Supervision of Markets Division

David J White is Executive Director responsible for the Supervision of Markets Division, and for Research and Policy.

HIGHLIGHTS
In cooperation with the Exchanges and other market bodies, the Division has pursued the following major initiatives during the year:
l	Closely monitored the risk management process of the markets during the volatile period in October 1997;
l	Issued internal code guidelines for persons registered with the SFC;
l	Establishment of the Hong Kong Securities Institute Ltd;
l	Continued efforts towards establishing an investment resources centre;
l	Continued efforts to ensure rectification of the Year 2000 computer problem;
l	Undertook a risk management review of the Hong Kong Securities Clearing Company Ltd (HKSCC);
l	Participated in the formulation of procedures to provide listed company's corporate communications to beneficial shareholders.
FUNCTIONS

4.1	The functions of the Supervision of Markets Division include, among others:

	l	the responsibility for supervising and monitoring the activities of the exchanges and clearing houses;
	l	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;
	l	promoting and developing self-regulation by market bodies in the securities and futures industries; and
	l	overseeing and managing Hong Kong's investor compensation funds.

SUBJECT MATTERS
4.2	During the past year, the Division has worked to maintain and enhance the integrity of the stock and futures markets for both domestic and international investors. The Division continues to work with the exchanges and clearing houses to enhance their effectiveness in providing fair, orderly, efficient and transparent marketplaces as well as facilities for the clearance and settlement of transactions.
October 1997 Market Volatility
4.3	During the last two weeks of October 1997, the Hong Kong markets experienced significant volatility. On 27 and 28 October for example, the Hang Seng Index dropped a total of 2,085 points (19.5%) to 9,059, and on 29 October the Index rebounded by 1,706 points (18.8%) to 10,765, the largest one-day rise in its history.
4.4	Throughout this period, the SFC was in frequent contact with the staff of the local exchanges and clearing houses to determine the latest developments in the market and to ensure that the trading, clearing and settlement and risk management systems operated effectively and efficiently. The SFC also maintained contact with its overseas regulatory counterparts, in particular those in the United States and United Kingdom, to share information on the latest developments in the major markets.
4.5	The Division believes that the market events of October 1997 have demonstrated that the trading, clearing and settlement and risk management systems built since 1987 have successfully weathered the test they were designed to withstand and have enabled the markets to operate smoothly and efficiently.
Internal Control Guidelines
4.6	After extensive consultation and numerous seminars conducted by the Division, the SFC issued in late May 1997 the "Management, Supervision and Internal Control Guidelines for Persons Registered with or Licensed by the Securities and Futures Commission" (the Guidelines). A Consultation Conclusions document on the Guidelines was also issued, summarising the main areas of comment received during the consultation period, the conclusions reached by the SFC, and the changes made to the Guidelines. A total of 13 written submissions were received.

4.7	The Guidelines provide guidance to registered persons and licensed traders regarding the SFC's expectations in relation to internal management and internal control systems of their businesses. The Guidelines do not have the force of law, but an intermediary's failure to comply could reflect adversely on his fitness and properness.
Hong Kong Securities Institute Ltd
4.8	In February 1997, a Steering Committee headed by Dr Edgar W K Cheng began meeting to prepare for the establishment of the Hong Kong Securities Institute (HKSI). Launched in early December 1997, the HKSI seeks to promote, through education, high standards of professionalism for practitioners within the securities and investment business. The SFC believes that Hong Kong's position as an international financial centre will be enhanced by the HKSI's activities.
4.9	The objectives of the HKSI are:

	-	to promote high standards of professional competence, personal integrity and ethical practice;
	-	to set and mark examinations leading to Diplomas which will be the basis for membership; and
	-	to create opportunities for practitioners to meet for professional purposes.

4.10	The HKSI aims to become a self-funding, independent organisation as quickly as possible, but will need financial support for up to two years. At its September 1997 meeting, the SFC approved funding for financing the start-up and recurrent costs of the HKSI's first year of operation. For the initial period, the HKSI's membership drive will concentrate on established practitioners of good repute. The HKSI has different grades of membership for practitioners with greater or lesser industry experience.
4.11	Dr Cheng has been appointed Chairman of the HKSI Board. The Division's Executive Director, Mr David White, is a director of the Institute. The HKSI has the support of Hong Kong's leading financial institutions, firms and individuals, including Government agencies, academics, the SFC, The Stock Exchange of Hong Kong Limited (SEHK) and the Hong Kong Futures Exchange Limited (HKFE).
Investment Resources Centre
4.12	As part of its public education effort, the SFC has urged investors to do their homework prior to investing in the financial markets. However, there has been no place in Hong Kong where all the necessary information and data are readily available to average investors. Towards that end, the Division has applied to the Land Development Corporation (LDC) for allocation of space for the Investment Resources Centre (IRC) at the LDC's new building on Queen's Road Central/Jubilee Street, scheduled to be completed in mid-1998. The LDC has supported the Division's request and submitted a proposal to the Planning Department, which is looking at the proposal and will submit a proposal to the Town Planning Board.
4.13	The SEHK is considering operating a public library within the IRC. The SEHK will bear the costs of fitting out the library and funding its recurrent costs. There will also be areas for the display of HKFE and SFC publications. The Financial Services Bureau has indicated its full support for the establishment of the IRC.
Inter-market Coordination Committee
4.14	During the year, the Executive Director of the Division chaired an inter-market committee which includes representatives of the SFC, SEHK, HKFE, HKSCC, SEHK Options Clearing House Ltd. and the Hong Kong Monetary Authority. The committee advises the constituent bodies on matters which transcend markets and makes periodic recommendations to improve the efficiency of, and to address systemic risk in, these markets.
4.15	Agenda items of the Committee during the year included, among other things, the coordination of inter-market operations, development of contingency plans and development of a cross-margin capability among the futures, stock options and stock markets.
Money Laundering
4.16	During the year, the SFC made amendments to the Money Laundering Guidance Notes issued to intermediaries to reflect a set of 40 revised recommendations by the Financial Action Task Force (FATF). The FATF recommendations will become effective in June 1998. SFC staff also continued to assist the Government in fulfilling Hong Kong's commitments with respect to the FATF recommendations in combating money laundering.
Year 2000 Problem
4.17	All computer hardware and software that use the two-digit year convention will potentially malfunction with the coming of the year 2000. Since calendar dates are part of every securities transaction, the computer glitch can directly or indirectly affect critical processes such as delivery and payment, as well as risk management.
4.18	The Division has been monitoring the progress of the regulated markets in addressing problems associated with the issue. In January 1998, an updated review of the HKSCC was carried out. It was found that considerable progress had been made in addressing the problem in accordance with the business plan it submitted to the SFC in July 1997. Similar reviews are scheduled to be carried out at other regulated markets in due course.

4.19	In addition, an SFC Task Force on Year 2000 was formed in January 1998 to oversee the readiness of all registered persons in addressing the problem. A survey to ascertain the readiness of all registered persons, particularly non-exchange members, was conducted during March-April 1998.
4.20	Year 2000 will be a major issue for the Division over the next eighteen months.
Corporate Communications to Shareholders
4.21	Unlike most mature markets, Hong Kong did not until recently have a systematic and regularised procedure for providing relevant corporate communications directly to those beneficial shareholders who have not registered their ownership directly with the share registrars of listed companies, but who hold shares through brokers and custodians. To consider ways to address the issue, the SEHK set up a Working Group with representatives from the Federation of Share Registrars, the HKSCC and the SFC.
4.22	After considering comments made during a public consultation exercise, a pilot program from a model recommended by the Working Group was introduced. Under the working model, beneficial shareholders would, via their brokers, provide their names and addresses to HKSCC for transmission to share registrars for the purpose of receiving listed company communications directly from the share registrars. Participation by investors and brokers will be voluntary. Listed companies will be required under the SEHK Listing Rules to participate and pay the printing and mailing costs, as they do for communications sent to registered shareholders.
4.23	The SFC endorsed the working model in July 1997. The new procedures were fully implemented in February 1998.
Modification of SEHK Short Selling Regime
4.24	The SFC believes that a viable short selling market serves to increase the liquidity and efficiency of the overall market and is thus an integral component of Hong Kong's market development. The SFC also believes however that efforts must be made to minimise the potential for its misuse.
4.25	Following consultations with the SFC to modify the short selling regime, the SEHK agreed to apply additional minimum criteria for the selection of securities designated for short selling (Designated Securities). In addition to setting minimum capitalisation levels and annual turnover percentage admission requirements, stocks which are under current investigation by the SFC or SEHK will be excluded from any proposed list of Designated Securities. With the use of these criteria, the SEHK in April 1997 extended the number of Designated Securities from 112 to 241. In January 1998 the list was further expanded to 310, to include the constituent stocks of the Hang Seng China-Affiliated Corporations Index. The SEHK and SFC are reviewing the selection process and criteria.
4.26	Average daily short selling on the SEHK for the twelve month periods ending 31 December 1996 and 1997 was $35.13 million and $185.86 million respectively.
Risk Management Review of HKSCC
4.27	Together with the Intermediaries and Investment Products Division (IIPD), the Division conducted an annual review of the operations of the Central Clearing and Settlement System (CCASS) Depository in August 1997. The review resulted in the granting to the HKSCC of renewal of its status as a satisfactory institution for custody of securities documents under the Securities Ordinance.
4.28	In December 1997 the Division conducted an operations and risk management review of the HKSCC with the aim of documenting the operational and risk management procedures of the organisation. The review mainly covered HKSCC's Continuous Net Settlement (CNS) operations, surveillance mechanisms, risk management measures, default management, and the Guaranteed Fund operation. It excluded matters pertaining to the CCASS Depository operations which are subjects of separate reviews. Fieldwork inspection was carried out at the HKSCC's Quarry Bay office with the participation of the IIPD and was completed in January 1998.