

• The factors considered (size, products cleared)

• Participants operational capabilities

• Monitor the participant requirements on a on-going basis

• The conditions the CCP can suspend and/or terminate participants membership, including the orderly exist of participants that no longer meet the participation requirements

• Requirements are clearly stated and publicly disclosed

• Consideration should be given to the establishment or enhancement of a formal certified training program for the brokerage community.

• NCCPL should conduct an exercise whereby it verifies and updates principal contact information maintained on its participant databases.

Financial resources Recommendation 5: A CCP should maintain sufficient financial resources to withstand, at a minimum, a default by the participant to which it has the largest exposure in extreme but plausible market conditions.

• Scenarios that include the most volatile periods that have been experienced by the markets (2008 financial crisis)

• Intraday funding: A CCP could need intraday funding (credit lines) to ensure certain payments (e.g. variation margin) could be made, which may be relevant in case of late payment by a clearing member

• Liquidity backstop: Access to backstop liquidity in the event of a financial crisis

• Types and values of resources that the CCP has to cover losses from participant defaults

• High degree of assurance on those resources for the anticipated value in the event of a participant’s default

• CCP rules that prohibit these resources from being used to cover operating losses

• Facilitate the transition of the current outsourced SGF stress testing from Akhtar & Hasan Actuaries Pvt Ltd. to an in-house developed model in coordination with the SECP Systemic Risk Unit.

• On-going re-evaluation of maximum exposure of the SGF in line with anticipated default scenarios

• Consideration to be given to the re-naming of the SGF to the Default Fund in line with international practices.

Custody and investment risk Recommendation 7: A CCP should hold assets in a manner whereby risk of loss or of delay in its access to them is minimised. Assets invested by a CCP should be held in instruments with minimal credit, market and liquidity risks.

• Procedures for cash investment and investment security

• Limitation of investments to avoid concentration risk

• On-going monitoring of the CCPs custodians financial conditions

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• Segregation and portability: - A CCP must have transparent segregation and portability arrangements to protect client’s

positions and their margin - A CCP should be able to readily identify customers of participants and keep their margin in

separate accounts where relevant - A CCP should have policy and procedures on segregation and whether accounts are omnibus

(comingled) or individually segregated

• NCCPL should undertake an annual due-diligence review of the financial and operational capabilities of their custodian CDC.

Money settlement Recommendation 9: A CCP should employ money settlement arrangements that eliminate or strictly limit its settlement bank risks, that is, its credit and liquidity risks from the use of banks to effect money settlements with its participants. Funds transfers to a CCP should be final when effected.

• Use of central bank model or private settlement bank model

• Legal arrangements with its settlement banks provide that funds transferred to its accounts are final when effected

• The Pakistan equity market has adopted BIS DVP Model 2 as it requires significantly less liquidity for settlement by netting the funds settlement obligations among participants

• Probably the easiest model in which to realise liquidity efficiencies

• The model is particularly popular in the emerging markets of Latin America, Africa and the Middle East

• The disadvantage of BIS DVP Model 2 is the intraday risk that can be created by the delay in settlement finality until designated times during the day

• Establish a formalised monitoring process to measure the impact of the settling banks exposure to concentration risk.

Physical deliveries Recommendation 10: A CCP should clearly state its obligations with respect to physical deliveries. The risks from these obligations should be identified and managed.

• Rules and regulations that clearly state the CCPs obligations with respect to deliveries of physical securities

• Clear lines of responsibilities (formal CCP documentation) between principal market infrastructure participants (PSX, CDC & NCCPL)

• Steps taken to mitigate such risks

• Redraft current NCCPL rules, regulations, policies and procedures to address their policy with respect to settling of physical securities without relying on those of PSX & CDC.

Efficiency Recommendation 12: While maintaining safe and secure operations, CCPs should be cost-effective in meeting the requirements of participants.

• Benchmarking of costs and charges against other CCPs that provide a similar service by analysing the reasons for significant difference

• Regular reviews of CCP pricing levels against its cost of operations

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NATIONAL CLEARING COMPANY PAKISTAN LTD. EVOLVING ROLE AS A CENTRALIZED KNOW YOUR CUSTOMER ORGANIZATION

16 January 2017

This publication was produced for review by the United States Agency for International Development. It was prepared by USAID Financial Market Development Activity.

FINANCIAL MARKET DEVELOPMENT ACTIVITY

• Regular review of of operational reliability, including its capacity levels against projected demand

• Undertake participant surveys on operational access, efficiency and reliability

• Review current fee scales in line with comparative regional and international organisations.

• Analyse the revenue impact with respect to changing the core fee criteria from a value based model to transaction/volume based model.

Annex 4: National Clearing Company Pakistan ltd. Evolving Role As a Centralized Know Your Customer Organization

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FINANCIAL MARKET DEVELOPMENT ACTIVITY

NATIONAL CLEARING COMPANY PAKISTAN LTD. EVOLVING ROLE AS A CENTRALIZED KNOW YOUR CUSTOMER ORGANIZATION

DISCLAIMER The author’s views expressed in this publication do not necessarily reflect the views of the United States Agency for International Development or the United States Government.

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Contents 

Introduction .......................................................................................................................... 40Objective and Scope of the CKO ........................................................................................... 40Field Work Regarding Deliverables ....................................................................................... 41Legal Basis in Pakistan for the CKO ....................................................................................... 41Technical Reforms.............................................................................................................................................. 41Additional Requirements for Banks and Financial Organizations .............................................................42A Potentially Viable NCCPL CKO Business Model .................................................................. 43CKO Business Model Detail.............................................................................................................................. 43KYC Information System (“KIS”): ...................................................................................................................... 43KYC International Standards: ................................................................................................. 44AML/KYC Laws by country: .............................................................................................................................. 44KYC Controls: ...................................................................................................................................................... 45Impact on debt capital market development of NCCPL’s transition to CKO.......................... 45ACTION PLAN PROCEDURAL FOR CKO IMPLEMENTATION .................................................. 46Technical Overview of Current KYC System: ................................................................................................. 46Technical Overview of Old KYC Systems in General: ................................................................................... 46Technical Overview of the New KYC Information System for CKO: ..........................................................47Organizational Transition for Functionality of the CKO: ............................................................................. 47CKO Functional Implementation Approach:.................................................................................................. 47CKO Long Term Testing Implementation: ..................................................................................................... 48

Conclusion:............................................................................................................................ 48Recommendations Regarding CKO Goals and Objectives: .................................................... 48IT Recommendations: ............................................................................................................ 51

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National Clearing Company Pakistan Ltd.: Evolving Role as a Centralized Know Your Customer Organization

Introduction The “USAID-funded Financial Market Development Activity” in Pakistan dispatched to Pakistan a Know Your Customer (“KYC”) specialist (the “Consultant”) to Pakistan to articulate and support implementation of procedural and organizational reforms that will facilitate the development of KYC functionality at the National Clearing Company of Pakistan Ltd (“NCCPL”). NCCPL, has been tasked by the Securities Exchange Commission of Pakistan (“SECP”) to become a Central KYC Organization (“CKO”) for all customers investing in the stock market.

SECP, as the apex regulator of the Pakistani capital markets, is entrusted with the overall development and regulation of the capital markets, the Self-Regulatory Organizations (“SROs”), the intermediaries operating in the capital markets, and protection of investors. The SROs include the Pakistan Stock Exchange (“PSX”), NCCPL, the Central Depository Company of Pakistan Limited (“CDC”), and the Pakistan Mercantile Exchange Limited (“PMEX”). The various intermediaries operating in the capital market include securities advisers, brokers and managers, debt securities trustees, balloters and share registrars, credit rating companies, and underwriters.

The clearing and settlement function is centralized at NCCPL, which provides for integrated settlement of trades executed at the stock exchange in dematerialized shares. The company also provides institutional delivery system facilitating direct settlement of institutional trades, margin financing and margin trading modules and registration of Unique Identification Numbers (“UINs”). Additionally, NCCPL is responsible for computing, determining, collecting, and depositing Capital Gains Tax (“CGT”) to the national exchequer on behalf of the capital market investors.

Objective and Scope of the CKO NCCPL has been designated by SECP to become a central know your client agency for all the customers investing in the stock market. This would avoid the duplicative and inefficient requirements that currently mandate that each capital market intermediary perform Customer Due Diligence (“CDD”) checks for all new clients. It would also establish a centralized CKO database for streamlined due diligence purposes. This functionality would represent a major step forward in relation to NCCPL’s current role of assigning a UIN to each investor in the market. The purpose of CKO functionality would be to issue another unique KYC Number (“UKN”) to each client in order to facilitate detailed due diligence for every investor from the perspective of source of funds, credit risk assessment and investor background. This functionality would significantly enhance the transparency of and investor confidence in Pakistan’s stock market, as it would strongly discourage money-laundering and market manipulation activities, and it would help reduce the risk of investor defaults. NCCPL is targeting the first quarter of CY 2017 for purposes of initiating its role as a CKO.

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Field Work Regarding Deliverables In order to provide above deliverables, the Consultant held a series of meetings, interviews and presentations that were conducted with directors, subdirectors, compliance officers, and IT employees at SECP, NCCPL, NADRA (the national issuer of identity cards), PMEX, CDC, and PMX, as well as at certain financial intermediaries and service providers. (Please see the list of meetings with names, infra.)

This purpose of these meetings was to obtain background information and knowledge of the actual and proposed KYC systems framework at NCCPL, and to compare that framework with international standards. Based on related analysis and evaluation, the Consultant then proceeded to develop recommendations to support the implementation and organizational reforms necessary to facilitate the development of KYC functionality at national and international levels under the roof of NCCPL.

Pakistani law, as well as the law of all OECD member states, as well as certain of Pakistan’s international commitments, dictate that financial institutions must ensure that they know their clients and verify their identities with appropriate data and documentation that proves that their clients (i.) are who they say they are; (ii.) that they are not involved with or related to anyone involved in money laundering or terrorist financing; and (iii.) do not represent a risk to the institution or the financial system.

Legal Basis in Pakistan for the CKO In April 2013 SECP established a Centralized KYC Unit. The relevant regulation mandated that the NCCPL would perform the role of CKO.

The CKO proposed by the SECP is to be established with the approval of the Federal Government in exercise of the powers conferred by Section 175 the Securities Act of 2015.

Technical Reforms Presently, each of the three-hundred brokerage houses in Pakistan must perform a new KYC registration each time an investor opens an investment account. To remedy the inefficiencies inherent in that system, the CKO, once it is established, would issue a UKN to all investors, and the UKN will be linked to the UIN of each such investor. This will supplant the requirement that each brokerage house perform KYC regarding each new customer. Brokerage houses will then have access to the new CKO, thereby avoiding duplication of effort. Moreover, because the mechanism and resulting database will be centralized, the KYC process will be more effectively supervised and controlled by SECP. This will also encourage investors to use the services of multiple brokerage houses, as an investor will not have to undergo additional KYC screening (and have to provide requisite documentation) if he opens an account with a new brokerage house.

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During a meeting with Mr. Akif Sayed, SECP Commissioner, the basic Customer Identification Program (“CIP”) employed in any KYC standard system was discussed. It incorporates the following key requirements:

Core Identification Program:

Full name Date of birth for individuals Address and or addresses National identification number Nature of business, geographies involved, expected nature of counterparties Purpose of account and type of account Collection of documents: birth certificate, passport, etc. Identification of customer type and segmentation Expected monthly turnover (amount and number of transactions to establish “Red-Flags”) Family and personal data: gender, marital status, dependents, etc. Employment or occupation.

Customer Due Diligence (CDD):

Demographic, region, section, subdivision, etc. Third party data, beneficiaries, trustees, etc. Employment type, source of funds, tax status.

Enhanced Due Diligence (EDD):

Screening with black lists: OFAC, local and other default lists Client location visit based on customer type Asset under management risk assessment: high, medium, low Verification that information is not misleading or false.

Additional Requirements for Banks and Financial Organizations The regulations issued by the State Bank of Pakistan were reviewed in this regard.

Full KYC requirements can be found in the “AML/CFT Regulations for Banks and Development Finance Institutions of September 13, 2012.” The following points are related to banks when they establish a new correspondent banking relationship (in addition to the above mentioned requirements):

KYC policy

Information about the correspondent bank’s management and ownership For banks with foreign ownership: AML/CFT and banking regulation and supervision the home country of the bank

The purpose of the account or service and the identity of any third party who will use the correspondent banking services

Single cash transaction or linked transactions above PKR 1,000,000 is/are suspicious.

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A Potentially Viable NCCPL CKO Business Model CKO Business Model Detail Coordination of activities and support among different departments at NCCPL in Karachi were essential for obtaining and developing knowledge on this assessment report for the CKO. The following are the four key elements of a viable KYC policy:

1) Customer Policy;

2) Customer Identification Procedures;

3) Monitoring of Transactions; and

4) Risk Management.

The CKO functionality must contain account-opening procedures detailing the identifying information that must be obtained from each customer. At a minimum, the financial institution must obtain the above “identifying information” from each customer before opening and account.

For purposes of a KYC policy, a customer/user may be defined as:

A person or entity that maintains an account and/or has a business relationship with banks, brokerage houses or any other financial institution such as insurance companies; one on whose behalf the account is maintained (i.e. the beneficial owner); beneficiaries of transactions conducted by professional intermediaries such as stockbrokers, chartered accountants, certified public accountants, or solicitors, as permitted under the law, or any person or entity connected with financial transactions that can pose significant reputational or other risks to the financial institution. (For example, a wire transfer or an issuance of a high-value demand draft as a single transaction automatically must be characterized suspicious activity.)

KYC Information System (“KIS”): The Central Database recordkeeping registration for the new CKO will be obtaining information from investors in the Capital Market of Pakistan in two (2) phases: Phase-I, for the Stock Brokerage and Mutual Funds industries; and Phase II, for the insurance companies and those companies that trade via PMEX, as well as any persons and companies registered with the SECP

The following directors, sub-directors, compliance officers and IT employees at NCCP were interviewed in their offices in Karachi:

1- Mr. Rana Muhammad Shahid Saleem, Manager of the Islamabad Office 2- Mr. Muhammad Luckman, Chief Executive Officer 3- Mr. Amir Mobin, Chief Compliance Officer 4- Mr. Rehan Saif, Deputy Manager in Charge of KYC Systems & CSS 5- Mr. Muhammad Asif, Head of Operations

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6- Mr. Imran Ahmed Khan. Chief Financial Officer 7- Mr. Kashif Alam Khan, Chief Internal Auditor.

All the above-mentioned Officers at NCCP have agreed to go “live” and to launch the new CKO system during the first quarter 2016, though they did not without specify a precise date. A presentation and a demonstration of this organization and system respectively were performed.

They appear to be in compliance with the KYC International Standards recommended by the Financial Action Task Force (“FATF”), established in Paris, France, and with AML/CFT regulations issued by the SBP) on September 13, 2012, as well as with the new Pakistan Securities Act of 2015 including SECP and NCCP regulations.

KYC International Standards: The objective of the KYC standards mentioned above is to prevent banks or financial institutions from being used, intentionally or unintentionally, by criminal elements for money laundering activities Related procedures also enable banks to better understand their customers and their financial dealings. This helps them manage their risks prudently.

Financial institutions usually frame their KYC policies by incorporating the four key elements mentioned hereinabove, including enhanced due diligence, for larger customers with a high volume of transactions.

AML/KYC Laws by country: India: The Reserve Bank of India (“RBI”) introduced KYC guidelines for all banks in 2002. In 2004, RBI directed all banks to ensure that they are fully compliant with the KYC provisions before December 31, 2005.

New Zealand: Updated KYC laws were enacted in late 2009 and entered into force in 2010. KYC is mandatory for all registered banks and financial institutions (“financial institutions” is a broadly-defined term).

South Africa: The Financial Intelligence Centre Act 38 of 2001.

United Kingdom: The Money Laundering Regulations 2007 are the underlying rules that govern KYC in the UK. Many UK businesses use the guidance provided by the European Joint Money Laundering Steering Group as a guide to compliance.

Mexico: Financial Intelligence Unit

France: FATF

Spain: Commission for the Prevention of Money Laundering.

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United States: Pursuant to the USA Patriot Act of 2001, the Secretary of the Treasury was required to finalize regulations before October 26, 2002 making KYC mandatory for all US banks. The related processes are required to conform to a CIP.

KYC Controls: KYC controls typically include the following:

(i.) Collection and analysis of basic identity information (referred to in regulations and in practice as a "Customer Identification Program" or “CIP”), including name matching against lists of known parties; (ii.) determination as to whether a customer is a "politically exposed person" or “PEP;” (iii.) determination of the customer's risk in terms of region, money laundering, terrorist finance, or identity theft.

Impact on debt capital market development of NCCPL’s transition to CKO During the last five years, three main financial events have occurred in Pakistan that will have a beneficial economic impact in the financial sector and specifically on the debt capital market development because of the NCCPL’s transition to CKO functionality. These three main financial events that have brought worldwide attention are:

1. The Morgan Stanley Capital International Index (MSCI-Index) Annual Market Classification Review in 2016 has decided that as of May 2017, Pakistan will be upgraded to Emerging Market Status.

2. FATF, the international body that sets standards for AML/CFT, in its plenary meeting held in France, removed Pakistan from the list of countries that contained adverse remarks.

3. The promulgation of the new Securities Act 2015 in Pakistan that provides advanced reforms in the capital market sector, including the establishment of the CKO to control AML activities will affect domestic and international investments in Pakistan.

Indeed, the “Economic Survey of Pakistan 2015-16,” at Chapter-6 states

“The capital markets in Pakistan have witnessed several developments during the period; including promulgation of the new Securities Act 2015, demutualization of exchanges and integration of three local stock exchanges into a single unified national stock exchange, the Pakistan Stock Exchange (PSX).

The Securities Act 2015 has replaced the Securities and Exchange Ordinance 1969. The new law incorporates global benchmarks such as International Organization of Securities Commissions (IOSCO) principles of securities’ regulation and investor protection, and provides for implementation of advanced reforms for preventing market abuses and manipulation practices. The new law also contains provisions for promoting public confidence in the market, including full disclosure at the

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time of the initial offering, continuous disclosure requirements and an inclusive compliance regime, among others.”

The Survey continues:

“Establishment of Centralized Know Your Clients (KYC) Organization: To facilitate the securities market investors, a centralized KYC Organization shall be established whose objective will be to register and maintain investors’ KYC records in line with international best practices pertaining to KYC and CDD policies. The said KYC records will be available for access by all market intermediaries and this measure will assist in removing the duplication presently faced in the KYC process by bringing uniformity to the same.”

Therefore, it is clear that Pakistan’s capital markets are poised to experience increased volume, and the economies of scale and other efficiencies offered by the establishment and operation of the CKO will allow a smoother transition to this heretofore unseen trade volume in Pakistan. In fact, Mr. Rehan Saif, Deputy Manager in charge of KYC System at the SECP, estimates that the CKO will register as many as 5,000 investors per month in the first year of its operation.

ACTION PLAN PROCEDURAL FOR CKO IMPLEMENTATION Technical Overview of Current KYC System: As per discussions with the NCCPL team, the existing KYC system is fully computerized, and was developed by an in-house IT team of NCCPL. The KYC system is currently operative, and it complies with the AML programs, policies and standards that are made applicable to financial institutions via domestic laws, such as the new Securities Act, 2015, and international commitments, such as the FATF, that aim to prevent of money laundering and help define the processes and scope for IT KYC systems to meet the requirements.

Technical Overview of Old KYC Systems in General: Older (and some presently operative) KYC systems are characterized by the following:

a) Old KYC systems segment customers at a very high level based on few fixed variables. This is a necessary, but not sufficient, methodology, as it does not anticipate customer transactions and dynamic categorization of customers into coherent groups.

b) In the majority of financial institutions and non-financial institutions, onboarding KYC systems and AML data bases are not integrated, as there is no end to end feedback mechanism established.

c) Older systems also lack adequate capabilities to manage data changes for the existing customers and the process of screening or periodically reviewing to analyze the relationship with the customer who might be constantly changing broker names and data, as well.

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d) However, the advantage of in-house developed KYC system is that it gives the institution full control over the system and its functionality with quick access for successive changes per day-to-day needs.

e) On the other hand, the disadvantage of in-house developed KYC system, could be that it requires more IT personnel which, in turn, can lead to higher overhead costs.

Technical Overview of the New KYC Information System for CKO: The new CKO system will be built upon the existing KYC system developed in-house by the IT Department at NCCPL. It will have improvements and enhancements as per the new regulations and changes to be controlled by CKO; it will be called the “KYC Information System” (“KIS”). Accordingly, by way of the presentation and demonstration of this new and improved system, it appears to follow the KYC International Standards recommended to Pakistan by the FATF and with the Anti-Money Laundering and AML/CFT regulations issued by SBP on September 13, 2012, as well as with the Pakistan Securities Act 2015.

The KIS for CKO is supposed to be a standard, one-stop solution for all the due diligence and money laundering requirements. It must be made to be scalable and consistent. It will support various risk weights parameterized for several factors across all the customer types: Individual, corporate, government, and brokers across the world. This approach feeds the AML system with predictive data and will help them to set variables and parameters, based upon which the investors will be identified. In theory, it helps to know the customer better and reduce false positives at a later stage. But in practice, constant monitoring of the KYC and testing of the system should be done before launching the CKO to avoid loops on the system and possible correction of errors for incorrect results. Testing must be done through: (a.) hands-on testing; and (b.) so-called User Acceptance Testing (“UAT”).

Organizational Transition for Functionality of the CKO: Conducting constant regular KYC reviews will ensure that the transition to CKO will be able to provide and capture any material change in the customer’s profile or any potentially suspicious activity that was not detected by the CKO’s real-time transaction monitoring platforms. In addition, as mentioned in the previous paragraph, testing of the system must be performed before launching the CKO to avoid loops on the system and possible correction of errors for incorrect inputs or results. Testing must be done through a) Hands-on testing and b) through User Acceptance Testing (UAT).

CKO Functional Implementation Approach: Below is the core identification program summary (including already-addressed details):

Customer Identification Program (CIP) Customer Due Diligence (CDD)

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Enhanced Due Diligence (EDD) Customer Acceptance Policy (CAP) Customer Identification Procedures Monitoring of Transactions; and Risk management.

CKO Long Term Testing Implementation: The testing of the CKO could be done in two phases.

Phase-1.- For new customers, any consumer, corporate, correspondent bank or government institution who/that is opening an account with a brokerage firm or financial institution for the first time, the aforementioned process must be applied. Only then, will the account be created and a relationship will be created with the UIN based upon the risk level assessment and after linking such information with NADRA (from which all citizens of Pakistan are legally obliged to obtain Computerized National Identity Cards.

Phase-2.- For existing customers, a default risk is assigned based on a few parameters, such as negative news checks, sanction country flags, occupation and industry code. At a later stage, a consistent periodic review will be performed in a phased manner and manual uplifting will be done. Also, “true beneficial owner” details are collected in this phase.

Conclusion: In addition to the business requirements of the CKO, facilitation of the opening of an account and performance of detailed due diligence for every investor from the perspective of the source of funds, credit risk assessment, and investor background, appear to be congruent with all necessary elements for the CKO functionality.

This perception is assumed according to system demonstrations, business meetings and supporting documentation obtained from the National Clearing Company of Pakistan (NCCP). Also, the KYC standards and tools for monitoring Anti-Money Laundering seems to be in in compliance with Pakistani law and international standards.

Since most financial institutions across the globe are looking out to comply with global AML policies, they should work for an enhanced risk management approach. This is in the interest of protecting the institutions from regulatory, fraud, legal, monetary risks. As discussed above, the KYC business model developed and rolled over into CKO appears to be scalable for any future regulatory and functional enhancements.

Recommendations Regarding CKO Goals and Objectives: The functional implementation and establishment of a CKO database is critical for the development of the capital market in Pakistan and for its prospective entrance to the world

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emerging markets list. Such KYC records will be available for access by all market intermediaries,and this measure will assist in removing the duplication presently faced in the KYC process by bringing uniformity in the capital market.

According to the information obtained from NCCP sources and outside sources (including interviews with brokerage houses in Karachi and via the Internet), there appears to be in place a robust and rigorous regime under the Securities Act 2015 that covers KYC procedures for the functionality of CKO which is measurable, achievable, and relevant in proportion to the parameters and resources in the capital market in Pakistan.

The following recommendations are offered for the accomplishment of such objectives according to the time frame stated above. These will help NCCPL reach the goal of the systematization of the KYC registration process including monitoring AML and IT-related testing to avoid illegal movements or transfer of funds from one country to another and to facilitate the transparency of applicable KYC/AML laws and rules.

1) Implementation of Long-Term AML Program: KYC and risk assessment is a normal part of the initial client onboarding process; however, it doesn’t end there. Financial institutions are tasked with performing client due diligence on an ongoing basis throughout the lifetime of the client relationship. The aim of this review process is to ensure continued compliance with existing AML and KYC compliance obligations, supported by updated and refreshed data and documentation. In addition to maintaining a risk-based approach to AML and KYC compliance, periodic client reviews have the potential to close many of the compliance process gaps that may exist, such as the absence or lack of data and documentation.

The need to do KYC client reviews is indisputable. However, the current approaches used to complete these are most definitely questionable. The scope of periodic reviews can be overwhelming, involving thousands of clients and thousands-upon-thousands of data and documentation that needs to be reviewed, with customers being categorized by the size of risk they represent to the financial institution (high, medium or low risk). The objective is to ensure that sufficient resources are assigned to the higher risk clients, who require more frequent reviews and involve more complexity than their lower risk counterparts. This AML program can be implemented according to the size and daily volume of transactions under the roof of the CKO in Pakistan.

2) CKO Testing: Note:

User acceptance testing is the last phase of the KYC system testing process. The goal of User Acceptance Testing is to assess if such system can support day-to-day business and user scenarios and ensure the KIS is sufficient and correct for business usage.

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KYC INFORMATION SYSTEM TESTING TO VERIFY CKO FUNCTIONALITY PROJECT TEAM AND USER AWARENESS:

Testing Results: he operational functionality testing of the new KIS of the CKO took place in the offices of NCCP in Karachi during a period of three days from August 22, 2016 to August 24, 2016 with the presence of the following Officers from the IT and Production Departments at NCCPL.

1- Mr. Muhammad Asif, Head of Operations 2- Mr. Amir Hussain Shah, Manager IT Operations – UAT Section 3- Mr. Amir Mansoori, Assistant Manager IT Operations – UAT Section

The testing was performed for two types of tests:

a) Hands-on Testing, and;

b) User Acceptance Testing (UAT)

a) Hands-on Testing Results:

The operational part of the system by the users (individuals, corporations, brokerage houses or Authorized Intermediaries [“AI”]). This test was performed in the actual computer operated by the examiner (the author of this report) acting as user (in this case, acting as Broker A, B and C) to measure the grade of difficulty in using the system and to verify whether all fields mentioned in the KYC requirements on the Account Opening Forms were in place to be entered in the KIS.

During this testing exercise, acting as Broker A, B and C, it was comfortable to operate the KIS computer system. It is “user-friendly,” easy to engage and understand all relevant steps. Broker A created an individual investor file by posting in KIS all required information and saving it to be approved by CKO. After CKO’s approval, the system (KIS) provided a Unique KYC Number (UKN) to this individual investor. Broker B did not have to duplicate all prior steps done by broker A. Broker B simply performed a tagging or inputting in the system the UKN only provided for this individual investor. Broker C performed a tagging only in the system with the UKN provided to this individual as well. If any changes or updates were performed on this individual data for any of the brokers, CKO will send such updates or changes to every single broker with whom this individual has done business within the time frame explained.

b) User Acceptance Testing (UAT) Results. -

It is necessary to examine the software functionality of the system to ensure that CKO is in compliance with the processes and procedures of its new concept and functions for assurance through formal UAT.

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This User Acceptance Testing was performed from the standpoint that a KYC system is either to satisfy the needs of the customer using the system and the requirements of the person or organization who requested it to be built. So, this is typically the last step before CKO goes live or before the delivery of the KIS is deemed to be functional according to the law of Pakistan.

For this UAT, NCCPL and the Consultant prepared a set of 34 standard UAT questions:

Number of Questions KYC Information System (KIS) Criteria for UAT Percentage %

4 IT Project Team CKO Preparedness 11%

14 UAT Team KIS Preparedness 41%

8 Test Preparation for KYC Information System (KIS) 24%

8 KIS: Test Execution and Evaluation 24%

34 Total 100%

The response obtained from CKO IT Department at NCCPL is positive in 99.99% with one exception only, regarding which IT has indicated the following: “Stress testing is pending and will be conducted once all business level requirements will be finalized”.

In conclusion, the UAT performed in KIS has been successful and is satisfactory to NCCPL.

IT Recommendations: 1) Scanning of Documents:

The key functionality that KIS is missing is the capability to store electronically in the same system physical documentation, such as: picture IDs, passports, signatures, certificates of incorporation received from the AIs for each UKN assigned as it is in other global KYC systems that the Consultant has had the opportunity to work with (for example the Global KYC systems of JPMorgan Chase, Citibank and other banks in other countries such the USA, UK, Spain and Mexico).

Therefore, the Consultant strongly recommends the addition of a “Document-Capture Scanning Feature” to KIS. When CKO retrieves the investor’s data with the UKN, all information about the investor should be available in the KIS.

The IT officers named above have agreed with this recommendation. However, Mr. Muhammad Asif, Head of Operations, has stated that NCCPL has another system where they scan such

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documents. In this case, a management decision should be made that finds the best approach to

link both systems or introduce this new feature to KIS in order to have the such capability.

2) Training:

Also, conducting training on systems is recommended. This was already mentioned in the UAT performed above. It should allow users to do hands-on training of the KIS software, so that user satisfaction can be achieved providing a system manual as well.

3) Record the Results. -

KIS can only be effective if issues are logged religiously through long term testing and monitoring (as mentioned previously) with the intent to obtain a Global Database of KYC infractions and list of names of financial delinquencies committed by individuals and organizations in Pakistan and in other countries around the world as suggested by Mr. Akif Sayed, SECP Commissioner, during the meeting on August 03, 2016.

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