HKEx Chief Executive Views on HKEx Market Structure Reforms
HKEx Chief Executive Charles Li published on 26 July an article in Chinese on HKEx’s market reform. Fifteen months have passed since HKEx announced its Strategic Plan 2010-2012 in March 2010. As HKEx is now midway through the plan, Mr Li is taking this opportunity to review the past, examine the present and ponder the future. The following is a summary of the article (the article has been posted in the Chinese-language section of the HKEx website).
Since the beginning of this year, Hong Kong Exchanges and Clearing Limited (HKEx) introduced several market reform initiatives after serious consideration. These market reform measures have raised some concerns and controversies in the market. I feel there is a need to provide a comprehensive explanation of HKEx’s Strategic Plan 2010-2012, its roadmap for reforms and its philosophies behind the reforms in the hope that the market will understand and support these reforms. As we are now midway through the plan, I think now is a good time to take a pause to review the past, examine the present and ponder the future.
This paper outlines some viewpoints of the HKEx management on the following questions:
1. What is HKEx’s vision and development plan for the future?
2. Why are reforms needed? What motivated HKEx to propose the various reforms and what is driving them?
3. What are the philosophies behind the reforms? How to take into account and balance the interests of various parties to secure the greatest level of market acceptance? How to set the timing and pace of the reforms?
II. HKEx’s Vision and Strategic Plan
Over the past 20 years, Hong Kong has been the gateway for Mainland capital and enterprises to enter the international market and for international participation in the Mainland economy. The continued rapid growth and opening up of the Mainland economy together with the acceleration of the internationalisation of the renminbi (RMB) will make Hong Kong’s role as a gateway even more important. In this context, HKEx and its Stock Exchange’s recent history and strategy can be summed up in three chapters, namely Mainland enterprises’ “Preferred Overseas Capital Formation Centre”, Mainland capital’s “Preferred Overseas Investment Centre” and the “Comprehensive International Financial Centre”.
Chapter 1: Mainland Enterprises’ Preferred Overseas Capital Formation Centre
This chapter’s feature has been and continues to be “Mainland enterprises going overseas, capital going into the Mainland”. This driver transformed Hong Kong into a prominent international financial centre over the past two decades.
However, HKEx’s marginal benefit from new listings from the Mainland has begun to fall given the already very large base of our market capitalisation. Therefore, we need to explore new opportunities and start new chapters.
Chapter 2: Mainland Capital’s Preferred Overseas Investment Centre
The Hong Kong capital market is facing its second historic opportunity for structural transformation. As the opening up of the Mainland’s capital account speeds up, the Mainland is shifting gradually from importing capital to exporting capital.
This chapter is driven by two trends: Mainland capital’s increased investment in overseas markets and the internationalisation of the RMB. Therefore, Hong Kong has an urgent need to introduce a variety of RMB-denominated investment and risk management products in a timely manner so that it will become the preferred overseas investment platform and first stop for Mainland capital going abroad. As Mainland capital accumulates in Hong Kong, it will certainly help attract more international companies to list in the city.
In order to attract and retain Mainland capital, HKEx must take the following three steps:
1. Achieve connectivity between the two markets both in hardware and software;
2. Enhance its capability so it is ready for market expansion; and
3. Prepare itself for increased competition as more capital will inevitably attract other international exchanges as well as alternative trading platforms.
Chapter 3: Comprehensive International Financial Centre
HKEx’s long-term objective is to become a comprehensive international financial centre, which includes on-exchange currency products trading as well as the trading of commodities products.
The key drivers in this chapter are:
1. With the internationalisation of the RMB, there will be huge demand from Mainland and non-Mainland investors for RMB-related exchange rate and interest rate derivatives as well as the over-the-counter (OTC) clearing services for these products; and
2. As Mainland China becomes one of the largest producers and consumers for many commodities, it will demand greater influence in the international pricing of these commodities.
With the Mainland market not yet fully connected to the international market, Hong Kong has a window of opportunity to develop on-exchange currency products and commodities products. However, we have yet to build the technology platforms and other market infrastructure needed for the development of these products. Therefore, efforts should begin in the following three areas:
1. Cooperate with the Mainland and help it internationalise by making the most of Hong Kong’s advantages;
2. Cooperate with the international markets and introduce their technologies and products to Hong Kong; and
3. Reform the existing market structure in order to take advantage of this historical opportunity.
III. Why Are Market Structure Reforms Needed?
Although Hong Kong’s financial markets have achieved extraordinary growth in the past decade, there are still a number of weaknesses and vulnerabilities, some of which could be fatal in the next crisis or could hamper the structural transformation in Chapter 2 or Chapter 3. Therefore, we need to remedy those weaknesses by kicking off market structure reforms now.
Our reforms can be divided into three categories: Reforms Critical to HKEx’s Core Capabilities, Reforms to Achieve Mainland Connectivity and Reforms to Enhance HKEx’s Global Competitiveness.
1. Reforms Critical to HKEx’s Core Capabilities
These reforms determine HKEx’s core capabilities and its survival during “rainy days”. Therefore, they are necessary and urgent. What’s more, the solution must be farsighted and scalable to meet the market’s needs as it continues to grow. These reforms include enhancing the information technology (IT) infrastructure, reforming the clearing houses’ risk management and raising their capital adequacy.
(1) Enhancing IT Infrastructure
The IT infrastructure is the backbone of HKEx and the foundation on which we grow and compete with our peers. In the past decade, our investment in IT infrastructure was minimal compared to our market scale. While it may not be a significant issue in our Chapter 1 strategy, which relies mainly on new listings, our IT infrastructure will not be able to support the structural changes in Chapter 2 and Chapter 3. Therefore, the enhancement of our infrastructure is a top priority in the Strategic Plan. We have begun upgrading our trading and information systems to the next generation, building a new data centre in Tseung Kwan O and developing hosting services.
We do not agree with the view that enhancing our IT infrastructure favours high frequency traders or the large brokers. Building the IT infrastructure is like building a highway; we should not abandon highway construction just because a few do not want to invest in new cars or a few fear accidents. We believe Hong Kong’s current market framework, which includes stamp duty, effectively limits high frequency trading, just like a highway with many toll booths discourages speeding. Besides, even if we don’t build the highway, we cannot prevent others from doing so and diverting liquidity, leading to market fragmentation.
In summary, in terms of enhancing IT infrastructure, HKEx strives to be safe, open and fair while seeking to help small brokers maintain their competitiveness.
(2) Reforming the Clearing Houses’ Risk Management Measures and Raising Their Capital Adequacy
The growth of our clearing houses’ capital has long been lagging behind the growth of the whole market. In the wake of the 2008 financial crisis, regulators all over the world have been enhancing the requirements for clearing houses’ capital adequacy. Being weak in this aspect, we have a strong need to remedy our situation quickly.
As a result, we propose reforming our clearing houses’ risk management measures, including, among other things, introducing margining in the securities market clearing house – a mechanism we have lacked for a long time – and having a dynamic guarantee fund for each of the three clearing houses. The proposal includes measures (such as granting credits) to alleviate the impact on brokers, especially the small and medium-sized brokers.
2. Reforms to Achieve Mainland Connectivity
These reforms are intended to build our connectivity with the Mainland market, a key to bringing Mainland capital to Hong Kong when it is allowed. As it requires full communication with our market participants as well as with regulators in both Hong Kong and the Mainland, we expect long lead time for these initiatives. Therefore, in spite of the uncertainty about the timing of such significant changes, we have to prepare ourselves in advance, be proactive and be flexible in order to capture the opportunities when they come.
These reforms include:
(1) Extending trading hours and aligning market open times with the Mainland;
(2) Remote Exchange Participantship; and
(3) After-hours futures trading.
(1) Extending trading hours and aligning market open times with the Mainland
For a long time, the Hong Kong securities market has had some of the shortest trading hours among major world exchanges. What’s more, with the increasing interaction between the Hong Kong and Mainland markets, different trading hours hamper Hong Kong’s price discovery function for Mainland-related securities.
Having widely consulted the market, we aligned the opening time of our stock market’s morning session in March this year with that of the Mainland market, and we plan to align our afternoon market opening time with that of the Mainland market in early March next year. The new morning opening time extended our trading hours and the new afternoon opening time will extend them further.
The benefits of these changes will not be apparent immediately. They depend on the Mainland market opening up further, particularly breakthroughs in the cross-listing of exchange traded funds, index products in general and stock index futures in the Mainland and Hong Kong.
We understand that biggest impact has been on the small and medium-sized brokerage firms, especially their staff. They bear most of the burden of this reform while their benefits are limited at this stage. We empathise with them and we understand their disagreement and anger. We will continue to listen to the brokers and their staff and see if we can find ways to ease their burden.
(2) Remote Exchange Participantship
This long-term initiative will connect our trading platform with the Mainland and establish another channel for Mainland capital to access our market. Due to the difference between Hong Kong and the Mainland in regulation, infrastructure and market structure, it’s quite unlikely that Mainland investors will be able to directly open accounts with our Exchange Participants when the Mainland’s capital restrictions are lifted. If that is the case, the introduction of Remote Exchange Participants would probably be one of the best solutions.
In terms of timing, this initiative will go hand-in-hand with Mainland’s gradual opening up of its capital account. This involves issues such as regulation, infrastructure, operating models, risk management and market practices. Hence, we should think early, communicate fully, prepare carefully and kick it off at the right time.
(3) After-hours futures trading
HKEx consulted the market in May this year on the introduction of after-hours futures trading. The rationale for the consultation was twofold: 1) the proposal was driven by market demand for ways to hedge and change positions after the market close; and 2) there will be more demand for such activities as the RMB continues to internationalise and RMB-related forex products, interest rate products, etc are developed.
We are fully aware of the possible additional operating costs and competitive pressure for some of the brokers who have a futures business as well as a securities business. We have also heard the concerns regarding risk management in after-hours trading. We will take these into consideration and allow sufficient time for any market preparation when we complete our consultation conclusions.
3. Reforms to Enhance HKEx’s Global Competitiveness
HKEx is facing more and more intense competition both internally and externally. On one hand, alternative trading venues, particularly dark pools, have emerged in Hong Kong. On the other hand, we will inevitably compete with our international peers as we execute on our strategy in Chapter 3. The following reform measures are intended to enhance our global competitiveness so we can meet the challenges we expect to face:
(1) Narrowing of trading spreads;
(2) Introduction of a closing auction session; and
(3) Trade anonymity.
While these reforms are not as urgent as others, they should not be taken lightly. In these three areas, we will think and study carefully, balance interests, move steadily ahead and avoid rash decisions.
(1) Narrowing of trading spreads
Trading spreads are a component of investors’ hidden transaction costs and hence an important factor in a market’s competitiveness. At present, our minimum spreads are larger than those of other exchanges and some of the other trading platforms operating in Hong Kong, resulting in lower efficiency for trade execution. Therefore, we propose the consideration of narrower trading spreads for some securities.
I would like to emphasise here that HKEx would not cut the trading spreads across the board and will take into consideration the costs and benefits for the brokers when considering this reform.
(2) Introduction of a closing auction session
It is hard for market participants to complete share trades at the closing prices in Hong Kong due to the current mechanism for determining closing prices. There is strong demand for execution certainty at the closing price, especially from managers of passive funds (eg exchange traded funds) and traditional equity funds, and the market is calling for a more market driven mechanism to determine closing prices.
This is a technical reform and should not require the consideration of many different interests, but we understand the market had a bad experience with a similar initiative in 2008 and is concerned about the possibility of manipulation. The current mechanism is also susceptible to manipulation and we will address the risk of manipulation in our proposal. We welcome input from market participants and will consider their views when we design the blueprint.
(3) Trade anonymity
Currently, our trading platform displays the identities of up to 40 securities brokers and the price and volume of their trades. For years, many market participants have been calling for a change of this practice, arguing that the information allows their counterparties to know their strategy, pre-empt their trades, create price volatility and substantially increase their costs of trading.
While these views are reasonable and anonymity is in line with international practice, we are aware that display of broker identity has long been accepted and expected in Hong Kong. When considering a change of the current practice, we need to be patient, prudent and practical. We will also need to respect the tradition and communicate thoroughly before pursuing any new course. On the other hand, we cannot agree with argument that the display of broker identity is “fair” and “transparent”.
IV. Philosophy of Reforms
Our philosophy of reforms is to seek: the Right Reforms, the Right Balance and the Right Timing.
1. The Right Reforms: Reforms should not only benefit the market as a whole and contribute to its further development but should also take into account the characteristics of Hong Kong, and the benefits should far exceed any costs.
2. The Right Balance: Reforms must be fair and reasonable. In other words, we have to strike the right balance among different stakeholders. In order to achieve that, we need to:
(1) Reach consensus that reforms are beneficial to the overall market and contribute
to its further development;
(2) Minimise any potentially adverse impact on minorities in the market; and
(3) Provide sufficient time and channels for affected stakeholders to express their views and ensure there is equal opportunity for input in the decision process.
3. The Right Timing: Different priority should be given to the reform initiatives according to their importance. Those that are critical to our core capabilities have to start now; those that are prerequisites for structural transformation have to be prepared early and we have to be farsighted in preparing them; and those that depend on particular external conditions require patience and we have to proceed at appropriate time.
We do not agree with the stereotyping of reforms into battles of the “large” vs. the “small” brokers, or the “international” vs. the “local” brokers. The success of the Hong Kong market today is rooted in several generations’ efforts, and the small to medium-sized brokers were the founders of this market. Without the “local” and “small” brokers, Hong Kong’s market would not have the energy and tradition it has today; without the “international” and “large” brokers, Hong Kong’s market would not have the scale and depth it has today. HKEx considers market characteristics and traditions when we strive to develop the market as a whole.
Last but no the least, I would like to emphasise that any discussion of market structure reforms should be based on rational analysis and facts. In the end, HKEx’s interests are aligned closely with our market participants so we should strive together to make the most of Hong Kong’s unique advantages and continue the market’s success and prosperity.
To capture our unique and historic opportunities, HKEx aspires to be Mainland enterprises’ “Preferred Overseas Capital Formation Centre”, Mainland capital’s “Preferred Overseas Investment Centre” and the “Comprehensive International Financial Centre”. These strategic goals rely on the joint effort of HKEx and market participants. The table below summarises the three types of proposed market structure reforms. We look forward to working hand in hand with market participants and together contributing to the Hong Kong market’s further development in the future.