Functions

The functions of the Supervision of Markets Division include, among others;

• the responsibility for supervising and monitoring the activities of the Exchanges and Clearing Houses;
• encouraging the development of the securities and futures markets in Hong Kong and the increased use of such markets by investors in Hong Kong and elsewhere;
• promoting and developing self-regulation by market bodies in the securities and futures industries; and overseeing and managing Hong Kong's Investor Compensation Funds.

Current Policy Initiatives

During the past year, the Division has worked to maintain and enhance the integrity of the stock and futures markets and the Exchanges and Clearing Houses' effectiveness in providing fair, orderly, efficient and transparent marketplaces and facilities for the clearance and settlement of transactions for both domestic and international investors.

The Division has devoted considerable resources to pursuing, in cooperation with the respective market bodies, various development initiatives. Several of the principal matters dealt with in both the areas of enhanced market integrity and market development include:

• publication for public consultation of internal control guidelines for persons registered with the SFC;
• establishment of a steering committee to set the way forward for the creation and development of a Hong Kong securities industry education institute;
• research and analysis from a market perspective into the recent growth in The Stock Exchange of Hong Kong Limited (SEHK) listed equity derivative warrant market;
• implementation of initiatives to enhance the trading and clearing operations of SEHK-listed stock options;
• further relaxation of the enhanced short selling regime on the SEHK;
• implementation of enhancements to one-day rolling currency futures contracts on the Hong Kong Futures Exchange Limited (HKFE);
• migration of trading of stock futures from open-outcry on the HKFE trading floor to the exchange's screen-based automated trading system (ATS);
• approval of a new category of membership on the HKFE, to help provide a lower cost of entry for market makers in non-equity products;
• introduction of long-dated HSI option contracts on the HKFE;
• continuation of levy holidays for SEHK stock options and HKFE one-day rolling currency futures;
• establishment of a working group to consider the use of automated trading systems; and
• participation in the SEHK's working group on new market development, which seeks to provide local access to regional investment products.

Figure 1 Stock Exchange of Hong Kong Turnover of Stock Option Contracts April 1996 - March 1997	Figure 2 Stock Exchange of Hong Kong Average Daily Open Interset of Stock Option Contracts April 1996 - March 1997

Subject Matters

Stock Options

During the year, the SEHK and SEHK Options Clearing House Limited (SEOCH) implemented a number of initiatives to enhance the stock options trading and clearing operations. The Division recommended that the Commission approve the various initiatives and related rule changes. These include improvements to margin and collateral procedures, modifications to market makers' obligations, introduction of automatic exercise in certain circumstances, and approval of new option stocks.

The Financial Secretary indicated in his 1996 budget speech that the Government would provide stamp duty concessions for stock option market markers in relation to their hedging transactions in the underlying stock with a view to providing a stimulus to the options market and trading in the underlying stocks. To facilitate the introduction of the stamp duty concession, the Division assisted the Inland Revenue Department in drafting the Stamp Duty (Jobbing Business)(Options Market Makers) Regulation, which went into effect on 1 June 1996. The Division also recommended to the Commission that it approve related changes to the SEHK Rules. The changes prohibit an options market maker from identifying a transaction as jobbing unless it satisfies the criteria prescribed by the Collector of Stamp Revenue. The changes also impose a record-keeping requirement in relation to market-maker hedging transactions.

SEHK Working Group on New Market Development

In June 1996, the SEHK formed the Working Group on New Market Development. The Working Group comprises representatives from merchant banks, fund managers, stockbrokers, the SEHK and the SFC (represented by the Executive Director of the Division).

Thus far, the Working Group has focused on the suitability of trading regional derivative warrants, convertible bonds and depository receipts on the SEHK. During its fourth meeting, held in December 1996, members agreed to expand the existing derivative warrant market on the SEHK to include derivative warrants on regional exchanges. A list of acceptable exchanges has been established. Members also agreed to move towards the early introduction of overseas convertible bonds on the SEHK. The SEHK has invited issuers and their advisers with an interest in developing this market to present proposals for its consideration.

Analysis of SEHK Equity Derivative Warrant Market

The SEHK listed equity derivative warrant market has experienced marked growth in the past year. The market has essentially tripled in terms of number of listings (109 to 296) and market value ($11,249.15 million to 31,686.04 million).

With a view to obtaining a more comprehensive understanding of this rapidly expanding market, its implications for the derivatives market and the underlying cash market, the Division has conducted a number of ad-hoc and ongoing discussions with the SEHK and market participants. A Working Group has been set up between the Division, the Corporate Finance Division and the SEHK to monitor the situation. A market database is also being maintained by the Division.

In one recent quantitative study, the Division obtained details on the positions and hedges taken by warrant issuers over a specific time period. This study has provided valuable information on market participants' risk management practices and their potential collective behaviour under different market conditions.

Relaxation of the Short Selling Regime

In February 1996, the Commission approved the expansion of the list of Designated Securities eligible for short selling to 113 securities, including all Hang Seng Index (HSI) constituent stocks, the 50 largest non-HSI capitalised stocks and the balance of Hang Seng MidCap 50 Index constituent stocks that are not included in the 50 largest capitalised stocks. Also the "tick rule" was eliminated, obstacles to the reporting of short selling activities were removed and the reporting system was enhanced. A review of the revised regime was conducted by the SEHK in October 1996 and the results were satisfactory. Reporting of short selling activities has increased, and there has been no evidence of problems with the SEHK's monitoring system.

In January 1997, the SEHK proposed additional modifications to the short selling regime. The proposals include allowing SEHK members to conduct direct business transactions with and for clients in short selling; removing the registration requirement for Short Selling members; further expanding the list of Designated Securities to include all constituent stocks of the Hang Seng China Enterprises Index, stocks with an associated derivative product and stocks which upon listing would fall within the 50 non-HSI largest capitalised stocks category; and allowing a stock which has been admitted as a Designated Security to remain on the list. After careful consideration, the Commission approved the proposals in its February 1997 meeting. The Commission, however, requested the SEHK to consult with it in setting the additional criteria for the selection of new Designated Securities, and specifically to exclude illiquid stocks and stocks believed to be the subject of misconduct.

SEHK Working Group on Corporate Communications

To consider ways to improve communications between listed companies and beneficial owners, the SEHK set up a Working Group with the Federation of Share Registrars, the Hong Kong Securities Clearing Company Limited (HKSCC) and the SFC. A Consultation Paper on a working model to improve communications was published in June 1996. In summary, the model provides for issuers, via their registrars, to send corporate communications directly to beneficial owners based on names and addresses supplied by brokers through HKSCC.

In October 1996, the Working Group recommended the first phase of the model be introduced in relation to the Central Clearing and Settlement System (CCASS) segregated account, with statement service and without any formal rule changes. This phase is now in operation. The HKSCC has also prepared a more detailed description of the working model to facilitate introduction of the second phase of the project. It has determined that the Brokers' Back-Office Software system used by many brokers can be modified easily to support the communications process. Work is continuing towards introduction of the second phase.

Overseas Linkages

During the year, the HKFE entered into a linkage agreement with the New York Mercantile Exchange (NYMEX) with a view to introducing NYMEX's petroleum and other commodities contracts to Hong Kong through HKFE members, utilising NYMEX's ACCESS electronic trading system. The Division continues to assist in this development and has been working closely with the HKFE and SFC's US counterparts on the establishment of the linkage.

One-Day Rolling Currency Futures (ODRCF)

During the year, the HKFE implemented several enhancements to improve the operation of the ODRCF market and also conducted a series of seminars to improve retail investors' knowledge and awareness of the product. The year also saw the launch of the British Pound ODRCF contract, on 20 September 1996, joining the Deutsche Mark and Japanese Yen ODRCF contracts. Trading activity in ODRCF contracts surged in the first quarter of 1997. Average daily volume in 1996 was 757 contracts, as compared to February and March 1997 averages of 1,812 and 2,410 contracts respectively.

To further increase retail investors' participation in the ODRCF market, the HKFE has recently proposed to the Division to introduce a set of handling procedures for stop-loss orders. Stop-loss orders are commonly used by retail investors in banks and leveraged foreign exchange products as a protective measure against their open positions in the event of adverse market movements. The Division is discussing the proposal with the HKFE.

Figure 3 Hong Kong Futures Exchange Turnover of One-Day Rolling Currency Futures Contracts April 1996 - March 1997	Figure 4 Hong Kong Futures Exchange Average Daily Open Interest of One-Day Rolling Currency Futures Contracts April 1996 - March 1997

New Category of HKFE Membership - Revitalisation of Hong Kong Interbank Offered Rate (HIBOR) Futures

At its March 1997 meeting, the Commission approved proposals by the HKFE to introduce a new membership scheme, including creation of a new category of shareholding in the form of "Non-Voting Redeemable Shares". The shares are designed to provide a lower cost of entry for market makers in relation to non-equity products, particularly debt products such as HIBOR futures. The HKFE is also planning to migrate trading in HIBOR futures to ATS and to introduce market makers to this market.

Long-dated Options Contracts

In 1993, the HKFE began trading in the HSI Option Contract. This market has grown steadily with average daily turnover of approximately 4,400 contracts in 1996. To further develop this market, the HKFE proposed and the Commission approved in July 1996 the introduction of long-dated HSI options. This has expanded the contract months to 8, including 12 and 24 month contracts. Long-dated options are subject to modified trading rules and a request-for-quote process.

Stock Futures

Stock futures contracts were launched in March 1995, with trading conducted by way of open outcry on the HKFE trading floor under an order-driven environment. Since the launch, turnover in stock futures contracts has remained low. In an effort to revitalise this market and to enhance its transparency and efficiency, the HKFE proposed, with the Division's support, to migrate the trading of these contracts to its screen-based ATS. The proposal also included the introduction of a market maker system to enhance the liquidity of this market.

At its August 1996 meeting, the Commission approved the proposal and related rule amendments. On 14 February, 1997, stock futures contracts commenced trading on the ATS. Stock futures currently approved for trading include contracts on Cheung Kong Holdings, HSBC Holdings, and Hong Kong Telecommunications.

Investor's Compensation Schemes

The Division continued to pursue recoveries of amounts previously paid out of the Compensation Funds pursuant to its subrogated rights against defaulting brokers. During the year, $8,179.50 was recovered from a defaulting securities broker and $2,264,093.28 was received from the SEHK as replenishment to the Unified Exchange Compensation Fund, after all relevant rights of action and other legal remedies of the SFC in relation to two defaulting stockbrokers was exhausted. Settlements with respect to commodity brokers that defaulted in 1987 resulted in the recovery of $1,915,472.76.

During the year, no compensation payments were made out of the Commodity Exchange Compensation Fund. In regards to the Unified Exchange Compensation Fund, payments of approximately $4 million were made to 117 claimants in relation to the defaulting broker, Bonus Securities Company, after recovery of the funds was received from the defaulting broker's Administrator.

An actuarial study undertaken by a consultant on each of the Funds was completed in October 1996. The two studies sought to evaluate the appropriate levels of the Funds under various types of compensation arrangements. The Division is now discussing the results of the study with the Exchanges and considering whether modifications should be made to the compensation arrangements. It is hoped that analysis will result in improvements to the level of coverage for individual investors.

As at 31 March 1997, the net asset value of the Unified Exchange Compensation Fund was approximately $462.2 million and the Commodity Exchange Compensation Fund was approximately $52.3 million.

Internal Control Guidelines

The incidence of major losses by financial organisations due to so-called rogue traders, inadequate management or internal controls has highlighted the need for improved management and internal controls procedures. To help address this need, the Division published a consultation document on 28 November 1996 titled "Management, Supervision and Internal Control Guidelines". The purpose of the Guidelines is to provide guidance to registered intermediaries regarding the SFC's expectations in relation to internal controls. As part of the consultation exercise, a series of seminars was organised to explain the proposals and to receive direct feedback from market practitioners. Thirteen written submissions have been received and reviewed by Division staff. The consultation conclusions and final guidelines will be published in mid-1997.

Standardisation of Education Requirements for the Securities Industry

The issue of establishing a cohesive, ongoing, educational and training process for participants in the securities industry in Hong Kong was first raised officially in a meeting of academic and professional bodies hosted by the SFC in December 1995. Participants in that meeting expressed general support for the establishment of a professional organisation whose primary function would be the promotion, through education, of high standards of professional conduct in the industry. Following that meeting, the SFC decided to undertake a study on how best to facilitate the development of industry training and accreditation policy for Hong Kong. A consultant was hired to undertake the study and met with various participants in the industry, higher education and Government. A paper was submitted to the SFC in September 1996. After considering various alternatives, the consultant recommended the establishment of an independent securities institute whose principal focus would be the development of training standards through the provision of industry courses and examinations.

Included among the principal recommendations of the consultant was the establishment of a Steering Committee made up of prominent members of the securities industry, who would set the way forward for the creation and development of the securities institute. Dr Edgar W K Cheng, Chairman of the SEHK, agreed to serve as Chairman of the Steering Committee. In addition to providing SFC representation on the Steering Committee, the Division is furnishing secretarial support. The first meeting of the initial members of the Steering Committee was held in February 1997. It was agreed in that meeting to pursue the establishment of the securities institute as an examination-based body. Overseas educational organisations will be consulted to ensure that appropriate examination standards are set. Terms of reference for the Steering Committee have been finalised, and the balance of its membership is being determined. In the near future, an industry discussion paper will be prepared.

Levy Holidays for HKFE ODRCF & SEHK Stock Options

When ODRCF contracts were launched in November 1995, they were eligible for a six-month levy exemption arrangement, as stipulated in the Securities and Futures Commission (Levy)(Futures Contract) Order. And when the SEHK introduced stock options trading in September 1995, the Securities and Futures Commission (Levy)(Securities) Order ("the Securities Order") was amended to exempt stock options from the levy. The SFC has observed that for both markets the level of trading has fluctuated, and that trading volume has not reached its potential.

In order to maintain an environment that is conducive to further market development, the SFC proposed to the Governor-in-Council, upon the request of both Exchanges, that the statutory levy on ODRCF be nil and requested a continuation of the 0% levy for stock options trading, with the situation of both markets to be reviewed in 12 months time. In October 1996, the Governor-in-Council approved the proposals. The nil levy provision for ODRCF became effective on 25 October 1996. The proposal for stock options did not require any change to the Securities Order.

SFC Working Group on Automated Trading Systems (ATSs)

In response to the emergence and use globally of ATSs, the SFC formed a Working Group in mid 1996 to consider the subject matter. The Working Group is chaired by a non-executive director of the SFC and includes representatives of the Exchanges and other professionals involved in the securities and futures markets. The Division provides secretarial and research support to the Working Group.

ATSs were broadly defined to include any automated system that provides a trading mechanism for securities or futures trading, but excluding the operations of the SEHK and HKFE. After considering the various types of ATSs operations, both internationally and in Hong Kong, and the regulatory regimes developed to date and being developed, the Working Group recommends a pragmatic and flexible approach for Hong Kong and provides a set of general principles in relation to ATSs operations. The Working Group provided its Report to the Commission in January 1997.

The Commission reviewed the Working Group's Report and considered the regulatory principles set out in the Report necessary and appropriate. The Commission also accepted the Working Group's recommendation to conduct a wider consultation and, based on the Report, published a Public Consultation Paper in February 1997, seeking additional views and comments on the Report. The consultation period ended on 15 March 1997. The Division is reviewing the submissions received.

Inter-market Coordination Committee

In view of the increasing sophistication of financial products and rapid advancement in technology used in the financial markets, the Division proposed the establishment of a standing committee, the Inter-market Coordination Committee. The Committee includes the chief executives of the SEHK, HKFE, HKSCC and SEOCH and a representative of the Hong Kong Monetary Authority. The Committee advises the constituent bodies on matters which transcend their respective markets and makes periodic recommendations to improve the efficiency of, and to address systemic risk in, these markets.

The objectives of the Committee include assisting intermediaries in dealing with their capital positions, improving linkages between Hong Kong markets, and providing a forum for development of consistent policy and procedures on risk management. Since its establishment on 22 September 1995, five Committee meetings have been held.

The main issues discussed at these meetings include the possibility of same-day foreign currency money settlement, information sharing arrangements among Committee members including large risk exposure of clearing members and bank guarantee positions, the feasibility of cross-margining among the three clearing houses, a cross-market contingency plan, the benefits of the Real Time Gross Settlement system to the securities and futures markets, the development of the Hong Kong debt market and a standardised approach for capital adjustments effecting derivative products.

Money Laundering

During the year, the SFC continued to assist the Government in fulfilling Hong Kong's commitments with respect to the recommendations of the Financial Action Task Force (FATF) in combating money laundering. In June 1996, the FATF revised its 40 recommendations which will become effective in June 1998. The Division has forwarded the new recommendations to the SEHK and the HKFE and asked them to draw the attention of their members to the new recommendations. SFC staff are preparing amendments to the Money Laundering Guidance Notes issued by the SFC to intermediaries to reflect the FATF's new recommendations.

Inter-Market Competitive Study

The SFC invited the Pacific-Basin Capital Markets Research Centre of the University of Rhode Island to conduct a study on the trading of Hong Kong listed securities on the New York and London markets. The objective of the study is to analyse the relevant trading patterns, in particular the role of the relative competitiveness of the various markets. The study comprises a quantitative examination of relevant multi-market trading and its impact on market volatility, liquidity, and efficiency in price discovery and a qualitative analysis of trading by ways of interviews with selected dealers/market makers in London and New York. The report findings will be published in the SFC Bulletin.