Information Note for the Legislative Council
Panel on Financial Affairs
Report on Financial Market Review
INTRODUCTION
This paper summarises the progress of implementation of the recommendations of the Report on Financial Market Review (the Report) published by the Financial Services Bureau on 23 April 1998. The paper also incorporates progress of the measures proposed under the 30-point programme announced recently by the Government as well as the 7 technical measures already put into force by the Hong Kong Monetary Authority (HKMA).
DETAILS
Background
2. The regional financial turmoil that first started in Thailand in late May 1997 spread to Hong Kong in late October 1997. Though Hong Kong rode through the stormy period with the currency remaining stable and the securities and futures markets operating in an orderly and efficient way, the combination of the interest rate hike and the asset price adjustments in both the securities and property sectors caused serious concern among the local community.
3. In early November 1997 the Financial Secretary made public his intention to call for a review of the operation of the financial markets. The then Provisional Legislative Council (PLC) further passed a motion on 26 November 1997 calling upon the Administration to do the same. During the debate on the motion, there was an overwhelming support among PLC Members for maintaining the linked exchange rate (LER) with the US dollar. Nonetheless, they also strongly urged the Administration to review the means of defending our currency mechanism as well as the operation of the financial markets. The motion also called for actions to enhance the Government's ability to withstand such volatility and strengthen investor education. Supporting the motion, the Secretary for Financial Services reiterated the Administration's commitment to launch a comprehensive review once the turmoil had settled.
4. The Review has been premised on two fundamental principles. Firstly, consistent with the mandate in the Basic Law, and bearing in mind the long-term interests of Hong Kong as an open and externally-oriented economy, we must maintain and enhance the status of Hong Kong as an international financial centre. Secondly, consistent with the objective of maintaining the stability of the Hong Kong dollar, the LER system which has served Hong Kong well must be preserved. On the basis of these two principles, the Review focused on the technical and practical levels to see if the operation of the existing systems can be further refined or improved. With the contribution of , inter alia, the HKMA and the Securities and Futures Commission (SFC) in their respective ambits, the Administration concluded the Review in April and the Report was released on 23 April 1998.
5. The Review confirms that the defence mechanism for the currency had very effectively preserved the stability of the exchange rate and the monetary system and that the operating systems of the securities and futures markets had been functioning effectively and were able to weather the extreme volatilities during the financial turmoil. That notwithstanding, the Review also identified a number of areas where improvements could be made. In drawing up the conclusions and recommendations, we have been careful in striking a balance between the need for prudent regulation and the room necessary for free market development, and between the need for improvements and the need for stability and certainty. These conclusions and recommendations are summarised in Chapter 5 of the Report. The following summarises progress made so far of the implementation of the recommendations.
6. In addition, following the incursions into the market in the second half of August, the HKMA and the Administration have introduced further measures on both the monetary aspect and the securities and futures markets. The progress of these measures is also summarised in the following paragraphs.
Review on the Currency Defence
The Currency Board Arrangements and the Role of Interest Rates (paras. 3.128-129)
7. It is mentioned in the Report that the use of interest rates as the stabilizer, whether or not an automatic one, cannot be avoided in the operation of fixed exchange rate system. The seven technical measures introduced by the HKMA on 5 September 1998 are part of our ongoing efforts to strengthen the currency board arrangements in the light of changing market conditions and our experience in defending the link. The technical measures are not intended to shield the Hong Kong economy from the interest rate pain, as interest rate adjustment is part and parcel of the auto-pilot mechanism under the currency board system to ensure exchange rate stability. Hong Kong is determined and prepared to bear the interest rate adjustments. Nevertheless, by making our foreign exchange and money markets less susceptible to manipulation, the measures will help to reduce the vulnerability of the Hong Kong economy to excessive interest rate volatility.
Improving Transparency of HKMA's Market Activities (paras. 3.130 - 3.135 of the Report)
8. In the Report, the HKMA has pledged to ensure a high degree of transparency in its involvement in the markets as far as practicable. Since 11 June 1998, the HKMA has started to provide, through the HKMA page at Reuters, Bloomberg and Bridge News, a forecast of changes in the Aggregate Balance 1 of the banks clearing accounts with the HKMA attributable to HKMA's foreign exchange transactions. The information is now available almost on real time and this is unparalleled in any other jurisdictions. The announcement of the forecast change in the Aggregate Balance resulting from HKMA's foreign exchange transactions will enable market participants to anticipate the changes in the liquidity conditions in the interbank market. This will enhance the transparency of the linked exchange rate system and facilitate a more efficient adjustment in the interbank interest rates.
9. To move towards greater transparency in the operation of the currency board arrangements, the HKMA will further work towards publishing the part of the Exchange Fund balance sheet showing Currency Board Operations, as frequently as it is technically feasible to do so. This will show, and enhance public understanding of, how HKMA is adhering to the discipline of a Currency Board system.
To Continue to Improve the Soundness and Robustness of the Banking Sector (paras. 3.136 - 3.138)
10. It has been emphasised in the Report that a safe and sound banking system can only be achieved if our supervisory system ensures that the risks in the banking system are being properly identified, managed and controlled, with adequate capital to support these risks. To this end, the HKMA has completed a review of the minimum capital adequacy ratios 2 of the local banks in June 1998. The purpose of the review is to help sustain the already high capital adequacy ratios maintained by local banks (the average was more than 18% as at end-June 1998) and to remove inconsistencies that have arisen over time in the minimum ratios set for individual banks. The outcome of the review is that the minimum ratios that apply to individual banks will be set in the range of 10-12%. This will result in an increase in the minimum ratios of some banks. The increases in the minimum ratios will take effect from 31 December 1998. This is not expected to cause any problems as all the institutions concerned have capital adequacy ratios well above their respective new minimum.
11. It is also mentioned in para. 3.108 of the Report that the HKMA will commission a consultancy study into the strategic outlook of the banking sector. The consultancy study has been going on. We will assess the recommendations of the study when available later this year to determine if any necessary regulatory and supervisory changes should be made. We will also introduce a Banking (Amendment) Bill in 1999 which, among other things, will bring our legal framework in line with the Basle Committee's Core Principles for Banking Supervision in the few areas where we have not yet fully complied with.
12. The HKMA has also been promoting the development of an active Hong Kong dollar repo market, making use of high quality debt securities held by banks as collateral for repo transactions. Such a market will help alleviate counterparty risk and consequently improve liquidity by facilitating interbank lending. We expect activities to pick up when market conventions are more fully developed.
The Development of Fixed Rate Debt Market (paras. 3.139-3.141)
13. It is identified in the Report that the promotion of fixed rate long term loans would help borrowers withstand fluctuations in short term interest rates. In this regard, the Hong Kong Mortgage Corporation (HKMC) has successfully completed the $1.4 billion pilot scheme to promote fixed rate mortgages. The scheme was expanded in September 1998 into a regular programme under which the HKMC is committed to purchasing $3.5 billion fixed rate mortgages in the next six months to March 1999. The HKMC has also been streamlining the purchase of mortgages from banks to facilitate the further development of money and debt markets and to enable banks to manage better their lending business and liquidity position. In addition, the HKMC introduced a Forward Commitment Facility in mid June 1998, which would commit itself to the purchase of an agreed amount of mortgages from the banks in the next 12 months. The Facility would give banks greater assurance of the liquidity of their mortgage portfolio, enable them to plan their lending business more effectively, and improve the efficiency of HKMC's mortgage purchase operations. The Facility has been very well received by the banks. In the 12-month period starting from late July 1998, they have committed themselves to the sale of an aggregate amount of HK$13.8 billion mortgage, exceeding the HKMC's target of HK$13 billion.
Review on the Securities and Futures Markets
Short Selling and Stock Borrowing and Lending (para. 4.14-4.32)
14. The Report recommends more stringent reporting requirements for short open interest to increase market transparency. Since the conclusion of the Review, the SFC and the Stock Exchange of Hong Kong (SEHK) have been working closely together to explore ways to improve the market transparency of short selling. As part of the 30-point programme recently announced by the Government, the SEHK reinstated the "uptick" rule for short selling on 7 September 1998. The rule prohibits short sales at a price below current best market price and thereby prevents the exacerbation of market downfall due to short sales. The SEHK is also considering proposals to increase disciplinary actions against contravention of its rules including penalty charges, temporary suspension of trading and revocation of membership for repeated offenders. The SEHK will also keep the List of Designated Securities for short selling under close scrutiny. On the legislation front, the SFC is finalising its proposal to make unreported short selling a criminal offence as well as to increase the penalties for illegal short selling.
15. In light of the exceedingly high level of short selling activities on 27 and 28 August 1998, the SFC and SEHK have, as suggested in the 30-point programme, issued more than 1,500 questionnaires to brokers, custodians, exempt dealers (including banks), fund managers and finance companies in relation to transactions in constituent stocks of Hang Seng Index as at T+2. They are currently analysing the returns to prioritise further investigation of possible naked short selling or breaches of SEHK Rules or SFC Codes of Conduct.
16. Stock Borrowing and Lending (SBL) is the most important complementary activity to regulated short selling. The International Organisation of Securities Commissions (IOSCO) and the Bank for International Settlements (BIS) have recently jointly convened a study on current market practices of SBL in their respective member markets. The results of the study will serve as useful reference for our regulators to have a better understanding of both on-shore and off-shore SBL activities, thus enabling them to respond to the regulatory need more effectively. In addition, in order to further develop the local SBL market, the Hong Kong Securities Clearing Company (HKSCC) will introduce a centralised SBL service by the first quarter of 1999. It will also help improve the transparency and surveillance of SBL activities in Hong Kong.
17. As part of the 30-point programme, the Government would in consultation with the SFC and the HKSCC in the near future commence a study on the regulation over SBL activities including possible regulation over custodians and other stock lenders so as to enhance transparency of SBL and provide better protection for the interests of beneficiary owners of stocks.
Share Margin Financing (para 4.33-4.37)
18. An inter-agency Working Group was established under the Financial Services Bureau in December 1997 to study the issue and make recommendations as to how share margin financing activities should be regulated. After thorough consideration of the prevailing market practice and the need to provide better investor protection, the Working Group issued a consultation paper on 8 May 1998 setting out the findings and conclusion of its study and its recommendations on the regulation of share margin financing activities.
19. The proposed regulatory regime covers finance companies which provide share margin financing facilities to their clients and brings such companies under the supervision of the SFC. The Working Group also proposes to amend the existing Securities Ordinance and the Financial Resources Rules and introduce a new Code of Business Standards to ensure that licensed entities which engage in share margin financing are financially sound and have in place appropriate measures for prudent risk management and protection of clients assets. It also proposes to strengthen investor protection and education.
20. The public consultation closed on 8 July 1998 and a total of 90 submissions were received. The respondents are generally in support of the policy of regulating share margin financing activities though there are different views as regards certain specific measures of the proposed regulatory regime. The Working Group is now finalising the proposed regulatory regime taking into account the comments received. The Administration aims to introduce the relevant legislative amendments to the Legislative Council (LegCo) by early 1999.
21. As a consequence to the legislative amendments, the Financial Resources Rules (a subsidiary legislation under the SFC Ordinance (Cap. 24)) will also be revised accordingly to, inter alia, reflect the new regulatory regime for share margin financing.
Review of the Concept of Treasury Shares (para. 4.38-4.43)
22. At times when the market falls rapidly, and when the share prices are driven down by extensive selling, it would be in the interests of both the market and the listed companies that the latter be allowed to repurchase their shares from the market. However, under the existing company law, shares bought back by listed companies are considered as a reduction in capital and therefore have to be cancelled. It is believed that companies would be more prepared to buy back their shares in the market if such shares could be treated as "treasury shares 3 " and need not be cancelled. On this basis, the SFC has commenced a review on the Share Repurchases Code and the concept of treasury shares. The review is currently in progress and it is anticipated that the result of the review will be submitted to public consultation by the end of 1998. Amendments to the Companies Ordinance would be initiated if it is decided to introduce treasury shares.
Compliance with SEHK Listing Rules (para. 4.44)
23. The Listing Rules of the SEHK (the Rules) have specified functions and responsibilities of different parties and people including directors, professional advisers and sponsors in relation to the initial application for and the continuing listing of the securities of a company. To ensure that the Rules are fully observed and that the listing and continuing listing of the securities satisfy the requirements set out in the Rules, it is essential that such parties discharge their functions and responsibilities properly and that failure to meet those requirements would be subject to disciplinary actions. To enhance enforcement and compliance, the SFC and SEHK have established a joint working group to consider whether statutory backing is required for these measures. It is expected that the working group's recommendations will be submitted to public consultation by the first quarter of 1999.
The Hang Seng Index (para. 4.45-4.53)
24. The Review recognises the importance of the Hang Seng Index (HSI) as an internationally accepted benchmark of the performance of Hong Kong's stock market and is satisfied that the index meets international standards of size, diversity and representativeness. The SFC has undertaken in the Report to continue to discuss with the HSI Services Limited (HSIS) on further improvements to the HSI.
25. Separately, following the launching of the HS100 index by HSIS in April 1998, the Hong Kong Futures Exchange (HKFE) launched the new HS100 futures and options contracts on 18 September 1998. The HS100 futures and options products are traded on the Automatic Trading System (ATS) and on the first day of trading, a total of 633 contracts were traded. .
Trading System of Hong Kong Futures Exchange (para. 4.67-4.79)
26. As an extension of its policy decision in April 1997 to introduce all its future products on the ATS, HKFE undertook during the Review to migrate the trading of HSI futures and options from open outcry to ATS. System development and staff training by HKFE members are underway. Pursuant to the recommendation of the 30-point programme, the Board of HKFE has further agreed to advance the migration to the third quarter of 1999.
27. As an interim measure to improve market transparency before the migration of HSI futures and options trading to ATS is completed, the HKFE has commenced a project to enhance its information dissemination system that supports the open outcry system. The upgrading of its clearing and trade reporting system is in good progress and expected to be completed by the end of 1998.
Margin Level for HSI Futures Contracts (para. 4.80-4.85)
28. As mentioned in the Report, we are generally satisfied with the mechanism for the determination of the margin level currently adopted by the HKFE. That notwithstanding, we have invited the SFC and HKFE to explore refinements to the margining system in order to further enhance the risk management of HKFE and its clearing house against exceptional market volatility. They have undertaken to commence a review on the margining system by late 1998 when SFC's routine inspection on HKFE has completed.
29. In light of the unprecedented build-up of large open position in recent months, the HKFE has determined to impose, with effect from 1 September 1998, a margin surcharge of 150% on all HSI futures and options position held by any client or member trading for its own account that exceeds 10,000 long or short contracts in all contract months combined. As part of the 30-point programme, the Administration has further requested the HKFE to consider to revise the threshold for the margin surcharge downwards to 5,000 contracts for the sake of more prudent management of overall market risks.
Derivative Warrants (para. 4.86-4.103)
30. To further develop the market in a way consistent with the requirement of a sound regulatory framework, a Working Group was established under SEHK in early 1998 to review and draw up recommendations with regard to the listing rules and practices for derivative warrants. The principal recommendations of the Working Group have already been put into practice with the consent of the SFC through amendments to the Listing Rules for derivative warrants as from 10 July 1998.
31. Under the new Rules, warrant issuers are required to demonstrate their capability of issuing and managing derivative warrants. They have to be either regulated entities or institutions with acceptable credit ratings and with a net asset of $2 billion. They are also required to specify at the launching of the derivative warrants the settlement method to provide greater certainty to investors. The formula for cash settlement will also be amended. While the balloting system 4 on the launching of derivative warrants has been maintained, the expiry dates of warrants have been further spread out to reduce the impact on the cash market. In order to further enhance the transparency of the derivative warrant market, issuers are required to disclose the percentages of the issue taken by the top five placees, and information relating to basket warrants is now also displayed on the Teletext system.
32. To further reduce possible warrant-induced volatility in the cash market, SEHK will continue its review of the rules on covered warrants as recommended in the 30-point programme.
Surveillance of Trading and Market Conduct (para. 4.117-4.123)
33. As the market regulators, SFC and SEHK assume the responsibility to detect improper market activities including suspected price manipulation and insider trading. To discharge their functions effectively, they must ensure that their capabilities for surveillance are adequate. In order to further reinforce their surveillance capacities, they have undertaken to install an enhanced real-time surveillance and analytical software for their computer systems. It is expected that the new system will come into full operation in the second quarter of 1999.
34. Furthermore, the SFC and HKFE are working together to develop a cross-market early warning system among the cash and futures markets to provide warning signals to the market and its participants whenever the futures market activity exceeds a predetermined level of the cash market. A response system will also be put in place to trigger appropriate actions which may include increasing margin in order to regulate market activities and facilitate market adjustment back to its prudent level.
35. The SFC will also continue to work closely with the SEHK and HKFE to explore ways to further enhance their capability of surveillance of trading and members conduct and in particular to strengthen their capability in obtaining market information from the intermediaries.
36. To further strengthen the inspection power of the market regulators and to increase deterrent effect on false reporting, the 30-point programme also proposes to make false reporting to the regulators a criminal offence and the legislative proposals for this purpose are being finalised by the SFC.
Link-up of CCASS and RTGS (para. 4.124-4.129)
37. The message link between the Central Clearing and Settlement System (CCASS) and the Real-Time Gross Settlement System (RTGS) was established on 8 May 1998. This linkage makes the real-time delivery versus payment (DvP) possible for settlement of securities transactions, thereby further reducing market risks of settlement. The HKSCC will also form a project team in the third quarter of 1998 to conduct a feasibility study on possible enhancement of settlements between brokers and custodians.
Investor Participation in CCASS (para. 4.130 - 4.133)
38. The Investor Participation Scheme in CCASS was launched by HKSCC on 8 May 1998. Under the Scheme, individual and corporate investors can open individual investor accounts with CCASS through which they can, in respect of their shares deposited in CCASS, have ultimate control of the movements of their shares and receive evidence of shareholdings. The Scheme renders better protection to the participants of their shares under HKSCC's custody. To further promote the Scheme, the HKSCC announced on 8 July 1998 the replacement of the minimum monthly usage fee by an annual dormant account fee. As up to 31 August 1998, a total of 1,429 applications were received under the Scheme, of which 1,231 accounts have already been in operation, with the rest of the applications being processed.
39. As a long term objective stipulated in the 30-point programme, the SFC will examine the feasibility of full investor participation in CCASS and a scripless market in Hong Kong
Cross Margining (para. 4.134-4.136)
40. To further improve the overall risk management at the market level, the SFC has undertaken to study the feasibility of having cross margining between related products traded on the SEHK and HKFE. The issue has been under study among the SFC, the SEHK and the HKFE under the Inter-market Co-ordination Committee of the SFC. Subject to the outcome of the discussions, cross margining between related products traded on SEHK and HKFE is expected to come into practice by early 1999.
Disclosure of Information by Companies Listed on SEHK (para. 4.143-4.145)
41. In order to enable shareholders to make their investment decisions on a better informed basis, on 9 July 1998, the SEHK released for public comment its proposed new requirements for issuers to disclose their aggregate financial exposure, including the amount due from and to a single entity as well as its related entities if such exposure exceeds 15% of the issuer's net assets (excluding normal trade balances arising from the ordinary course of business and except for issuers that are banking companies, where the threshold is 25% of the issuer's net assets). Issuers would also have to make disclosure if the financial assistance and guarantees given for facilities to its affiliated companies that in aggregate exceed 15% of its net assets (again except for issuers that are banking companies, where the threshold is 25%). Further amendments are being considered by the SEHK in this regard.
42. In addition, the SFC and SEHK are considering other amendments to the Listing Rules in respect of timely public disclosure and financial reporting by listed companies. The proposal is expected to be submitted to public consultation by the end of 1998.
Fidelity and Compensation Schemes of Stock Market (para. 4.148-4.150)
43. As mentioned in the Report, there are three different fidelity insurance and investor compensation schemes operating in co-existence, namely the Brokers Fidelity Insurance Scheme, the Fidelity Fund and Guarantee Scheme and the Unified Exchange Compensation Fund, providing various safeguards for the interests of investors and brokers in the event of stockbroker defaults. The SFC and the SEHK have been working together on a review on whether these schemes could be further improved to offer better and more cost-effective protection to investors and market practitioners, with input from outside consultant. An option under consideration in the review is to combine the Brokers Fidelity Insurance with the Unified Exchange Compensation Fund into an integrated compensation scheme with partial insurance coverage. It is expected that the new arrangement could provide much greater flexibility and better utilisation of resources than the present arrangements.
44. The consultant's report has been completed in June 1998 a consultation paper on SFC's recommendation was issued for public comments on 30 September 1998.
Investor Resources Centre (para. 4.451)
45. The Land Development Committee has approved for the space allocation to accommodate the Investor Resources Centre. Town Planning Board's approval has been given and the Centre is expected to come into operation in early 1999.
Investor Education (para. 4.152-4.153)
46. As undertaken in the Report, the market regulators continue their efforts in investor education programs. The SFC has recently released a new TV announcement and sponsored the production of a series of new investor education programs on radio as well as a new investor education page on two Chinese newspapers. Both SFC and SEHK have also introduced new "frequently asked questions" sections on their respective websites beginning from mid-1998, in addition to their investor hotlines. In addition, over 100 sessions of investor education seminars attended by more than 12,000 members of the public on different topics relating to investment have been held by the SEHK over the last year. They will continue to organise such seminars and introduce new topics to meet the needs of investors.
Promotion of Use of Plain Language (para. 4.154-4.155)
47. The SFC and SEHK have been making persistent efforts to promote the use of plain language. Since July 1998, all announcements and prospectuses issued have been required to be prepared in plain language format. SFC and the two exchanges are meanwhile working to extend the project to exchanges rules and practices.
Other Measures in the 30-point Programme
48. The 30-point programme also recommends to strengthen the enforcement of securities legislation and Members Rules of the Exchanges, which has already been put into practice by the respective regulators. Through the amendments to its rules, the HKSCC has also tightened up the settlement rules of T+2 with effect from 24 September 1998. Meanwhile, HKSCC is also exploring the mechanisms for compulsory stock borrowing for undelivered stocks both under the Central SBL scheme (para. 16 above refers) and in the interim period. The Administration is studying further the pros and cons of strengthening the contingency power to better safeguard public interests under crisis and extreme market situations, and if so, how the additional power should best be instituted.
49. In response to the 30-point programme, the HKFE has already provided information of large open interest to the SFC on a daily basis. It is also examining together with the SFC on the details of further market disclosure relating to large open interest at a broker level.
50. Finally, the Financial Services Bureau will soon convene the first meeting of the inter-agency cross-market committee to be chaired by the Secretary for Financial Services.
CONCLUSION
51. On the whole, implementation of the recommendations contained in the Report as well as those measures introduced in early September by the HKMA and the Administration is in good progress. Some of the proposals, such as improvements in the listing rules and practices of derivative warrants, have already been put into practice whereas in the others, legislative amendments are under preparation or the issues under active consideration. The Financial Services Bureau in conjunction with HKMA, SFC, SEHK, HKFE and HKSCC will closely monitor progress of those items that still remain outstanding, with a view to ensuring their full and timely implementation as soon as practicable. We believe with all these measures in place, our financial markets would become less susceptible to market volatility and more resilient to speculative attacks. We will also continue to keep in touch with the market and the securities industry to examine any other proposals to further improve the operation and the order and transparency of our markets.
Financial Services Bureau
30 September 1998
1. Under the currency board system, the Aggregate Balance is determined predominantly by the flow of funds into or out of the Hong Kong dollar. As
HKMA 's foreign exchange transactions are mostly conducted on a spot basis which are settled two days afterwards (i.e. T+2), their effect on the Aggregate Balance will only be known to the public at the close of the settlement day under the previous practice .
2. Capital Adequacy Ratio is the proportion of a bank's capital base to its risk-weighted assets. Capital is a cushion against the various risks to which banks are exposed. Adequate capital can ensure that banks have sufficient resources to withstand the potential aggregate loss, avoiding failure in all but the most unlikely cases. The statutory minimum is at present set at 8% which is also the international-accepted level. The Banking Ordinance provides that the Monetary Authority may, after consultation with an authorised institution, increase its statutory minimum ratio to up to 12% (in the case of a licensed bank) or 16% (in the case of a restricted licence bank or deposit-taking company).
3. "Treasury shares" refer to issued shares held by a listed company but not cancelled as a result of share repurchase. Such stock is available for reissue, but receives no dividends and carries no votes.
4. Under this system, whenever conditions are satisfied to permit more than five issues of derivative warrants on the same underlying shares, a maximum of five issues (selected by ballot) will be launched in every 7-day launch period, subject to the requirement that the warrants issued in each of these launch periods do not exceed 10% of the public float of the underlying securities.
