- STRATEGIC CHALLENGES
Since I joined HKEx, I have talked to my colleagues and many of our stakeholders about their views on the company and its market. The discussion revealed a number of strategic challenges facing HKEx.
At the macro level, we need to define the future role of HKEx with respect to the global trends of the financial services industry. Currently, the main flow of new businesses to HKEx and to the Hong Kong stock market comes from Mainland China. Our China business stream, established in the early 1990s with the H share initiative, seems to be the bright spot in the picture. More than 240 China-related companies, including H share and red chips, were listed on HKEx over the past ten years. Yet, with the further opening up of China to foreign investors under the QFII scheme, we need to think ahead of how the role of HKEx as an international capital market for China may change over time.
Secondly, there is the international dimension. HKEx, as one of the larger markets in the Asia-Pacific region and the most open and competitive, has been engaged in some alliance discussions with overseas counterparts. These discussions revolve around similar themes - co-trading of each other's products, sharing technology, and possibly, investment in one of these exchanges. While it may be tempting to expand our business to another continent, we cannot under-estimate the difficulties both in terms of financial and human resources involved in cross-border exchange alliances.
Thirdly, there is the business scope of the enterprise. At present, HKEx is the operator of the central infrastructure of the market. We offer trading, clearing and settlement services to our participants; we also distribute trading information to the data vendors. Should we consider extending vertically or horizontally along the transaction chain? For example, should HKEx offer software support services to brokers? Should we develop value-added data services? Should we try to market our systems to other exchanges? Other exchanges have done each of these things, some with apparent success.
Fourthly, there are the demands of our stakeholders. Many of the smaller brokers have suffered and are still suffering from low business volumes. There is pressure on them to increase their share capital, particularly if they continue to act as custodians of their clients' shares. They see an improved IP account service as a solution to their survival and competition with the bigger players, including the banking industry.
The regulator and the government advocate progress on market infrastructure such as the scripless initiative and a centralised stock borrowing and lending facility and on further strengthening of Hong Kong's corporate governance regime.
Our customers are also our stakeholders. It is therefore vital for HKEx to continue to improve its products and services and, as far as possible, deliver them at a lower cost but with greater efficiency.
Last but not least, there are our shareholders. In the past financial year, HKEx's business profits declined mainly as a result of the lower business volume due to the bear market. Although the market has been more active in recent months, the implementation of large-scale market infrastructure projects would unavoidably put further pressure on HKEx's profitability. As a listed company, this is an issue we cannot afford to ignore.
- ROLES AND STAKEHOLDERS
Therefore you can see that HKEx is facing a difficult problem. There are many things on our plate and all of which are considered of high priority by some of our stakeholders. It would be difficult for us to address all of them at the same time due to the manpower and financial resources constraints we are now experiencing. Hence the immediate task of HKEx is to select a few initiatives that are really critical to our future. And here, we need your input and advice to help us prioritise.
I would like to first share with you what we think the roles of HKEx are.
Roles
HKEx has multiple roles:
- It is a business enterprise, earning revenue from the operation of a central marketplace for securities and derivatives businesses and from ancillary services such as information distribution.
- At the same time it is a regulator with front line responsibility for the supervision of issuers listed on its markets. As a market operator, it is also charged with a responsibility to maintain a fair, competitive, transparent and orderly marketplace.
- And HKEx has a public role as operator of a key market infrastructure for Hong Kong. In case of conflict between the public interest and our commercial interest, the law requires us to put the public interest first.
In any case, the overall positioning of HKEx is always crystal clear to us. HKEx must seek to maximise its business role within the given boundary as a regulator and a public institution. We must not and will not pursue business in a way which may compromise the regulatory standards of Hong Kong or threaten the broader interests of the market.
Regarding the listing process, I must emphasise again that all listing applications are approved by a Listing Committee of which all members are independent market participants, except me. We also employ a large team of more than 100 professional staff, together with support staff. This team is dedicated full time to regulatory work. The whole arrangements are under review following the Expert Group report, and no doubt they will be improved upon. But no matter what, the basic principle of resources dedicated separately to the regulatory role will be maintained. In our view, regulation is equal to quality control from a business perspective. Without quality we will never be able to achieve business success. It is therefore in our best interest to maintain a high standard of regulation in the Hong Kong marketplace.
Stakeholders
What about our relations with the various stakeholders in the marketplace -- the Government, the statutory regulator, issuers, investors, brokers, investment banks, accountants, lawyers and other market professionals?
Again, all the groups are important to us and each must be listened to. The issue is one of proportionality and proper relationship. Though the definition of roles and responsibilities of different groups is always being discussed, I would like to take this opportunity to share with you how I think HKEx can work with various parties in a trust-based and co-operative manner. Our view is that:
- The Administration is responsible for setting the high level policy direction whereas market operators like us should focus on the implementation.
- The SFC is the statutory regulator. It has a duty to exercise oversight on how we operate and step in when we cross the lines as well as to offer us support and assistance when necessary.
- The brokers are our business partners and we will not and should not compete with them. Not only because we do not know the investors as well as the brokers, but also because we do not have the resources or the culture to service large numbers of investors directly. There are 1.1 million investors in Hong Kong, and we hope many more will come from the Mainland and elsewhere in the future. We rely on brokers to serve the investors; and in that way, we will jointly prosper.
- The data vendors are also our business partners. We rely on their resources and their skills to provide a variety of information services to the end users. We only provide basic information for vendors to add value to before selling it to their customers. We will improve the scope of information services and the efficiency of delivery, so that we will support the vendors better and both of us will prosper.
- The listed companies, investment banks and other professionals are our business partners on the issuer side. They help bring us new issuers and new products. To maintain market quality, we must ensure that our standards are up to the international level and act against any violators of our rules. We need to remember that we provide a service to them as well, and as a result it is important that we should further improve the service culture of HKEx.
- And finally, investors are our ultimate users and customers. Though there are too many investors for us to provide services directly, we do have a duty to disseminate timely and accurate information to them to support their investment decision-making. It is also in our interest to offer training and education to investors so that they can better understand our products and market operations. As a service provider, we should also consult investors from time to time and align our offering with their needs and expectations.
China business
Let us first look at the long term future flow of business. What long-term role does HKEx have in servicing the Mainland? The Mainland exchanges are developing rapidly. Will they eclipse us in the long run?
China is a developing economy. That means there is unfulfilled potential and unsatisfied demand. It is true that China has been developing rapidly, and improving its markets; but this does not mean that the unsatisfied demand for capital market services has reduced. In the next few years, China will continue to open wider to foreign participants as part of its WTO obligations, this means that its issuers need sophisticated capital market services to help them restructure and upgrade to meet foreign competition. Many qualified companies in China can potentially benefit from being listed in Hong Kong. So on the issuer side, I would say that the prospect continues to be bright.
On the Mainland investor side, we have barely begun to tap the potential. At present, Mainland investors are not permitted to invest directly in the Hong Kong market. But this state of affairs may not continue forever. Mainland institutions want to diversify their investment portfolio for better returns. Mainland retail investors may follow their issuers who are listed in Hong Kong. And Mainland brokers, like their counterparts in Hong Kong, would welcome expanding their business across the border.
We have to continue doing the right things to attract Mainland issuers and eventually investors. In particular, there may be new opportunities arising from the Qualified Domestic Institutional Investor scheme, and other market opening measures. It is difficult to say in advance what we will do before we know the measures exactly. But I think we will not go far wrong if we continue to operate and regulate the market to a high standard and fully utilise our strengths as an open and international capital market. On the regulation side, we have to do a better job. We have to demonstrate to investors that we can effectively regulate issuers listed on our Exchange.
To develop our growing China business, we are in the process of setting up a representative office in Beijing. This will enable us to service our China customers better and conduct marketing, promotion and liaison work more effectively in the Mainland.
International business
In the past years the Exchange has put considerable effort into introducing foreign products. The result however is not encouraging. Hong Kong investors seem not interested in trading overseas products offered in Hong Kong. The reason is simple: if they want to trade, say, US stocks, they can very easily approach their brokers in Hong Kong to access the domestic market where all the liquidity resides. This is because liquidity tends to reside in one's home jurisdiction. This is also true of most other stock exchanges in the world. With the exception of a few giant exchanges, exchanges generally succeed only with their domestic products.
HKEx is already very fortunate in having, in addition to Hong Kong stocks, Mainland China issuers. Currently, we have 243 China companies listed on our Main Board and GEM markets, including 81 H shares and 73 red-chip companies. These China companies together accounted for HK$1,200 billion or 27 per cent of our total market capitalisation and so far contributed nearly one-third of our total equity turnover for 2003 (HK$3,500 billion). We also list other China-related securities, including 83 derivatives warrants, 13 bonds and 11 funds.
However, I am not saying that international business is not important to HKEx. As a matter of fact, nearly 40 per cent of our stock market turnover and over one-fifth of our derivatives market turnover are contributed by foreign investors . We have, among our participants, almost all the leading international brokers from around the world. Most important, Hong Kong's international flavour has been and will continue to be our strongest competitive edge. It is important for HKEx to further develop its services and overall market structure to comply with the best international standards and practices with the necessary adjustments to address local characteristics so as to retain its attractiveness to international players.
Derivatives
HKEx operates both a stock market and a derivatives market. However, our position on the derivatives side is not nearly as strong. While the stock market is about tenth in the global market capitalisation rankings, among derivatives exchanges we rank only about 35th. Partly this is because of the limitations of the Hong Kong environment. The Government is not indebted, so there is little potential for debt-related futures products. Hong Kong does not produce or consume commodities on a major scale, so there is little potential there.
In spite of these limitations, we are doing our best to promote the use of derivatives in the market. One thing that we will not do, however, is to launch too many new products. If you look at successful derivatives exchanges, most of them have only a few products, or even just one or two products, that really trade. The leading derivatives exchange in the world, the Korea Stock Exchange, has essentially just one product, the KOSPI option. Last year they traded 1.9 billion contracts in this product, while we in all our products traded just 11 million. The issue is not diversification, it is building liquidity for those products that meet the needs of our brokers and their clients.
Market operation
Regarding challenges facing our market operation, I would start with the trading side, which carries a shorter list of projects.
Our existing cash market trading system AMS/3 was only introduced in late 2000. Market participants are satisfied with its functionality and performance. Therefore we see no need to introduce any big change to AMS/3 in the next two years. Instead, we will focus on its system reliability and stability as well as further streamlining its operations. Our derivatives market electronic trading system HKATS was launched in April 1999. It needs to be upgraded and we are doing this. The new software upgrade, to be completed later this year, will better protect system users, support central order size limit and make sure HKATS is compatible with DCASS, our coming integrated derivatives central clearing and settlement system for futures and options products, to be introduced in the first quarter of next year. This takes us to the clearing side.
In the Cash market, the market direction is towards a scripless environment. In fact, trading on HKEx is already fully electronic while broker-broker settlement within CCASS is processed by book-entry transfers without the involvement of physical scrip. However, outside the CCASS environment, physical certificates are still in use. Elimination of paper would be beneficial as it would improve the operational efficiency of brokers, custodians and share registrars, and reduce the risk of lost or fake certificates.
At the same time, the government and the SFC would like us to upgrade our IP account mechanism to attract investors on a larger scale and hopefully give better protection to investors' assets. Currently the IP service is not actively used, with merely one per cent of the estimated total Hong Kong investors taking up this service. This is mainly because trading through IP accounts is not very convenient to either investors or brokers. There are also other areas for improvements. For instance, under the existing structure, CCASS acts as a common nominee holding all the shares in its custody. As a result, IP account holders are not directly registered shareholders of the companies in which they invest. From the issuers' perspective, any improvement in the transparency of their Registers of Members will certainly be welcome. The challenge facing HKEx is to come up with a more transparent, user-friendly and convenient IP service, which will attract large-scale participation of retail investors. If we can do this, the significant pool of assets under CCASS will enable us to consider other new services, such as centralised stock borrowing and lending.
On the derivatives clearing side, the big infrastructure issue is the implementation of DCASS. We are going to replace the two existing derivatives clearing systems by an integrated system which can clear and settle trades of all our derivatives products in a more efficient and flexible manner. Currently, we are putting our full strength on this project and, as mentioned earlier, we aim to have the system up and running early next year.
After all these initiatives, a possible next step in our clearing infrastructures will be the consolidation of the clearing houses. Currently we have three separate clearing houses, each with its own participant structure, margin requirements, operational procedures and guarantee funds. Theoretically, a joint clearing house with a common guarantee fund for all HKEx participants will be beneficial. However, this is easier said than done. The risk profiles of cash and derivatives products are very different. It will be a big challenge for HKEx to design a risk management mechanism which can allocate the risks to all participants on a very fair and equitable basis, particularly when three quarters of our participants do not participate in both the cash and derivative markets.
CONCLUSION
Today I have shared with you the strategic issues facing HKEx. I hope you will agree with me that both HKEx and the securities industry in Hong Kong face a future full of challenges. There are many obstacles we must overcome but also many opportunities. It is a time requiring everyone in the industry - regulators, market operators, brokers, investment banks and other professionals - to co-operate and work as a team. If we do these things right, I am sure that we will build a strong, high quality marketplace which can attract business and talents from everywhere, including Mainland China and overseas, to the benefits of all of us.
We are currently working on a strategic plan for HKEx. We very much welcome input from market practitioners and other stakeholders, in particular the SFC. And we should be ready to present our three-year strategic plan to our Board within the next two months. After that, I wish to have an opportunity to share our strategic plan with you in more detail.
Thank you very much.
Please click here for Paul Chow's presentation.
