Published On: Mon, Dec 14th, 2009

HKEx Chairman Ronald Arculli’s Speech – Roles and Challenges of Stock Exchanges

Good afternoon distinguished ladies and gentlemen. It is a pleasure to be spending this lunchtime with you.

The past two years have been a roller-coaster ride for many in the financial markets. Few would have foreseen the severity of the downturn and the volatility we experienced, or indeed the sharp upswing in most asset classes since March. Nevertheless, the recent events in Dubai have reminded us to be vigilant, as we are not completely out of the woods and no one can know for sure where dangers lurk.

Although I would like to forecast where index levels are headed next, there are many more qualified than I to give such estimates. All I can advise is, as always, for investors to exercise caution amid concerns about possible overvaluation. Instead, today what I would like to talk about is the role of stock exchanges, especially in the aftermath of the crisis, and the challenges they face going forward.

A stock exchange essentially serves as a central platform for companies, investors, and the economy. And the roles it fulfils stem from this.

Companies can raise funds on the stock exchange to expand their operations through initial listings and subsequent capital-raising exercises such as placements or rights issues. As importantly, a stock exchange serves to improve a company’s operations, management and corporate governance standards. It does so through listing and disclosure requirements, monitoring compliance and regulatory action.

A publicly listed company is also subject to media scrutiny, as well as the scrutiny of its shareholders who, as owners, may take part in votes, make their opinions known at meetings, or indicate their disapproval by selling the stock, hence punishing the stock price. Independent and executive directors of listed companies also have fiduciary responsibilities they have to live up to and could face legal sanctions.

For investors, a stock exchange offers them enhanced investment choice for their savings, and the chance to earn returns on them. Investors also benefit from the assurance that the platform they are investing through is one that upholds fairness, transparency and efficiency.

Trades are conducted through the exchange, meaning the exchange acts as the counterparty in every transaction and through its associated clearing houses guarantees payment and settlement, even should a party fail in its obligation to pay or deliver. This limited default and counterparty risk gives investors confidence to conduct transactions which generates liquidity, and liquidity in a stock usually means no single order should significantly impact current market prices.

Fair prices on regulated exchanges are determined or “discovered” through demand and supply for a stock, a situation that is visible through the bid/ask queue details which are publicly available. This price discovery process is a crucial function of stock markets.

For the economy as a whole, a stock market aids in the efficient allocation of resources – from investors to companies – for companies to grow and for industries to continue developing. Companies that are not up to standard will either not be able to be listed or eventually be delisted. A stock market through its transparent and liquid platforms and risk management abilities serves to maintain market stability.

Additionally, the stock market itself generates employment opportunities for those associated with it, including intermediaries and related market professionals. It also contributes to government revenue through, for example, stamp duty on market transactions. More broadly, the health of a stock market is a barometer of how well an economy is doing, as represented by the actual earnings and forecast earnings of the listed companies.

So, regulated exchanges serve a variety of crucial roles. Their worth was demonstrated amid the recent financial crisis. Almost all exchanges continued to function normally and remained open during the turmoil, providing ongoing and transparent price discovery for financial assets, as well as much needed liquidity in the credit crunch.

In fact since 2008, about US$10 trillion has been raised on stock exchanges in the US, Europe and China by listed corporations to continue developing their businesses. This compared with the US$4 trillion capital injections by governments 2008-2009.

Although there was greater volatility in listed stock prices in the crisis, buyers and sellers remained. Unlike credit markets, stock markets did not freeze.

Especially during times of uncertainty, stock market participants find the combination of good risk management, transparency, fairness, a reliable infrastructure and the central counterparty services exchanges offer very attractive.

Indeed, the unique value of exchanges has been recognised by governments around the world. For example, there is a broad consensus that one way to better regulate and monitor unregulated over-the-counter (OTC) derivative activities, which were generally seen to have magnified the severity of the crisis, is to have the contracts become more standardised and for more trades to occur on-exchange or cleared through a central counterparty.

The meeting of the G20 leaders in Pittsburgh two months ago endorsed this recommendation. The EU is expected to make broader proposals by the end of December for regulating derivatives, including possible measures to encourage standardised OTC contracts and set up a regional data warehouse. In the US, the Obama administration and the US Congress have also been working on related legislative measures.

Apart from reducing counterparty risk, this could also help limit systemic risk and help trading activities to be monitored better as central clearing facilitates regulatory oversight by providing a single location for access to information on the extent of market participants’ potential liabilities. Over-the-counter trading by its private nature is characterised by opaqueness which is virtually opposite what regulated exchanges offers — transparency, disclosure and efficient price discovery. The market and regulators did not know the extent of the OTC liabilities some financial institutions had during the crisis until it was too late.

At the Hong Kong exchange we have explored how our platform and central clearing facilities can contribute to limiting risks associated with private bilateral trades. To this end, we plan to expand our product range and introduce Flexible Index Options in the first quarter of next year, pending regulatory approval. Flexible Index Options on Hang Seng Index and H-shares Index options contracts would allow market participants to request customised strike prices and expiry months.

While more central clearing could be beneficial, there are also difficulties as some OTC products cannot be standardised. There have also been concerns voiced internationally about the added risks central counterparties would take on, as well as the increased collateral and margin requirements that would come from participants. These could affect progress in this area.

And while there has been emphasis and agreement on the need for better transparency and disclosure, highlighting the useful and important functions of stock markets, we are simultaneously facing a more challenging global financial context in which we operate. These challenges arise from the interconnected issues of evolving technology, investor demands and regulation.

Changes in legislation in the EU and the US in the past few years have reduced the barriers to entry and given rise to a proliferation of alternative trading platforms, funded by institutional investors which allow them to conduct transactions bypassing the regulated exchanges.

The so-called dark pools are one such example. Dark pools refer to platforms showing buy and sell orders and deals that are not transparent or available to the general investing public. They are limited to members only. Dark pools are typically run by broker dealers and large market makers looking to save on transaction costs and fees, and not alert the broader market of impending deals which could affect a stock’s equilibrium market price.

The popularity of these off-exchange trading venues has grown with advances in technology which enable for example powerful computers to conduct high frequency algorithmic trading.

Using algorithms, these computers place numerous large orders to buy and sell stocks within fractions of seconds on both on-exchange and off-exchange platforms to profit or arbitrage on small price differences.

In tandem with more and more money being devoted to high frequency trading, the market share of dark pools has been rising. In the US, dark pools have grown from capturing 1.5 per cent to 12 per cent of market trades in under five years. In Europe they currently account for about 4 per cent of equity trades.

The rise of alternate platforms such as dark pools has implications for stock exchanges, and how effectively they can serve investors, companies and the broader economy.

Because participants in dark pools have access to information about trades that investors using publicly available quotes do not, this in effect creates a two-tiered market and means the playing field is no longer level.

The fair price discovery process is impeded because a portion of demand and supply for a stock is effectively concealed, meaning the public, typically retail investors, may not have access to the best prices.

The proliferation of many alternate platforms and new trading methods also means that liquidity is increasingly fragmented, translating into the diversion of volumes away from publicly traded exchanges. While there is no denying exchanges would of course like more business not less on their platforms, market fragmentation has implications beyond that, affecting investors and listed companies. Smaller companies in particular may suffer as high frequency traders tend to prefer larger, more liquid shares. This could affect companies’ development potential. Increased market fragmentation not only affects effective price discovery, it also increases price volatility, and adds to surveillance difficulties.

Dark pools could theoretically create an information advantage for their operators and participants, which could be used to trade in public markets. As these platforms are largely unregulated, they could be subject to trading irregularities.

As importantly, the lack of regulation and transparency could result in notable systemic risk, like we saw when Lehman Brothers and AIG found themselves in trouble last year. As dark pools typically lack a central counterparty, the default of a large participant could have severe consequences on market stability.

Deeper issues that some of these new developments bring up include the increasingly transactional nature of share trading. Arguably when shares are held only for fractions of a second, it is no longer about participating in the ownership of a company or ensuring it is well run. The opaqueness of trading, and its fragmentation have negative implications for effective corporate governance.

Could the rise of these alternate platforms set up by investment banks indicate a trend towards the re-mutualisation of stock trading? As you are probably aware, most stock exchanges around the world were set up as associations by their trading members but in the last two decades they have demutualised and turned into commercial, often listed, corporate entities to better serve their stakeholders and protect the investing public.

Now as the bigger trading participants are getting together again to create their own networks is the trend reversing? Complicating matters even further, some exchanges have decided to join the fray and team up with large institutions to set up their own dark pools.

While off-exchange trading is still in the early stages in Asia, making up a small percentage of the average daily turnover, in a globalised marketplace we cannot afford to ignore the issues they raise.

The World Federation of Exchanges has asked G20 leaders to assure a level playing field for the responsibilities assumed by all securities market order execution venues, and called for more uniform rules between exchange-traded and less-regulated markets. Regulators in the EU and the US have been reviewing the rise of these dark pools and considering stricter measures to ensure a fair and stable trading environment. The International Organisation of Securities Commissions has also commenced a new project to examine potential regulatory issues.

We, in Hong Kong, will continue to work with our regulatory and exchange counterparts internationally to monitor and tackle these and other issues to strengthen the global financial system. Regulatory arbitrage, where one market has looser standards and rules than another, has to be avoided if we are to succeed in our efforts.

And while regulation is important, exchanges cannot dismiss the changing environment in which we operate and the evolving demands of investors. Investors, especially institutional ones, are seeking better, faster, cheaper services for progressively more computerised methods of trading.

We have to find ways to improve our platforms and functionality to offer best execution to accommodate new trading strategies in a fair manner, while protecting investors and maintaining market integrity. We must also continue to seek to offer efficient pre- and post-trade services in order to stay competitive.

Competition is not a new phenomenon, nor is it to be feared. For us in Hong Kong, there has also been worry voiced about the challenges posed by the rising Mainland markets like those of Shanghai and Shenzhen.

With the rise of China, its cities are growing and receiving well-deserved attention. At the Exchange we welcome their rise and the enhanced prospects for all that they bring. In combination, Hong Kong and other Chinese cities can achieve better results than on their own. Each market has a unique role to play, offering different strengths and, although it has been said before, China does have the capacity and the need for more than one successful financial centre.

Competition between our cities is not for supremacy over the other. Rather it is complementary competition, geared to enhance China’s overall economic development and the country’s contribution to the global economy. The Exchange in Hong Kong will continue to work closely with our counterparts on the Mainland to achieve this.

Ladies and gentlemen, we welcome challenges that strengthen our markets and make them more effective and efficient. But we are concerned by those that increase systemic risk or disadvantage a certain segment of investors to the benefit of others.

Market integrity and market quality have always been the key focus for the Exchange in Hong Kong and been the motivating force behind all our endeavours.

We strongly believe that it is only by upholding our standards and maintaining orderly, informed, fair and reliable markets, despite the pressures we may face, that we can fully serve our purpose in a sustainable manner.

But, at the end of the day, we are but platforms and need the support of market participants to truly be effective. The recent financial crisis has highlighted the value and the importance of exchanges in financial markets. Lessons from the crisis should not be forgotten.

In an ever-changing world, we will continue to seek to strengthen our operations, products and services to fulfill our responsibilities to our stakeholders and to benefit investors, companies and the broader economy. There will be further details on how we intend to do this in our strategic plan for the next three years which will be published early next year. In the meantime, I welcome your questions and suggestions on the way forward.

Thank you.

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