Arculli's rant against competition for HKEx
29 July 2010
Last week Ronald Arculli, government-appointed director and Chairman of Hong Kong Exchanges and Clearing Ltd (HKEx, 0388), the owner of HK's monopoly stock and futures exchanges, gave a speech in Shanghai titled "The Role of Exchanges in the New Economic Order". It was a thinly-disguised and factually flawed rant against the competition that investors in less-protected markets enjoy from competing exchanges and alternative trading systems. It is a competition which results in narrower bid-offer spreads and lower transaction costs than in HK, where HKEx booked a pre-tax profit of 78.8% of its total revenue in 2009. If that isn't a monopolistic profit margin, then we don't know what is.
To many, the speech may have seemed like just another of the dozens of speeches that HKEx officials give annually, but if you read between the lines and put it in context, this is probably the opening shot in a campaign to get HKEx exempted from the Competition Bill which was gazetted on 2-Jul-2010. This seems more likely given that Mr Arculli's law firm, Arculli Fong & Ng (now known as King & Wood) was appointed by the Government as a consultant on the design of the competition law. Ironically, Mr Arculli also chaired HK's gambling monopoly, the Hong Kong Jockey Club, from 2002 to 2006. He's also a member of HK's cabinet, the Executive Council, so his comments never stray far from Government policy.
HKEx and the Government may be planning to claim that HKEx should be exempt from the law because it provides "services of general economic interest" (Schedule 1, paragraph 3 of the Bill). We see no justification for exempting HKEx. It is such a visible part of our economy, and competing trading systems are so common elsewhere in the world, that any attempt to exempt HKEx from competition would make an international mockery of the proposed law. Investors in HKEx should factor the likely introduction of competition into their valuation of the stock, which currently trades at 29 times last year's earnings. Don't expect those profit margins to last forever.
Background
HKEx owns HK's only stock exchange, HK's only futures exchange (for now), and HK's only clearing house for stock transactions, Hong Kong Securities Clearing Co Ltd (HKSCC). In fact, only one of these is a legally protected or de jure monopoly, namely The Stock Exchange of Hong Kong Ltd (SEHK). After a competition law is passed, there will be pressure to repeal that protection. The others are de facto monopolies, but any anti-competitive practices, such as restricting access to the clearing house from competing clearing houses, would be subject to the Competition law. This issue of interchange is similar to the network access provided to competing telecom companies.
SEHK's statutory monopoly over stock markets is subtly embedded in a series of definitions in the Securities and Futures Ordinance (SFO) which go along the lines of "there shall be only one god, and the god is SEHK". The law goes like this:
Definitions:
"Stock Exchange Company": The Stock Exchange of Hong Kong Limited [SEHK].
"relevant recognized exchange controller": a recognized exchange controller which is a controller of the Stock Exchange Company. [This can only mean HKEx.]
"stock market": a place where persons regularly meet together to negotiate sale and purchases of securities (including prices) or a place at which facilities are provided for bringing together sellers and purchasers of securities..."
Section:
19(1): No person shall -
(a) operate a stock market unless the person is:
(i) the Stock Exchange Company [SEHK]
(ii) a recognized exchange company of which a relevant recognized exchange controller [HKEx] is a controller; or
(iii) a relevant recognized exchange controller [HKEx] which is itself a recognized exchange company"
Despite this, the law does provide for "Automated Trading Systems" which provide virtually the same functions as a stock market, but the SFC's convenient interpretation of this provision is that an ATS becomes a stock market if it opens its services to the general public (via brokers). In Guidelines for the Regulation of Automated Trading Services, it says in paragraphs 8, 43 and 66 that there may be "circumstances" in which the operations of an ATS may fall within the definition of a "stock market". It doesn't actually spell out what those "circumstances" are, but by looking at the approved list of ATSs, and the conditions applying to them, it is clear that they are all prohibited by the SFC from allowing retail investors to deal through them, except for recognised overseas stock exchanges. Bloomberg Tradebook, for example, is limited to "professional investors" and excludes individuals or their wholly-owned companies.
HKEx has until now been relatively sanguine about ATSs, because they have only a small (low single-digit) share of trades in HK stocks, and because these trades are all reported to SEHK and cleared through CCASS (Central Clearing and Automated Settlement System) operated by HKSCC. So HKEx gets its fees either way, whether the trades are matched in an ATS or on SEHK.
However, under a competition law with a level playing field, ATSs certainly wouldn't have to pay trading fees to HKEx for a trade it didn't do. These ATSs might prefer to arrange their own clearing and settlement and cut costs. To do that, their clearing system would need an interconnection with CCASS, because that is where the vast majority of publicly-owned shares are held, registered in the name of HK's de facto monopoly central depository, HKSCC Nominees Ltd. You cannot trade a share on HKEx unless it is deposited into CCASS for settlement.
The Government, while introducing a competition law, also has put itself into a conflict of interests by owning 5.9% of HKEx. On the one hand, the value of its shareholding, around HK$8bn, depends on HKEx maintaining its monopolistic profit margins, while on the other hand, the Government is supposed to be favouring competition.
The Chairman's speech
The arguments Mr Arculli raised against competition were in many instances false and deceptive, and we itemise them below in order to dismiss them. Let's start with a criticism of Alternative Trading Systems:
"the fair price discovery process is impeded because a portion of demand and supply for a stock is effectively concealed."
This really is baseless when you consider that whether on an exchange or an ATS, a large buyer or seller is unlikely to display is full appetite to buy or sell a stock. He would more likely slice up his order and issue it gradually, possibly placing opposing orders in the opposite queue in order to disguise his overall intent. Secondly, this is a symmetric situation - there is just as likely to be latent demand as there is to be latent supply. If some large investors find it more efficient to meet anonymously in an ATS, avoiding the risk of leaking their intentions to brokers who might engage in proprietary trading or even front-running, and avoiding any display of orders, then matching these orders is arguably less likely to disturb the market price, which is why some large investors prefer to deal that way.
In reality, we suspect that a lot of institutions are deluding themselves if they think that dark pools, as a trading system, reduce the amount of "market impact" their transactions have. That's because a seller can only sell at the mid-market price (half way between the best bid and offer) if there are sufficient buyers who are willing to do the same. Otherwise, the orders will not be filled until they lower their offer, resulting in market impact. The same logic applies for buy orders. Thus, the only likely advantages of ATSs, whether dark or lit, is if they reduce the amount of information leakage caused by humans in the chain and avoid conflicts of interests by brokers with proprietary trading desks, and if they charge less for execution. That's the real attraction of ATSs.
If HK's law were amended to allow fair competition between SEHK and other trading systems, effectively an open market for exchanges, then it would make sense to follow the US approach, which has the "National Market System" governed by SEC Regulation NMS and the Consolidated Tape Association which produces real-time transaction data on the Consolidated Tape System and quotation data on the Consolidated Quotation System (CQS). These unify the quotes and transactions from competing exchanges, and also from certain types of ATS.
In the USA, many brokers have smart order-routing systems which capture the best quotes from competing systems. In effect, this unifies the pools of bids and offers. The CQS doesn't cover all ATSs, because some work on the basis of being "dark" to their participants, so no bids or offers are displayed, and investors just input their bids and offers in hope of a match. These "dark pools", however, accounted for only about 7.2% of US volume in 2009 Q2, according to the SEC. In other words, the vast majority of ATS trading is in "lit pools". Under SEC Regulation ATS, an ATS with 5% or more of the total trading volume in a stock is required to display their best-priced orders in the CQS. On 21-Oct-2009, the SEC proposed reducing the trigger for reporting quotes to the CQS from 5% to 0.25%, and also removed a loophole in which some ATSs had been disguising quotes as "actionable indications of interest" and sending them to each other, effectively unifying dark pools into a larger pool.
Trading spreads
If ATSs result in some investors getting closer to the mid-market price or paying lower fees than is achievable on an incumbent exchange, then it is up to that exchange to innovate to improve the attractiveness of its service. The London Stock Exchange launched its own dark pool project, called Baikal, and on 21-Dec-2009, it announced a merger of Baikal with Turquoise Trading Ltd, an ATS founded by banks. In a competitive environment, former monopolies are compelled to innovate or lose. Turquoise accounted for 5.4% of UK equities trading in Jun-2010. Similarly, NYSE Euronext operates SmartPool, a dark pool jointly owned with HSBC, J.P. Morgan and BNP Paribas.
Long-time readers of Webb-site will remember how the government-controlled HKEx has resisted the reduction of minimum bid-offer spreads, pressured into a U-turn by small brokers who have 13 votes in the Election Committee for HK's Chief Executive, and their own representative in the Legislative Council. To this day, if you want to improve the best bid on a stock at $0.50, you'll have to pay 2% more, at $0.51. At the time of writing, some 822 out of 1357 listed stocks are priced below $2.00 (here's a list sorted by stock price), meaning that the minimum spread on these stocks ranges from 0.5% to 2.0% (or even more, for a few stocks below $0.05). It's ridiculous. Competition would surely force that to change, improving service to investors.
Flash crash
Mr Arculli points to the "flash crash" of 6-May-2010 in the US, in which prices briefly plunged and then bounced back and says that:
"newer trading methods could result in higher highs and lower lows: greater volatility and with more frequency".
He implies that the flash crash was caused by the existence of competing trading venues. There is no evidence of that. Whether a market has a monopoly exchange or competing exchanges, it will always be possible (in the absence of trading curbs) to drive down the quote by hitting all the bids and then lowering the offer until buyers step in to welcome the free lunch.
Mr Arculli is not alone in promoting this misconception - in a speech at the HK Securities Institute on 8-Jul-2010, SFC CEO Martin Wheatley said that competing trading systems cause "huge problems" and have "very negative impacts", and bemoaned the fact that more than 2 months after the US flash crash, there has been no explanation. Both of them should look closer to home: HKEx has had its own "flash crash" in the shares of HSBC on 9-Mar-2009, when the stock plunged 12.5% in the final 5 minutes of trading, then bounced back 13.9% the next day. The SFC commenced an investigation, but there has been no public result, not 2 months later, not even 17 months later.
Corporate governance
Grasping at another straw, Mr Arculli says:
"Arguably, when shares are held only for fractions of a second, it is no longer about participating in the ownership of a company or ensuring it is well run. The opaqueness of trading, and its fragmentation have negative implications for effective corporate governance"
That's nonsense. If high-frequency traders don't hold stocks for long, then they collectively won't hold much stock whenever a shareholder vote takes place, so it will have no material impact on shareholder governance of companies. Indeed, a lot of high-frequency traders aim to be "market neutral" and to clear their books by the end of each day. If they hold no shares when the music stops, then they have no voting rights. As for "fragmentation", we hardly need to say that it doesn't matter which platform you buy your shares on, they still have the same voting rights, so fragmentation of trading is irrelevant to corporate governance.
Mr Arculli's new-found interest in corporate governance is touching, but way off target. He should focus instead on urging tycoons to support quarterly reporting and cutting the general mandate, and cease efforts to weaken governance at HKEx as he tried earlier this year with majority signature proposals for board decisions. Thankfully HKEx shareholders voted him down on that one.
Listing regulation
Mr Arculli then embarks on a soliloquy:
"Furthermore alternative trading platforms do not regulate securities issuers. In a sense, investors in these venues have to adopt a 'caveat emptor' or buyer-beware approach. Meanwhile, on the flip side, the standards that traditional exchanges maintain, and are indeed required to have, remain high. We must then ask: why are some share trading venues not subject to the same rules and requirements as others? And what is the regulatory objective - to protect investors, ensure fairness, or to simply promote competition? Or should competition override investors' interests or fairness?"
Here, he is conflating the role of exchanges with the role of listing regulators. Webb-site has long advocated that the regulation of issuers be removed from HKEx, which as a for-profit regulator has a conflict of interest, and transferred to the statutory regulator, the SFC. HKEx has been clinging on to that role since 2003 when it opposed the recommendations of the government-appointed Expert Group to transfer regulation to the SFC. There is no reason why HKEx, or any trading system, needs to be a listing regulator, so it is a red herring to suggest that ATSs don't regulated listed companies - they shouldn't. Exchanges and ATSs simply trade existing stocks which are listed by the regulator. By the way, in case you might think that listing regulation is a burden on HKEx, on which ATSs might get a "free ride", think again - HKEx pulled in HK$728m in listing fees and made $381m of profit before tax on its regulatory business in 2009.
Capital raising
Then another misleading statement:
"Another advantage traditional exchanges have is the capability to help companies raise capital in a cost-effective manner. The new trading platforms have yet to be able to gain traction in this area"
That is based on a false premise. Exchanges don't "help companies raise capital", they simply allow buyers and sellers to trade shares after they have been issued. When a company conducts an IPO, it does so with consent of the listing regulator after a prospectus has been authorised for publication. In the US, that regulator is the SEC. In HK, it is HKEx and the SFC under a mangled "dual-filing system" - we have two air-traffic controllers for one airspace. But HKEx performs this function as a regulator, not as an exchange. The exchange does not conduct the IPO - the issuer with its sponsors, book-runners and receiving banks does. When trading commences, that is when exchanges, and ATSs, perform their function.
Clearing and settlement
Mr Arculli says:
"For the system as a whole, central clearing of trades by investors on exchanges facilitates regulatory oversight by providing a single location for access to information on the extent of market participants' potential liabilities."
This conflates two different functions - trading and clearing. It so happens that HKEx owns both an exchange, SEHK and a clearing house, HKSCC. But there is no reason why we cannot have competing exchanges which do not provide clearing services, and competing clearing houses which do, and some which provide both. In the telecom analogy, we have competing telecom operators, and person A on network B can call person C on network D. So long as the networks are inter-connected, the call gets through. Alternatively, we could have a single but separate clearing house, run on a non-profit basis in which it returns economies of scale to users through reduced tariffs. If that sounds utopian, it isn't - HKSCC was run exactly that way until it was thrown into the HKEx merger as a sweetener.
In fact, HKEx, is relatively unusual in running both functions. For example, all US stock transactions clear through the National Securities Clearing Corporation owned by the Depository Trust & Clearing Corporation, which is owned by its users. It also owns European Central Counterparty Ltd, or EuroCCP, which clears trades for several exchanges and ATSs in Europe. It competes with Euroclear plc and Clearstream.
Robustness
Returning to that speech, Mr Arculli gets into a complete non-sequitur:
"The robustness of the regulated exchange model was re-affirmed during the financial crisis when exchanges continued to offer their services without disruption. They were able to provide much-needed liquidity even on days when the OTC and interbank market segments seized up."
Um, since when can you trade stocks on the interbank market? That is a money-lending market, between banks, and it seized up because they were unwilling to lend to each other. It has nothing to do with stocks or stock markets. He might as well say that stock exchanges performed well during the recent oil spill, when the Louisiana oyster market dried up. As for the OTC market, he doesn't say what products he is talking about, but it presumably isn't listed stocks.
However, since he raises the issue of robustness, what could be less robust than having a single point of failure in the form of a monopoly exchange? If one trading venue (in our case, SEHK) dominates the market, and its systems fail, the whole market fails. If trading can occur on multiple competing venues, and one of them has a computer glitch, then the others will keep going. This argues in favour of competition, not against it. The fact that HKEx is a monopoly means it has to gold-plate its systems with multiple redundancy to avoid reduce the risk of taking out the whole market.
The rise of the machines
Finally, a piece of technophobic babble:
"Computer-generated liquidity is already affecting real liquidity and altering trading activity. We run the risk of having it all just be a mathematical playground for the few to the detriment of many. A piecemeal approach seems inadequate to these vast changes. Perhaps a more fundamental reassessment of how to achieve the right balance between humans and technology in the financial field is called for."
The right balance between humans and technology? Beware the rise of the machines! Perhaps he's been watching too many Terminator movies. Mr Arculli seems to think that it is fundamentally unfair that someone should be able to program a computer to trade more effectively than a guy in a red jacket with a phone, without front-running its client's orders or leaking information to the market. Perhaps he is unaware that his entire business depends on computers - brokers no longer chalk up orders on blackboards, and messengers no longer run around town with bundles of street-name share certificates to meet settlement deadlines.
Computerised exchanges, clearing, settlement and order-routing systems and electronic communications between them have opened the door to competition in a form that could not have existed the last time we had more than one stock exchange in Hong Kong (there were four until 1986). Get over the technophobia. Let the competition begin.
Postscript
This article proved right - HKEx and 6 of its subsidiaries, including the Stock Exchange, Futures Exchange and their clearing houses, were granted exemption under the Competition (Disapplication of Provisions) Regulation.
© Webb-site.com, 2010
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