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Flotation of Exchanges not in the Public Interest
3rd March 1999

In today's budget the Financial Secretary announced plans to merge the Stock Exchange of Hong Kong, the Hong Kong Futures Exchange and the respective clearing companies. This is a commendable move which should serve to increase the efficiency of market trading and settlement and to allow a technological upgrade and the abandonment of many anachronistic features, particularly in the case of the Stock Exchange.

Unfortunately, it didn't stop there. The government proposes that the enlarged entity should be listed on the combined Exchange. That is, it should become a for-profit entity. In the past, it has been clear that the exchanges and clearing companies should essentially be non-profit entities with any surpluses reinvested in market infrastructure or reserves, not distributed to shareholders.

In the case of the SEHK, the Memorandum and Articles provide that the Exchange shall not pay any dividends to its members, and that its assets will only be distributed to them upon a winding up. Of course, since the SEHK has no plans to voluntarily go out of business, a winding up was always a highly unlikely event. Like the HKFE, its existence as a monopoly is mitigated by the fact that it is supposed to provide services essentially at cost.

Levies and fees are set to provide a secure but low-cost trading environment and allow for reinvestment in market infrastructure. For example, Hong Kong Securities Clearing Company has successively reduced its fees as its operating costs have reduced, benefiting all market participants.

The motives behind the shake-up are unspoken but laudable. For years it has been clear that the structure of the SEHK has been anachronistic. Its rule-making bodies are dominated by small brokers, who have held back its development in the following ways:

• membership of the SEHK is limited to a fixed number of trading "seats", each attached to one of the 929 shares. This creates an artificial value on memberships which would not exist if they were simply issued on a "demand" basis, that is, to any suitably qualified and adequately capitalised applicant. Remember that the SEHK is supposed to be non-profit, so on a going-concern valuation basis, the memberships yield no income and should be worthless. In a demand-based system, memberships would not be transferable and would simply lapse on surrender. Membership numbers would fluctuate based on demand.

• the greatest justification for the "seat" system has been the physical limit on space in the trading hall. However, for many years, the trading hall itself has been unnecessary as electronic trading systems have made it possible to place orders from terminals all over the city. The members have sought to preserve the trading hall partly so as to justify the limitation on membership.

• by limiting the number of memberships, small brokers (who held the great majority of seats when the 4 predecessor exchanges were merged into the Unified Exchange in 1986) were able to dominate the rule-making bodies of the Exchange. This has held back development in a number of key areas:

• Commissions are not freely negotiable between brokers and clients, but are subject to a minimum set by the Exchange of 0.25%. That is, there is not a free market in the cost of using the free market.

• Investment in systems such as a modern electronic news dissemination system have been slow. We are still in the realm of a text-only teletext system with announcements physically delivered to the Exchange.

• The gradual move to electronic trading has been prolonged, with the gradual introduction of "second terminals" and then "third terminals" in off-exchange offices. No mechanism yet exists for electronic interface between these terminals and the brokers or their clients' systems. All orders have to be keyed in by hand.

In addition to the problems with the SEHK, there have been clear difficulties with running the futures exchange (many of whose products relate to equities) separately from the stock exchange, in terms of overlapping products and lack of harmony in rules.

More recently, the government has gained new motivation for restructuring the market. During the 1998 intervention, it had to deal with several different bodies that weren't all singing from the same song sheet. For example, the stock clearing company initially opposed the enforcement of T+2 settlement on practical grounds, and allowed some firms to late-settle shares that they sold during the D-Day intervention of 28-Aug-98, increasing the amount of stock the government ended up with. Meanwhile, the HKFE opposed several of the measures which the government requested in an effort to increase transparency and restrict the activities of major players in the stock index futures market. At the SEHK, brokers objected to moves to require disclosure of beneficial ownership of clients.

All of this has increased the government's resolve to remove some of the vested interests and take a greater involvement in stimulating structural change. It also plans to take new legal powers to direct the activities of the two exchanges and bypass their regulation by the SFC, something it assures us it will not normally do (but obviously would if things became too difficult). At the same time, it has required the exchanges to become public bodies, placing them within the domain of anti-corruption laws. This follows the acquittal of a former SEHK Council member for allegedly taking bribes in return for the approval of seat transfers. Past scandals have included the jailing of a former SEHK Chairman on corruption-related charges.

The SEHK and HKFE are monopolies. Protected by law, they are the only place in Hong Kong where investors can legally trade in stocks and futures. There is nothing wrong with monopolies as long as they don't operate against the public interest. For example, the government is the monopoly provider of piped water, the postal system and the airport, and that's OK with me if they are run efficiently and on a user-pays basis.

There are certain sectors of the economy, mostly involved in the provision of low-level infrastructure, where it is inefficient to have more than one player, in which case we settle for a cost-based utility. For example, it would not make sense to have two competing water distribution companies if they both had to provide pipes into each building to service their respective customers. Similarly, we only have room for one airport, and creating competition by selling the runways off separately is not an option. I contend that the same applies for the Exchange. Sure, we could have two different stock exchanges, like Amex and NYSE, but this only creates extra costs for brokers and investors as they need two sets of accounts, two sets of dealing systems and so on.

Turning the Exchanges into a listed entity would work against the public interest. Suddenly, we would have a listed monopoly which has a fiduciary duty to maximise the profit it makes from people who trade securities and futures. Small brokers would have a golden windfall as they could sell their membership (their stock in Newco) while retaining their trading rights on the Exchange. Kind of like having your cake and eating it. Alternatively, if they keep their stock, they will get dividends which they never had before. Perhaps this windfall is what it will take to get them to approve the scheme voluntarily.

With no competition, and the duty to maximise profits, there is no reason to think that development of the market infrastructure would be prioritised by a listed Exchange. Certain people may argue that there is sufficient competition between the SEHK and other global exchanges (such as Singapore) to ensure fair play, but this is not the case so long as there are barriers to cross-border exchange membership, price dissemination and dealing. That argument is about as valid as the suggestion that Changi airport keeps landing fees at Chek Lap Kok in check. They are in two different places serving two different markets.

If the combined Exchange lists, then what if someone decides to take it over by buying up all the shares? Will limits be placed on individual shareholdings in the Exchange? What about groups of shareholders acting in concert? This is probably the most difficult thing to prove. Initially, of course, the largest group of shareholders would be small brokers. In the past, the non-profit nature of the Exchange meant that they had no motive to set excessive trading levies or listing fees - it came straight out of their own pocket. But in a profit-making future, if someone, or a group of people, has control of the Exchange, then would they be free to set whatever trading levies they choose? We have to presume that the government will come up with some kind of "scheme of control" to allow a "fair" rate of return to the Exchange (whatever "fair" means - how much risk are we talking about here?). That turns it more into a utility. Do we really need another listed monopoly?

Another result of creating a listed exchange is that, to the extent that part of its income derives from a levy on stock trading, it has a direct motive to encourage increases in volume for volume's sake. You may think this is a good thing if it creates liquidity, but it is a bad thing if it encourages speculation and a return to the kind of day-trading frothy market that we saw in 1997. Would the Exchange be as quick to suspend a stock if it could see half the company turning over every week? It seems that this authority would have to be passed to the SFC to avoid a conflict of interest.

It would be barely credible if the Exchange, as a listed company, tried to regulate itself. If the government proceeds with the flotation plan then the regulation of listed companies should be removed from the Exchange to the SFC, which will then operate along the lines of the US SEC. The SFC would regulate the merged exchange as well as the listed companies, and the listing division of the former SEHK would be transplanted to the SFC. This would at least remove the potential for disputes between the Exchange and the SFC over listing rules, that has existed until now. In addition, it would remove the risk that the Exchange would approve the listing of unsuitable companies simply to increase its own revenue.

I started this piece by commending the proposed merger of the exchanges and clearing companies. It is a long overdue move. However, there is no reason to turn the resultant key piece of civil infrastructure into a listed, profit-oriented body. It should exist to provide an efficient forum for the exchange of equity capital, not to profit its owners.

In his speech, the Financial Secretary introduced the proposal by reference to the success the HKMA has had in establishing the Central Money-markets Unit, a government-owned clearing system for debt securities. The merged stock and futures exchanges should follow the same model, with ownership vested in the government. Members can be compensated for any financial loss they can prove in this process. It's a small price to pay for removing the vested interests. The net asset value of the SEHK at 31-Dec-97 was HK$883m, or about $0.95m per share. That is probably the fairest basis given that, in the absence of dividends, the only way members could ever extract the value of their shares is by liquidation. There should not be compensation for loss of future earnings, as it was never intended that the Unified Exchange should be a protected for-profit monopoly. A similar valuation basis should apply to the HKFE.

The mandate of this nationalised entity should be to provide the most modern and efficient market possible, at the lowest possible cost. Once owned by the government, there is no reason why the exchanges cannot be merged with the SFC to provide a super-regulator. Rule-making for the trading and listing of securities and the regulation of market participants would be by the combined entity, advised by committees of market participants. Rules would have statutory backing with the abilty to impose financial penalties for breach. Currently the exchanges are limited to ineffective powers of censure and suspension for breaches of their rules.

In turn, the SFC should be subject to the over-ride of the Financial Secretary, which should only be exercised in extreme circumstances and, like all government policy, his actions should be subject to legislative review.

© Webb-site.com, 1999

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