Revised
(3/12/1998)

LC Paper No. CB(1) 535/98-99
(These minutes have been
seen by the Administration)

Ref : CB1/PL/FA/1

Members present :

Hon Ambrose LAU Hon-chuen, JP (Chairman)
Hon Kenneth TING Woo-shou, JP
Hon James TIEN Pei-chun, JP
Hon David CHU Yu-lin
Hon Cyd HO Sau-lan
Hon Albert HO Chun-yan
Hon NG Leung-sing
Hon Margaret NG
Hon Ronald ARCULLI, JP
Hon James TO Kun-sun
Hon CHEUNG Man-kwong
Hon Ambrose CHEUNG Wing-sum, JP
Hon HUI Cheung-ching
Dr Hon Philip WONG Yu-hong
Hon Jasper TSANG Yok-sing, JP
Hon Timothy FOK Tsun-ting, JP

Members attending :

Hon LEE Wing-tat
Hon Martin LEE Chu-ming, SC, JP
Hon Christine LOH
Hon CHAN Yuen-han
Hon CHAN Kam-lam
Hon LAU Kong-wah
Hon Emily LAU Wai-hing, JP
Hon CHOY So-yuk

Members absent :

Hon Eric LI Ka-cheung, JP (Deputy Chairman)
Dr Hon David LI Kwok-po, JP
Hon Bernard CHAN
Hon SIN Chung-kai
Hon CHIM Pui-chung

Public officers attending :

Mr Donald TSANG, JP

Financial Secretary

Mrs Rebecca LAI, JP

Secretary for Financial Services (Acting)

Mr Norman CHAN, JP

Deputy Chief Executive

Hong Kong Monetary Authority

Mrs Laura CHA, JP

Chairman (Acting)

Securities and Futures Commission

Mr David White, JP

Executive Director (Supervision of Markets)

Securities and Futures Commission

Attendance by invitation :

Stock Exchange of Hong Kong

Mr H C LEE, JP Chairman

Mr Alec TSUI, Chief Executive

Hong Kong Futures Exchange

Dr Geoffrey YEH, Chairman

Mr William Grossman, General Counsel

Hong Kong Securities Clearing Company Ltd.

Mr John CHAN, JP, Chairman

Mr Stewart SHING, Chief Executive

Clerk in attendance :

Ms Estella CHAN,

Chief Assistant Secretary (1)4

Staff in attendance :

Ms Pauline NG,

Assistant Secretary General 1

Mr Andy LAU,

Senior Assistant Secretary (1) 6

I Continuation of the discussion on actions taken by Government in the foreign exchange, stock and futures markets
(LC Paper No. CB(1) 172 - Strengthening of currency board arrangements in Hong Kong,

LC Paper No. CB(1) 175 - Measures to strengthen the order and transparency of securities and futures markets,

LC Paper No. CB(1) 185 - Arrangements for settlement of unsettled CNS short positions for trades done on 27 and 28 August 1998)

The Chairman invited members to continue the discussion on the actions taken by the Government in the foreign exchange, stock and futures markets, which was adjourned due to time constraint at the meeting on 7 September 1998.

Meeting with the Administration

Government's preparedness to counter market manipulation

2. Referring to some members' comments that the Government was slow in reacting to market manipulation, the Financial Secretary (FS) explained that the Administration was also concerned about the possibility of cross-market manipulation during the speculative attacks on the Hong Kong dollar in October 1997 and in January 1998, and had therefore monitored the market situation carefully. The evidence then available did not support the allegation that the primary objective of the currency speculators was to reap profits from the securities and futures markets. However, the circumstances in August this year were different. There was clear evidence of cross-market manipulation as shown from the information given below:

1. In October 1997, when the overnight interbank interest rate soared to almost 300%, the Hang Seng Index (HSI) was at 9,000 to 10,000 points and daily turnover of the cash market was in the region of HK$20 - 35 billion. The open interest of HSI futures apparently was not affected by the volatility in the currency market and stayed in the range of 60,000 to 70,000 contracts;
   
   
2. In January 1998, when there were again attacks on the Hong Kong dollar, HSI stayed in the region of 9,000 to 10,000 points and the daily turnover of the cash market was in the region of HK$10 billion. The open interest of HSI futures stayed in the range of 60,000 to 70,000 contracts. No double-play was detected in the markets; and
   
   
3. In August 1998, whilst the HSI dropped to 6,600 points and the daily turnover in the cash market reduced to HK$4 - 5 billion, the open interest of HSI futures rose sharply by over 10,000 contracts in three consecutive trading days to over 110,000 contracts. At the same time, there were severe attacks on the Hong Kong dollar round the clock in the local and overseas markets, giving strong indications that there was planned and co-ordinated cross-market manipulation.

3. Some members remained of the view that Government had underestimated the seriousness of the financial turmoil and should have put in place measures to strengthen the currency board arrangements at an earlier stage. Mr Ambrose CHEUNG Wing-sum suggested that the Government, apart from reviewing the regulatory measures, should also review its own decision-making process including the solicitation of views from academics, professionals and market practitioners. Mr LAU Kong-wah opined that the Administration should have been more proactive in taking appropriate measures to take account of the market situation and asked how the Administration would better prepare itself in this respect in future.

4. FS pointed out that the Administration, like other financial analysts, treasury secretaries, finance ministers and central bankers elsewhere, might have underestimated the contagion effects of the Asian financial turmoil last year. While Hong Kong could not stay immune from the contagion, the Administration had initiated a series of measures to make the market systems less susceptible to cross-market manipulation. These measures could not be instituted earlier because regulatory control measures often created repercussions elsewhere. It was therefore necessary to examine the full implications, the need for such measures and the latest market development before introducing any changes.

5. Responding to members' concern about the impact of massive capital flows on the financial markets after the speculators had realized a substantial amount of stocks at the end of August, FS said that the management of capital inflow and outflow would need to be addressed by the Government at the international level. As there was currently no international standard or agreement governing the operations of hedge funds including disclosure requirements, Government would need to raise the issue for discussion at the international level. Meanwhile, the series of measures to strengthen the currency board arrangements and the order and transparency of the securities and futures markets would serve to improve the system and make it less susceptible to market manipulation.

6. On the suggestion to review the decision-making mechanism of the Government, FS said that whilst different channels were available for the Government to seek advice from various sources, the final decision of the operations had to rest with the top officials and their deputies, in particular when the nature of the operations was highly confidential, sensitive and critical. To further improve the existing mechanism, a Subcommittee on Currency Board Operations had recently been set up under the Exchange Fund Advisory Committee (EFAC) to oversee the operation of the currency board arrangements in Hong Kong.

7. Regarding consultation with academics, FS advised that since the outbreak of the Asian financial turmoil in October 1997, the Administration had already invited academics to provide advice on how to further improve the market systems. Whilst some of the measures announced were akin to those proposed by academics, the implementation was subject to refinement and having regard to the latest development in the market. The Administration would continue to seek advice from academics.

Utilization of assets under the Exchange Fund

8. Miss Margaret NG pointed out that according to Hong Kong Monetary Authority (HKMA)'s latest Annual Report, the net assets of the Exchange Fund was only in the region of US$96 billion, which apparently had included the Land Fund and Government's fiscal reserves. She enquired if the Government had utilised any part of the Land Fund to finance its recent operations in the securities and futures markets, and whether the Legislative Council's approval was required for the use of the Land Fund and the fiscal reserves to defend the currency. She also asked FS to confirm whether the funds involved had exceeded the Government's original estimate.

9. In response, FS said that the Exchange Fund was established for the purpose of maintaining the stability of the Hong Kong dollar. The foreign currency assets of about US$96 billion held in the Exchange Fund and the Land Fund could also be used for the aforesaid purpose. He assured members that there was still a substantial amount of foreign currency assets available for defending the Hong Kong dollar. Information on the foreign currency reserves held in the Exchange Fund and the Land Fund was published on a monthly basis.

10. As regards the Legislative Council's role in this respect, he said that approval from the Finance Committee was required for the use of the fiscal reserves. As for the Land Fund, he would check the exact provision of the Resolution under which the Land Fund was established and would provide a written reply after the meeting.	FS

(Post-meeting note: This was subsequently explained by the Acting Secretary for Financial Services at the LegCo motion debate on 9 September 1998, an extract of which is attached.)

11 On the estimation of the capital requirement for the operations, FS said that due to the financial instability in Russia and the Wall Street market slump occured at the time of the market operations, the actual amount of capital required was in excess of the Government's original estimate, but the difference was not significant. He would provide further details of the assets procured and the capital involved at an opportune moment when the markets became more stable.

Conflict of interests

12 Given that HKMA staff might have access to privileged information during the operations, a member enquired whether it would constitute a contravention of the Securities (Insider Dealing) Ordinance (Cap 395) or other relevant ordinances. FS stressed that Government had no intention to manipulate the market nor to fix market prices at any particular levels. The Government's actions in the markets aimed at sending market manipulators a clear message that they could no longer be sure of profiting from cross-market manipulation. He pointed out that only a designated group of personnel of the HKMA was involved in the operations and none of them was involved in any work relating to banking supervision. He reiterated Government's intention to set up an independent company to manage the assets procured in the operations. As regards whether Government would be required to disclose the securities held, FS assured members that Government considered it of utmost importance to maintain the integrity of the system. The Government would disclose information about the assets procured at an opportune moment as it was in the public interest.

13. Referring to the issue of conflict of interest on persons involved in the proposed cross-market surveillance committee as they would have access to sensitive information, FS said that Government would take precautions to ensure that there was a proper mechanism like that for the EFAC to prevent members from using privileged information for their own benefits. The system for EFAC had been working well over the years. Appropriate legislation would be also in place to prevent individuals from using such kind of privileged information for their own benefits.

(Post-meeting note: On the advice of the Administration, the proposed "cross-market supervision committee" mentioned in the information paper should be renamed "cross-market surveillance committee".)

Possibility of further actions in the markets

14. Regarding the "extreme conditions" referred to in the seven measures for strengthening the currency board arrangements to render if necessary for the Government to take actions in the interbank market, FS explained that the circumstances within the scope of "extreme conditions" should be similar to those in August 1998, where substantial speculative selling of Hong Kong dollars leading to a sharp increase in the Hong Kong dollar interest rate and exceptional volatility in the securities and futures markets were observed. There should be an absolute need for the Administration to restore order in the markets in view of the circumstances.

15. In response to a member's question, FS confirmed "maintaining economic stability" fell outside the scope of "public interests" in the context of authorising public officers to intercept the transmission of messages under section 33 of the Telecommunication Ordinance (Cap 106).

Monitoring the work of regulatory bodies

16. Whilst indicating his support to the Government's move to maintain the stability of the Hong Kong dollar, a member pointed out that the episode in August had revealed deficiencies in the co-ordination among the Securities and Futures Commission (SFC), the Stock Exchange of Hong Kong (SEHK), the Hong Kong Futures Exchange (HKFE) and the Hong Kong Securities and Clearing Company Limited (HKSCC). He asked if the Government would review the operation of these regulatory bodies.

17. FS responded that the present regulatory structure was drawn up on the basis of the Report of the Securities Review Committee published in May 1988 on the operation and regulation of the Hong Kong securities industry. One of the major principles adopted was that Government should not get involved in the daily operation and regulation of the exchanges and their activities. The system had worked well over the years. However, in the light of the recent market situations, the Administration had put forward a series of measures to further enhance the order and transparency of the securities and futures markets, such as the establishment of a cross-market surveillance committee to facilitate regular exchange of market information among HKMA, SFC, SEHK, HKFE and HKSCC. The Acting Secretary for Financial Services (SFS(Ag)) also advised that since the outbreak of the financial turmoil last year, the Administration had taken a thorough review on the currency defence mechanism and the operations of the securities and futures markets and had identified a number of areas where improvements could be made. The findings and recommendations were included in the Report on Financial Market Review published by the Financial Services Bureau in April 1998. A task force was then established to monitor the progress of implementation of the recommendations made therein. She said that the review of the regulatory framework was an on-going task and the Administration would work closely with the regulatory bodies to introduce appropriate measures with a view to maintaining the robustness and integrity of the market systems.

18. A member pointed out that the Chief Executives of HKMA and HKSCC appeared to have different understanding of the settlement rules, and asked if it was due to the lack of coordination amongst the regulatory bodies. FS responded that owing to the confidentiality of the operations, SEHK, HKFE and HKSCC were not informed of Government's plan in advance. Due to the exceptionally high turnover, especially at end of August, certain deficiencies in the market systems were indeed exposed. Nevertheless, defaulter could not escape from their obligations as the SFC would continue its investigation and take legal actions against any illegal activities. The strict enforcement of the T+2 rule was also being pursued under the Government's 30-point measures.

19. As to whether the proposed measures to strengthen the order and transparency of the securities and futures markets had been agreed by the respective regulatory bodies, FS said that the measures, being part of an overall strategy to strengthen the financial market, represented the initial consensus among the Administration and the Chairmen of the respective bodies. The final decision, however, would be subject to the approval of the Board of Directors of the respective bodies. He believed that they were aware of the urgency of the matter and would make their decisions as early as possible.

20. FS further explained that individual bodies might have their own concerns and interests in respect of the proposed measures. Given the rapid development in the market, it would therefore be necessary that the Government would be able to react promptly to market changes by giving directives to the respective bodies at critical times. Whilst it was the consensus of the regulatory bodies to strengthen the financial system in Hong Kong, the remaining were technical and operational in nature and could be resolved through discussion.

21. Whilst supporting the Government's move to introduce measures to improve the regulatory regime to make the markets less susceptible to manipulation, a member pointed out that the framework should be fair, objective, clear, and transparent, and should not be discriminatory against any parties. However, given that the Government had become a major player in the securities and futures markets with a substantial amount of stocks in hand, he expressed concern about the proposal to empower the Chief Executive of HKSAR to give direction to the exchanges and clearing houses as the Chief Executive saw fit. He asked if this was a reflection of Government's worry about the effectiveness of the measures announced or its incapability to co-ordinate the operations of the regulatory bodies in case of emergency.

22. FS responded that the measures announced were intended to maintain the stability of the financial markets. In proposing the various measures, the Administration had already considered the issue of market acceptability and the need to avoid granting excessive discretionary power to regulatory bodies. However, he pointed out that given the dynamic nature of the equity and derivative markets, there was a need to strengthen the power of the Chief Executive of HKSAR to give direction to the exchanges and clearing houses to ensure that Government could react promptly whenever public interests were under threat. He assured members that the Chief Executive would only exercise his power under very exceptional circumstances and similar provisions were also in place in other ordinances. He further advised that such discretionary power was also provided in other countries for the handling of unforeable situations. At the request of the member, he undertook to provide further information about similar legislation in other countries when the relevant legislative proposals were to be introduced into the Council.

Admin

Meeting with the Administration and regulatory bodies on measures to strengthen the order and transparency of securities and futures market

Securities and Futures Commission

23. The Chairman, Securities and Futures Commission (Acting) (C/SFC (Ag)) briefed members that SFC would strengthen enforcement and prosecution against illegal short selling. Investigations on the large amount of outstanding positions after T+2 in respect of trades executed on 27 and 28 August had already started, and prosecution would follow if justified. SFC was in support of the Government's proposals to increase the penalties on illegal short selling, and to make false reporting to SFC and the exchanges and unreported short selling a criminal offence. On proposals to move towards a scripless market and to launch full investor participation in Central Clearing and Settlement System, she advised that these were longer term objectives and SFC would examine the feasibility with all parties concerned in due course.

24. Addressing members' concern about whether the measures would lead to heavy-handed over-regulation, C/SFC(Ag) explained that in view of the special circumstances, a number of loopholes in the market system had been revealed. SFC would try its best to plug these loopholes. Nevertheless, for the long term development of Hong Kong, over-regulation would not be desirable as it would lead to contraction of the market. SFC would liaise with parties concerned with a view to striking a balance between market viability and the need for prudent regulation. The introduction of remedial measures at this critical moment might be justified but these measures should be subject to review as appropriate.

25. Referring to FS's remarks that there were cross-market manipulation in the financial markets, a member enquired whether SFC had ever identified such activities and duly informed the Government. C/SFC (Ag) said that SFC was only tasked with the responsibility of maintaining the order of the securities and futures markets. As the regulation of the currency market was the purview of HKMA, it would not be possible for SFC to detect any cross-market manipulation in this regard. As to Government's plan to take actions in the securities and futures markets, she said that the Chairman of the SFC was only informed of the Government's intention in the morning on 14 August.

26. Regarding whether Government's operations had contravened any provisions in the Laws of Hong Kong, C/SFC(Ag) advised that section 66 of the Interpretation and General Clauses Ordinance (Cap 1) stipulated that "no ordinance shall in any manner whatsoever affect the right of or be binding on the State unless it is therein expressly provided or unless it appears by necessary implication that the State is bound thereby". Since there was no expressed provision to bind the State in the relevant ordinances, the Government's operations were outside the jurisidiction of SFC.

Hong Kong Futures Exchange

27. The General Counsel, Hong Kong Futures Exchange (GC/HKFE) briefed members that HKFE shared the common view to stabilize market conditions and would co-operate with other parties to achieve the objective.

28. On proposals to strengthen the enforcement of HKFE rules on capping trade limits in relation to brokers' capital and limiting the "buffer" to no more than 20% of the capital, GC/HKFE said that HKFE had been adhering to its rules but would continue to explore ways to ensure more effective risk management. Indeed, all HKFE members had abided by the Financial Resources Rule approved by SFC. Regarding disclosure of real-time information of holders of large open interests to SFC on a daily basis, GC/HKFE advised that it was already a legal requirement and the necessary enforcement would continue.

29. As to public disclosure of large open interests at a broker level to the market, GC/HKFE remarked that the proposal might not be able to provide useful information to the public. Without corresponding disclosure of the offsetting or complementary positions in the equities or other related markets, the kind of information disclosed could be misleading. HKFE would further examine this proposal in collaboration with SFC and Government.

30. Regarding the proposal to reduce the threshold for a margin surcharge to open interests of 5,000 contracts or below, GC/HKFE advised that HKFE had already imposed a margin surcharge of 50% to open interests of 10,000 contracts or above on 29 August. This had already led to a significant reduction of the gross open interest of Hang Seng Index futures contracts from 107,000 to 82,000 contracts. Over 50% of this reduction were concentrated in a small number of accounts. The HKFE considered it more appropriate to allow a longer time to test the effectiveness of the existing measure before reviewing the threshold.

31. On the timetable for the migration of Hang Seng Index futures trading from open outcry to the Automated Trading System, GC/HKFE said that HKFE members had been requested to install the hardware and software of the system by February next year. By then, HKFE would be in a better position to estimate the actual completion date of the project. Whilst HKFE would attempt to advance the completion date from the end of 1999 to the third quarter of 1999, the full integrity of the system would not be compromised. Furthermore, HKFE would work with parties concerned to set up a cross-market early warning system.

32. Regarding the concern about whether the proposed measures would lead to over-regulation of the markets, the Chairman/HKFE (C/HKFE) responded that the Board of Directors was also very concerned about the proposal for disclosure of large open interests at a broker level to the market. They were worried that such restriction would drive away investors. He said that the products available at HKFE were not franchised, hence not exclusive to the exchange. If too much restriction was imposed, overseas exchanges could take the advantage to launch similar products in their markets. If the development of Hang Seng Index futures was affected, it would also upset the complementary role of futures market to the securities market, which in turn, would affect the contribution of our market to the mobilisation of capital and the economic restructuring process in the Mainland. HKFE would closely liaise with SFC and Government to see how a balanced approach could be adopted.

33. About the query of whether some of the senior officials of HKFE were associated with hedge fund companies under Mr George Soros and large foreign securities firms like Morgan Stanley, C/HKFE clarified that no senior official of HKFE had ever worked with Mr Soros or in large foreign brokerage houses. GC/HKFE added that the access of market sensitive information in HKFE was limited to only a few persons, and none of these persons were associated with the firms mentioned by the member.

Stock Exchange of Hong Kong

34. The Chairman, Stock Exchange of Hong Kong briefed members that SEHK welcomed Government's move to review the operations of the financial market from time to time so as to maintain its stability. SEHK was, in principle, in support of the Government's proposals. He informed members that some of the measures proposed had already been implemented and some were still under discussion within SEHK.

Hong Kong Securities and Clearing Company Limited

35. The Chairman, Hong Kong Securities and Clearing Company Limited (C/HKSCC) said that HKSCC supported the principle to maintain the order and stability of the financial market. The HKSCC Board would shortly hold a meeting to discuss the details of the measures proposed by Government. Whilst the final decision of the measures would rest with the Board of Directors, he and the Chief Executive of HKSCC had recommended that the proposals to revise the CCASS rules to strictly enforce the T+2 settlement requirement and to impose penalties on default brokers be implemented. He trusted that the Board of Directors would consider their recommendation favourably in the light of the prevailing market situation.

36. Regarding the proposal to institute compulsory stock lending and borrowing arrangements for outstanding positions after close of market on T+2, C/HKSCC advised that in order to help the development of a local stock borrowing and lending market, HKSCC intended to introduce its own stock borrowing and lending facilities. This centralized service would make on-shore stock borrowing and lending facilities much more accessible to all market participants. He hoped to announce further details in due course.

T+2 settlement rule

37. A member pointed out that according to his recollection, there had been a hot debate between local and overseas brokers over the length of the settlement period prior to the introduction of the Central Clearing and Settlement System (CCASS), and the T+2 settlement rule was adopted after extensive consultation. He expressed strong dissatisfaction over the stretched settlement period for the trades executed on 27 and 28 August, where a buy-in order would only be executed by HKSCC for brokers if stocks were not delivered by 11:00 am on T+5.

38. C/HKSCC advised that according to the rules of HKSCC, a buy-in could only be effected in relation to Market Contracts which had been overdue for settlement for more than one Settlement Day (i.e. not earlier than T+4). General Rules 3501 (iii) and (iv), which governed the late delivery obligation of Market Contracts of which the broker was the seller, specifically provided that a buy-in should be applied to Market Contracts which had been overdue for settlement for more than one Settlement Day. Such an arrangement had been in place since CCASS started operation in June 1992. The Chief Executive/HKSCC (CE/HKSCC) added that taking into account the time zone factor, there was a need to allow sufficient time for overseas investors to make arrangement for settlement.

39. The Executive Director (Supervision of Markets)/SFC further advised that the settlement rule was adopted after extensive consultation within the industry and had not been changed since its adoption. In the past, average settlement efficiency of continuous net settlement stock positions was over 95% on T+2, rising to 99%-99.5% on the day after settlement day, i.e. T+3. The remaining positions could be settled on T+4. Compared with other countries where settlement periods ranged from T+1 to T+10, the T+2 settlement efficiency in Hong Kong was already very high.

40. CE/HKSCC said that in response to requests made by Government on 29 August 1998 and after consultation with SFC, HKSCC informed the market on 31 August 1998 that as of 1 September 1998, HKSCC would strictly monitor the settlement obligation of broker participants under the Continuous Net Settlement System. Once the selling broker failed to deliver the required securities by T+2, HKSCC might at its discretion effect a buy-in on T+3. HKSCC's legal advisor was of the view that the modified rules could not be retrospective and HKSCC could not apply the revised settlement arrangements to trades executed on 27 and 28 August 1998.

41. On whether broker participants who failed to deliver stocks on the settlement day were largely overseas brokers, CE/HKSCC replied that HKSCC did not have such statistics. He, however, stressed that the settlement rule was consistent with the international standard, under which there was a built-in risk management mechanism to avoid the default of broker participants.

42. At Members' request, the Administration agreed to provide further information on whether the Chief Executive/HKMA was aware of the settlement rule when Government took action in the markets.	Admin

(Post-meeting note: A written reply provided by the Administration had been circulated under LC Paper No. CB(1) 196/98-99 dated 14 September 1998)

43. In view of the time constraint, the Chairman advised that the discussion would continue on Saturday, 12 September 1998 at 9.00 am.

II Any other business

44. There being no other business, the meeting ended at 6:45 pm.


Legislative Council Secretariat
3 December 1998