LC Paper No. CB(1)1074 /98-99
(These minutes have been
seen by the Administration)

Ref : CB1/PL/FA/1

Members present :

Hon Ambrose LAU Hon-chuen, JP (Chairman)
Hon Eric LI Ka-cheung, JP (Deputy Chairman)
Hon Kenneth TING Woo-shou, JP
Hon James TIEN Pei-chun, JP
Hon David CHU Yu-lin
Hon Albert HO Chun-yan
Hon NG Leung-sing
Hon Margaret NG
Hon CHEUNG Man-kwong
Hon Ambrose CHEUNG Wing-sum, JP
Hon HUI Cheung-ching
Hon Bernard CHAN
Hon SIN Chung-kai
Hon Jasper TSANG Yok-sing, JP
Hon FUNG Chi-kin

Members attending :

Dr Hon Raymond HO Chung-tai, JP
Hon Martin LEE Chu-ming, SC, JP
Hon CHAN Kam-lam
Hon CHOY So-yuk

Members absent :

Hon Cyd HO Sau-lan
Dr Hon David LI Kwok-po, JP
Hon Ronald ARCULLI, JP
Hon James TO Kun-sun
Dr Hon Philip WONG Yu-hong
Hon Timothy FOK Tsun-ting, JP

Public officers attending :

Agenda items IV and V

Mr Rafael HUI, GBS, JP

Secretary for Financial Services

Mr Bryan CHAN

Principal Assistant Secretary for Financial Services

Mr Andrew SHENG, SBS

Chairman, Securities and Futures Commission

Mr David WHITE, JP

Executive Director, Securities and Futures Commission

Agenda item V

Mrs Rebecca LAI, JP

Deputy Secretary for Financial Services

Mr Norman CHAN, JP

Deputy Chief Executive,

Hong Kong Monetary Authority

Clerk in attendance :

Ms Estella CHAN

Chief Assistant Secretary (1)4

Staff in attendance :

Ms Pauline NG

Assistant Secretary General 1

Ms Connie SZETO

Senior Assistant Secretary (1)1

I Confirmation of minutes and matters arising

The Chairman welcomed Hon FUNG Chi-kin as a new member of the Panel.

2. The Chairman advised that the Administration's comments on the minutes of the meeting held on 7 September 1998 had just been received and the minutes would be available for confirmation at the next regular meeting.

II Information papers issued since last meeting
(LC Paper No. CB(1)250/98-99 - Regional Monitor, Issue No. 16: September 1998 provided by the Stock Exchange of Hong Kong

LC Paper No. CB(1)360/98-99 - Complaint about inappropriate suspension of operation of finance companies)

3. Members noted the information papers issued since the last meeting.

III Items for discussion at the next regular meeting scheduled for 7 December 1998
(LC Paper No. CB(1)386/98-99(01) - List of outstanding items for discussion)

4. Members agreed to determine at a later stage items to be discussed at the next regular meeting scheduled for 7 December 1998 at 10:45 am.

5. The Chairman reminded members that two special meetings had been scheduled for 7 and 14 November 1998 at 9:00 am to meet with market practitioners and academics respectively for discussion on the mechanism for defending the linked exchange rate (LER) system.

6. The Chairman also reminded members of the House Committee's decision on 23 October 1998 that the Financial Affairs Panel should be tasked with the responsibility to invite the Financial Secretary (FS) to brief the Panel, as well as all other Members, on macro economic issues such as overall economic performance, measures to revive and revitalize the economy, etc. on a periodic basis. Members agreed to discuss details for holding the briefings at the next regular meeting.

IV A Consultation Paper on New Investor Compensation Arrangements for Hong Kong
(The Consultation Paper issued by the Securities and Futures Commission on 30 September 1998 and LC Paper No. CB(1)413/98-99 issued after the meeting.)

7. At the Chairman's invitation, Chairman, Securities and Futures Commission (C/SFC) briefed members on the proposals for new investor compensation arrangements for clients of members of the Stock Exchange of Hong Kong (SEHK), the details of which were tabled at the meeting. C/SFC highlighted the main features of the proposals as follows :

1. there would be a new investor compensation company (NewCo) which would be recognized and regulated by SFC to take charge of the new investor compensation arrangements including determination of the validity of claims. Rules of the NewCo would be approved by SFC;
   
   
2. the board of directors of NewCo would comprise seven members, three of whom including the chairman were to be appointed by FS, two by SFC and two by SEHK;
   
   
3. the NewCo would have a three-tier financing structure, the first tier being a specified amount of fund retained by NewCo. The second tier would be insurance covering excess risk. The last tier was a back-up credit facility to be provided by Government or private lenders, which could be repayable for instance, by a special levy if it was activated;
   
   
4. a per investor basis of compensation, estimated to be in the region of $100,000 to $250,000, would be introduced to replace the current compensation limit of $8 million on a per broker basis; and
   
   
5. the new compensation arrangements were designed to be flexible that would allow other sectors of the financial market, such as futures, to be incorporated subsequently.

8. The Executive Director, Securities and Futures Commission (ED/SFC) supplemented that the proposals were developed by consultants making reference to international best practices in investor compensation arrangements and existing schemes in place in other jurisdictions. Public consultation which aimed at soliciting views on the proposals from the industry, other interested parties and the public would close by the end of November 1998.

9. Responding to Mr CHEUNG Man-kwong's enquiry about the basis for proposing the per investor level of compensation and views of SEHK on the proposed level, ED/SFC said that the compensation range of $100,000 to $250,000 was purposely set by the consultant to invite comments. In setting the level of compensation, it was important to strike a proper balance between providing sufficient level of compensation and minimizing the problem of moral hazard. In the long run, the per investor compensation level should be affordable by the scheme and acceptable by market practitioners and the investing public. He added that it had always been the intention of SFC and SEHK to review and introduce a more flexible compensation scheme for investors. As regards SEHK's views, ED/SFC said that although the improved scheme had been developed in consultation with SEHK, formal consultation with individual members of SEHK was necessary and SFC was still awaiting their replies.

10. On Mr FUNG Chi-kin's concern about the burden of the special levy imposed on brokers, the Secretary for Financial Services (SFS) advised that as a matter of principle, the levy for repaying the back-up credit facility would have to be borne by investors, brokers and the exchanges. Whilst concerns on the levy were expressed by some members of SEHK, there was no strong objection against the principles of the new arrangements. In this connection, ED/SFC supplemented that the current net assets of the Compensation Fund (CF) of about $500 million comprising partly fees from members of SEHK and, largely, transaction levies paid by investors to date, and the proposed insurance scheme should be sufficient for implementing the new compensation arrangements. It was statistically unlikely that the back-up credit facility would ever be needed. The proposed financing structure of the compensation scheme was designed so that the special levy would only be imposed if the back-up funding was drawn in case of a major default resulting in substantial amounts of claims.

11. Messrs FUNG Chi-kin and James TIEN Pei-chun were concerned that the proposed new compensation arrangements might lead to problems of moral hazard where brokers and investors might become less alert to risk due to over-reliance on the compensation scheme, and it would be unfair for sophisticated brokers and investors to bear the risk of their less prudent counterparts. Mr James TIEN Pei-chun opined that the scheme should also aim to enhance investors and brokerages' awareness of the risks concerned and of their own responsibilities for the decisions made.

12. In response, SFS stressed that the proposed new compensation scheme was an improvement to the existing scheme which had been established since 1970s. The proposal would address problems associated with the existing arrangements and provide investors with an enhanced level of protection commensurate with the rapid growth of the market in recent years. On the issue of moral hazard, C/SFC said that SFC and SEHK were aware of the need to minimize the problem. ED/SFC explained that the proposed financing structure would help to improve the risk management control system in the market by providing disincentives for bad practices. The brokers' risk factor would be reflected in the premium of their insurance, which in practice would encourage them to make effort to improve client asset protection and risk management systems so as to reduce the premium to be paid out as part of their operating costs.

13. Noting that the proposed arrangements were only for clients of members of SEHK, Mr SIN Chung-kai enquired about the overall strategy on compensation for other sectors of the financial market. Pointing out that brokerage failure might partly attribute to insufficient regulation by SFC and that there was no compensation scheme for other types of financial investment, such as bank deposits and properties, Mr FUNG Chi-kin queried the reason for enhancing compensation protection for securities investors only.

14. C/SFC responded that although the current proposals would be initially applicable to members of SEHK, the new arrangements were designed to be flexible and would allow additional arrangements to be developed to cater for other segments of the market. ED/SFC supplemented that the proposed arrangements had been developed in a modular fashion to enable other compensation and insurance arrangements to be added on in future, such as securities margin finance providers, and members of the Hong Kong Futures Exchange (HKFE).

15. As regards the overall policy on protection of investors' assets, SFS said that the Administration had no plan to introduce new compensation schemes for other types of investment at the moment. He explained that in considering the need for establishing a compensation scheme for the financial industry the Administration would take into account, inter alia, the nature of individual segments of the industry, its regulatory regime and the impact of such a scheme on other segments of the financial system. As far as protection for bank depositors was concerned, SFS advised that the issue had been covered in the consultancy study on the banking sector review commissioned by the Hong Kong Monetary Authority (HKMA) early this year and results of the study would be available very soon.

16. Concerning when the new compensation scheme could be put in place and whether it would be applied to the default brokerage cases already known, SFS advised that the Securities (Amendment) Bill 1998, which was necessary to implement the compensation arrangements announced in June 1998 for claimants of the C.A. Pacific Securities Limited, was currently under scrutiny by a LegCo Bills Committee. Whilst it was the intention of the Administration to have the proposed new compensation scheme in place as early as possible in order to remove uncertainties in compensation for future default cases, implementation of such a new scheme would require extensive legislative amendments that inevitably took considerable time. Subject to further consultation with SFC on the detailed legislative timetable, the Administration's target was to submit the relevant bill(s) at the beginning of the 1999-2000 LegCo session.

V Continuation of discussion on Report on Financial Market Review (the Report)
(The Report and the booklet on "Frequently Asked Questions" issued under LC Paper No. CB(1)261/98-99; LC Paper No. CB(1)280/98-99)

Short selling and stock borrowing and lending

17. Noting from the Report that stock borrowing and lending (SBL) activities of Hong Kong stocks conducted off-shore was more active than on-shore and that unreported short selling of Hong Kong stocks based on off-shore borrowing existed both in Hong Kong and overseas, Mr Eric LI Ka-cheung sought the Administration's views on possible regulation of off-shore SBL activities and international co-operation in this regard. He also enquired about measures to improve the access and transparency in the development of a local SBL system.

18. In response, C/SFC said that there had been increasing awareness of and support from the international financial community for the need to enhance knowledge on and transparency of international fund flows. SFC would hold discussions shortly with regulators of major financial markets including those of the United States and United Kingdom in this regard and on related issues, such as access to information on SBL activities in their markets.

19. As far as the development of a local SBL system was concerned, ED/SFC said that SFC was aware of the problem of lack of access of some local market participants to overseas stock lenders because of an under-developed domestic SBL market. To address the problem, the Hong Kong Securities Clearing Company (HKSCC) had already issued a consultation paper on stock lending and borrowing system and planned to introduce a centralized SBL service by the first or second quarter of 1999. The centralised service would be helpful to the further development of the on-shore SBL business as it would improve access of all stock brokers and investors to short selling, and transparency and surveillance of SBL activities in the market. This service would provide a more level playing field for all market participants and had become necessary since the strict enforcement of the T+2 settlement rule and compulsory buy-in arrangement on T+3 for outstanding positions.

20. On the overall monitoring of short selling activities, ED/SFC advised that whilst measures, such as the reinstatement of the "uptick" rule for short selling, had been implemented, the Administration's 30-point programme for the securities and futures markets also included legislative proposals to amend the Securities Ordinance (Cap 333) for increasing the penalties on illegal short selling and enhancing market transparency through the disclosure of total net short sale positions for the Hong Kong market. However, it would take time to implement the proposal as the compilation of net open short positions for the market would need to be based on relevant information collected over a period of time.

21. Mr James TIEN Pei-chun enquired whether the strict enforcement of the T+2 settlement rule since September had caused operational difficulties for brokers, particularly those who conducted SBL activities off-shore. C/SFC replied that although some problems were experienced by overseas brokers in complying with the settlement rule due to the time zone factor, and there were concerns that the strict enforcement of the rule might lead to a reduction in stock trading volume, settlement efficiency remained at about 98% on T+2 and there had been no adverse impact on market turnover. He added that the international trend was moving towards fully automated stock trading systems where scripless and real time transactions could be made in order to reduce risk of settlement failure. SFC would work closely with the clearing houses to develop the relevant systems.

International competition

22. Mr James TIEN Pei-chun remarked that notwithstanding the Liberal Party's support for the Administration's 30-point programme to strengthen the order and transparency of the securities and futures markets, the Administration should be mindful of possible over-regulation, which might have adverse impact on the development of the markets and viability of the financial services industry in the face of increasing competition from other financial centres. He enquired about the Government's responding strategy to Singapore International Monetary Exchange (Simex)'s imminent launch of its Morgan Stanley Capital International Hong Kong Index Futures (HiMSCI). In this connection, Mr CHEUNG Man-kwong further enquired about measures to counter the possibility of "cross-city" manipulation in the markets of Hong Kong and Singapore.

23. Acknowledging the keen competition arising from development of new investment instruments in other financial centres, C/SFC stressed that it was the responsibility of the market bodies concerned to devise appropriate strategies to cope with competition from other markets. Regarding the launching of Simex HiMSCI, SFC as the market regulator was concerned about the possible problem of "regulatory arbitrage" between Hong Kong and Singapore markets. To this end, SFC would discuss with the Monetary Authority of Singapore on the regulatory aspects of the two similar products in these two markets. As to whether SFC would accede to HKFE's possible request of lowering the margin surcharge on futures contracts in order to enhance its competitiveness, C/SFC stressed that SFC would consider such request from the perspective of a prudent regulator committed to enhancing the order and transparency of the securities and futures markets.

24. On the concern about difficulties in detecting cross-market manipulation with the launch of Simex HiMSCI, SFS remarked that tightening up of regulation over the cash market should also contribute to curbing manipulation in the futures market. He emphasized that the Administration would strike an appropriate balance between enhancing the competitiveness of the local financial market and the need to ensure stability of the market.

The Hang Seng Index

25. Mr NG Leung-sing expressed concern about the representativeness of the Hang Seng Index (HSI) and the possibility of the Index being manipulated by speculators to create volatile market situations with a view to reaping profits, particularly with the reduced volume of shares available in the market after Government's substantial acquisition in August. He also enquired about possible improvements to HSI in the future and the time-frame for their implementation.

26. In response, ED/SFC explained that like other stock indices around the world, HSI being a commercial product, was compiled and managed by the HSI Services Limited (HSIS) which was a private company and was therefore outside the supervision of both SFC and SEHK, notwithstanding that trading of derivative products based on HSI was regulated by SFC. Nonetheless, HSI met international standards of size, diversity and representativeness, and was widely used by local and overseas financial institutions and fund managers as a benchmark indicator of Hong Kong market's performance. Regular reviews on HSI were undertaken by a relevant committee of HSIS comprising representatives of the industry and overseas experts in stock indices compilation. Improvements on HSI had been made in response to changes in the local stock market and HSIS would continue to make improvements on HSI to ensure its representativeness and its capability to reflect the performance of the market effectively.

27. On SFC's role in effecting improvements on HSI, C/SFC re-iterated that developments and improvements on stock indices should be driven by market forces. SFC as the market regulator would give advice from the regulatory perspective to prevent manipulation and ensure market stability. As to the basis or criteria for initiating improvements to HSI, ED/SFC remarked that discussions on changing the composition of HSI would be very sensitive and might have substantial market implications. The process should be conducted in strict confidence. He assured members that SFC would continue the co-operation and discussion with HSIS on improving the HSI.

The need for a further review on the financial market

28. Mr Albert HO Chun-yan pointed out that new developments in the local and international financial markets since release of the Report in April, such as the recent Government's operations in the securities market and emergence of financial problems of international hedge funds, might render some of the conclusions and recommendations of the Report obsolete. He opined that the Administration should consider the need of conducting a further review on the financial market in the wake of new developments. He and Mr SIN Chung-kai were also concerned about whether the Government would revise the investment strategy of the Exchange Fund (EF) to include local stocks since part of the EF had already been used to fund the operations in the securities market in August.

29. In response, the Deputy Chief Executive, Hong Kong Monetary Authority (DCE/HKMA) said that the acquisition of the portfolio of $118 billion worth of shares was for stabilizing the market and should not pre-empt consideration of the long-term investment strategy of EF. A review on the long term investment strategy of EF, including whether the portfolio should include local securities and the relative proportions of its components, would need to be conducted.

30. SFS noted that there was no substance in the speculation that after the August operations, the Government had decided to hold local stocks under the EF as a long term strategy. He stressed that the Government's objective was still to dispose of the shares acquired in August and retreat from the market in an orderly manner. This objective should not be in conflict with the Government's intention to review the overall investment strategy of EF for the long term. He advised that local securities had always been in the investment portfolio of the Land Fund (LF). As changes in overall investment strategy of EF and LF would have profound implications for the financial market, the Administration would consider the issue thoroughly and prudently. While there had not been any firm decision on the matter, he assured members that appropriate consultation with relevant parties would be conducted when necessary. He also clarified that while the Government was committed to maintaining Hong Kong's free and non-interventionist economic policy, it would not preclude the possibility of taking actions in the securities market if considered necessary and critical for maintaining the stability and integrity of our financial system.

31. Mr Eric LI Ka-cheung declared interest as a board member of the Exchange Fund Investment Limited (EFIL) set up under the Exchange Fund to manage the securities acquired by the Government in August 1998. He clarified that the objective of EFIL was to dispose of the shares as soon as possible in an orderly manner without disrupting the market. He also remarked that the issue of whether the investments of EF should include Hong Kong securities was the purview of the Exchange Fund Advisory Committee.

Interest rate pain

32. Mr Kenneth TING Woo-shou expressed concern that retail interest rates remained at a high level even with the present stable market situation. The prime rate standing at 9.75% with a nil inflation rate inflicted much pain to the economy and the business sector. Given the prevailing market situation, he opined that there should be ample room for further interest rate cuts. Mr James TIEN Pei-chun further remarked that a stable and low interest rate environment was vital to economic recovery and enquired about possible measures to increase liquidity for banks with a view to easing the high interest rate pressure.

33. DCE/HKMA responded that whilst HKMA recognized the pressure of high interest rates on businesses, setting of interest rates was a commercial decision made by banks based on factors like cost of funds and market risk. As the financial market had stabilized and interest rates had come down, it was anticipated that the trend of interest rate cuts would continue and be expedited by increasing competition among banks. The feasibility of lowering short term retail deposit interest rates was continually reviewed by the Hong Kong Association of Banks.

34. As regards the possibility of HKMA injecting liquidity into the economy to relieve the interest rate pain, DCE/HKMA explained that as the objective of HKMA's monetary policy was to maintain a stable exchange rate for the Hong Kong dollar within the framework of LER system under the currency board arrangements, it would not perform any function which would conflict with its role as a currency board, such as to manipulate the level of money supply to stabilize the interest rate. He added that under the LER system, it was unavoidable that interest rates would increase for defence of the Hong Kong dollar during periods of currency attacks, and adjustments in the local economy had to come through lowering of domestic prices to regain competitiveness amid rapid depreciation of Asian currencies.

35. As regards economic recovery in Hong Kong, DCE/HKMA said that it depended on a number of factors including improvements in the external economic environment and the economic cycle. He remarked that Hong Kong could still be the first to recover in the Region although its economic recovery might require impetus from some initial improvements in economic performance in neighbouring economies, especially Japan.

VI Any other business

36. There being no other business, the meeting ended at 12:45 pm.


Legislative Council Secretariat
31 March 1999