Two years after the SFC shut retail investors out HSBC's automated trading system, an SFC announcement gives some indication of what happened, but still leaves retail investors wondering why a pioneering service which offered potential price improvement and competition for HKEx's monopoly stock market was not allowed.

Why did the SFC kill HSBC's Stockmax?
20 December 2013

Cast your mind back to August 2011, and you may recall that Hong Kong's Securities and Futures Commission (SFC) amended the license on HSBC's "Stockmax" Automated Trading System to limit it to professional investors only. This killed the prospect of HSBC's retail stockbroking customers gaining access to price improvement on their orders by matching them internally with institutional orders. This would have been a first for Hong Kong and would have introduced real competition to the monopoly Stock Exchange run by Hong Kong Exchanges and Clearing Ltd (HKEx, 0388), with its wide bid-offer spread table, particularly for stocks priced below HK$5.

So why did the SFC intervene? Yesterday's announcement from the SFC provides only a partial answer, or perhaps just an excuse. It emerges that the SFC was peeved that HSBC had failed to tell it that its business plan had changed from an "opt-in" system to an "opt-out" system. Under the opt-in system, retail investors would have to sign a form in order to benefit from the Stockmax service, while in an opt-out system, they would have to sign a form if they insisted that their orders should go only to the Stock Exchange. An archived FAQ is here.

It was really a no-brainer to make this an opt-out scheme, because if an investor is offered a chance of instant price-improvement on their order (paying less than expected on a purchase, or receiving more than expected on a sale), then they will take it, so HSBC was right to make this an opt-out system. Very few people would opt out. It also has the administrative advantage of less paperwork. Any orders that could not be matched internally at a price at least as good as that quoted on HKEx would be sent to HKEx in the normal way.

You might think that this was a relatively minor detail in the overall licensing of an Automated Trading System, but when news media started reporting on Stockmax on 15-Jul-2011, the SFC realised that they were out of date, apparently hit the roof, and on 8-Aug-2011, the regulator modified the license to professionals-only. Yesterday, the SFC announced a reprimand and HK$5m fine on HSBC for failing to keep the SFC informed of the "significant change" of plan.

This outcome doesn't make a lot of sense. The SFC could have dealt with the disciplinary matter separately, and could have imposed a license condition that the retail service be amended to opt-in, if that was their real concern, and then allowed HSBC to go ahead and launch Stockmax. Two years later, retail investors still don't have this option, and they regularly sit and watch as institutions get price improvement by dealing with each other in off-market pools (such trades are reported to HKEx and tagged with an "X").

So the market will continue to wonder whether, after Stockmax received widespread publicity ahead of its launch, there were pressures on the regulator, and on HSBC itself, to prevent HSBC going into competition with HKEx for retail business as an automated trading system. A miscommunication in the details of a license application does not seem like a good reason to stop it dead-on-arrival. After all, the SFC was initially willing to license, and did license, what it thought was an opt-in retail system. HSBC of course has other important relations with the Government, and perhaps was told to back off.

Don't forget that the Government protects and controls HKEx. The Government directly and indirectly appoints 7 of its 13 directors, the Chief Executive of HK approves the Chairman, and nobody can own more than 5% without the SFC's approval "after consulting the Financial Secretary". Every Chairman of HKEx has simultaneously been an Executive Councillor (a member of HK's cabinet). By law, nobody can run a physical "stock market" in HK other than The Stock Exchange of Hong Kong Ltd, the 100% subsidiary of HKEx. As a consequence, HKEx in 2011 (before buying LME) had a pre-tax profit margin of 77% on its revenue, far above peers in more competitive markets, and that is why it was able to pay through the nose to buy the London Metal Exchange (stand by for nose bleed).

Meanwhile, HK retail investors get a monopoly market with wide spreads, high trading costs, and where brokers bicker about having their lunch hours shortened or their working day lengthened, stand in the way of spread reductions and propose a return to cartel minimum commissions. Those same small broking firms, who elected 18 members of the Chief Executive's Election Committee and 1 Legislative Councillor, can't have been excited about HSBC offering a better service to customers either.

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