Serving the Public Interest?
14 June 1999
Over three months have passed since Hong Kong's Financial Secretary announced in his budget speech the proposed merger of the Stock Exchange and Futures Exchange, and their subsequent listing as a for-profit body.
We wrote at the time that we commended the merger but believed that the merged Exchange should be nationalised and provided as a piece of public infrastructure rather than trying to create a listed, profit-making monopoly.
Since then, Morgan Stanley Dean Witter has been appointed to advise the Futures Exchange, Merrill Lynch to advise the Stock Exchange, and HSBC to advise the Government (which is a big shareholder in HSBC). John Wadsworth of Morgan Stanley Dean Witter is Vice-Chairman of the HKFE.
Management consultancy McKinsey has also been appointed, presumably to look at the pricing structure and Scheme of control for the merged entity, which we discuss below.
Webb-site.com brings you up to date with the latest thinking on this complicated issue.
Competition Policy
Actually, that should read anti-competition policy. The Government confirmed to Legco's Financial Affairs Panel on 8-Jun-99 that the merged body would retain its legally-protected monopoly on the running of a Stock Exchange here. It is a tenuous argument to talk about competition between regional bourses, because in reality a lot of the demand for the services is what economists call "price inelastic", that is, the difference in costs would have to be huge before that part of the business is driven away. There are 3 main sources of income:
Listing fees: the costs of listing in Hong Kong would have to be a lot higher than in other markets before Hong Kong-based companies would move en masse to another market. The reason: most of their investors, including their controlling shareholders, are here. The poor performance of the Jardine group's shares and its reduced media profile since it delisted from Hong Kong provide an instructive example.
Transaction levies: it is true that some institutions, particularly those based in other time zones, are price-sensitive to costs and will deal in their own time zone if it is cheaper. However, local institutions would generally prefer to deal while they are awake, and almost all retail investors (comprising some 40% of transaction volume) would find it inconvenient to transact in other markets or time zones. Therefor levies would need to be raised dramatically before the man on the Star Ferry finds it preferable to deal and settle Hong Kong shares in London or Singapore.
Data fees: the fees we pay the Exchange for real-time and historic price and stock data. If you own the reporting system for stock trades, then by definition you have a monopoly on the information that system generates. This power is open to abuse, and the Government must ensure that there is affordable access to statistical data of this nature.
In Australia, the Government has gone out of its way (with limited success so far) to encourage competing exchanges with the newly-listed ASX. The economy also has a general competition law, the Trade Practices Act. This is something that Hong Kong has never felt willing to introduce, presumably because it would invite all manner of cases against well-established cartels.
Having more than one Exchange is not ideal, but if you are going to allow profit-making exchanges then having more than one is the only real way to create local competition.
As we have argued before, we don't think key pieces of public infrastructure such as the Exchange should be run for profit in this way, since it inevitably necessitates either a competition policy or a scheme of control to prevent monopolistic pricing. Competition doesn't always make for an efficient economy. It would not, for example, be efficient to put the two runways at Chek Lap Kok into separate companies and float them off, simply to provide competition in landing fees. Nor would it be efficient to divide the road network into lanes owned by different companies and have electronic road pricing depending on which lane you were driving in. Two domestic postal services, with two sets of sorting and delivery staff, would be equally stupid - we think our point is made.
Monopolies need a Good Scheme of Control
If you are going to allow a monopoly with only overseas competition to limit its charges, then it is crying out for a scheme of control which prevents tariffs for services from rising against the public interest. The importance of an efficient and low-transaction cost equity market to an economy cannot be underestimated. It is about as important has having an efficient phone system, or a fair court system for resolving commercial disputes.
Other markets, when privatising monopolies or near-monopolies, have created regulators to review pricing policy. These regulators typically set and review a scheme of control, which allows prices to rise at not more than "CPI minus X" where "X" is the percentage that prices should fall in real terms, and CPI is the rate of consumer price inflation. This in effect says that as technology allows greater efficiencies, these must be shared between shareholders and consumers by way of a reduction of charges in real terms.
In the past, Hong Kong's government has never really got to grips with regulation of monopolies. It has favoured a "Return on Assets" arrangement where companies are allowed to set tariffs so that they make a pre-agreed rate of return on their investment. This has the effect of encouraging them to invest more money for what would be marginal returns in a CPI-X arrangement. The Return on Assets applies to Hong Kong's two electricity utilities as well as its franchised buses.
This is one reason why we have so many nearly-empty buses driving around during the non-peak hours, worsening air pollution. The more buses you buy, the more money you make so long as you don't price it so high that people switch to other transport (if their route allows it). The companies have no incentive to curtail services during slow periods, since they are allowed to price their service to achieve the target rate of return. Recently the Return on Assets arrangements has come in for criticism in Legco when an Audit Report revealed that power demand estimates, made in the early 1990s, had been excessive, allowing for the installation of excess capacity and hence higher tariffs than would otherwise have been the case.
Minimum Commissions
There has so far been no mention of whether our Big Bang will include the abolition of minimum commissions, which serve to preserve a revenue stream for small brokers by preventing the free negotiation of commissions. When the minimum is abolished, Hong Kong will become a lower-cost place to transact, which should increase trading volume on the Exchange.
The advent of "AMS3" next year, which will connect the Exchange's automated matching system directly to brokers and hence to their clients, will allow straight-through dealing. The days when a large trade cost more to execute than a small trade are fast receding, as orders which are placed on an "execution-only" basis will require no human intervention. Hence commissions will no longer be set only on value. If commissions become negotiable, then we will have internet brokers executing orders for a fixed fee which could be as low as HK$88 per trade (inevitably, the market will settle on a lucky number, just as internet access fees have settled at $108/138 per month). This is already happening in the US.
Trading Rights
Small brokers have pressured the Government to allow a staggered release of new seats on the Exchange, and to allow them to continue to transfer (read "sell") their seats during that period. In other words, they will get shares in the New Exchange and still be able to sell their seats, which is like having your cake and eating it twice. This is less of a Big Bang and more of a "little whimper" in the reform process.
Small brokers,like blacksmiths at the dawning of the motor car, must face the fact that their days are numbered unless they adapt and invest in new technology. Adaptation in this case probably means merging in order to allow the economies of scale that broking in the future demands, as margins will be wafer thin.
By proposing to allow the transfer of trading rights and the release of fixed quotas of new seats over a number of years, the Government is backtracking on a key need of the reform process, namely to open the broking market up to new, low-cost entrants. The necessary implication of this position is that new seats will be limited and costly, so as to allow brokers to realise a similar price for their seats. Instead, we believe the Exchange should immediately allow any company with the necessary prudential capital and appropriately qualified management to obtain trading rights on the Exchange.
The perpetuation of a finite supply of Exchange seats is similar to the way a large part of your taxi fare relates to the fact that there is a finite supply of taxi licenses. A large part of each fare goes to service the loan taken out to buy the license, which usually costs more than the cab itself.
Each broker should be allowed to use as many trading terminals as they want, on a user-pays basis.In any case, when AMS3 comes along, the number of trading terminals will be almost irrelevant since orders will not be limited by the speed of a human hand on the keypad, but by the speed of electronic links. Of course, the Exchange could place artificially limits by setting a cap on the number of outstanding orders per terminal. Key to the removal of the limit on seats is the closure of the Exchange Floor, which is a relic whose main purpose is now to physically limit the number of seats, as well as making it easier to commit offences such as rat-trading and front-running by unrecorded person-to-person communication.
Control
The Government will have appointed seats on the board of the Exchange. In Australia, the ASX has no government appointees, and regulation by the Australian Securities and Investments Commission is considered good enough. We must ask ourselves whether it is overkill to have government appointees on the board, given that the Exchange itself will be overseen by the SFC. The answer again points to the oddity of having such a key piece of public infrastructure floated as a profit-making body. The Government knows that the Exchange is key, which is why it wants control. It is surely concerned that small brokers, who will dominate the initial shareholder list of the new body, would otherwise use their power to run the Exchange by determining the outcome of directors' elections.
It has been suggested that shareholdings will be limited to 2.5% per person (including associates) but it seems almost impossible to define who is an associate of someone else in a way that would prevent small brokers, or other shareholders, from voting together. Therefor we are likely to see a board which comprises a majority of Government appointees and Exchange staff.
Regulation
Reports suggest that the Steering Committee on Enhancement of Financial Infrastructure is leaning towards all regulation of brokers and listed companies being conducted by the SFC. We commend this approach, which is a step on the way to statutory backing for the Listing Rules and regulation of brokers. The SFC will take on a role much like the Securities and Exchange Commission in the USA. We will no longer see the terrifying penalty of a "public censure" but instead more meaningful financial penalties being doled out to offenders.
It is important that in its new role, the SFC continues the existing Exchange practice of using advisory committees of market participants when formulating policy. Only in this way can regulation remain in step with the practicalities of the market.
Valuation
The valuation exercise is probably turning into a bit of a bragging match. Since it is only the relative values of the two bodies which determines what percentage the members will get, it is in each side's interest to maximise their valuation. The problem is, they have no way to estimate future earnings until we know what the Scheme of Control (or not) on prices of the monopoly's services will be. The looser the Scheme, the more the merged Exchange will be worth. Each side is busy inventing hypothetical figures for the value of their future businesses, such as the Exchange's GEM market which will not be open for business until later this year.
Clearing Houses
The good news is that the parties seem to have accepted that the Clearing Houses should retain their non-profit making status. That is, as their surplus rises, that which is not needed for investment in the infrastructure should be returned to investors in the form of lower fees for things like custody and settlement. It would be wrong to turn the clearing system into a profit-making part of a listed company, since the whole object is to provide a safe and low-cost body for the centralised custody of securities and settlement of transactions. This should be a stepping stone to the eventual "dematerialization" of shares, whereby share registers become electronic and certificates for individual stocks are no longer issued.
Timing
Our greatest fear is that this whole process will be rushed and half-baked. If it were not for the difficult politics of being seen to pay around HK$4-5bn to a relatively small group of people, then the Government might have done the logical thing and nationalised this key public infrastructure. Thereafter it could be run by incentivised, progressive management at the lowest possible tariffs for the benefit of Hong Kong. Performance targets are not incompatible with Government ownership.
If the Government proceeds with the flotation path, then it is essential to put in place a sensible Scheme of Control which puts the public interest and long-run real tariff reduction ahead of maximising profit by the monopoly. It will leave the shares of the Exchange as a pretty unexciting, utility-type investment, but that is in the greater interest of the future capital market in Hong Kong.
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