Internet Investment Services Conclusions and Recommendations for Hong Kong

The author gratefully acknowledges the leadership and vision of Dr. Edgar W. K. Cheng, former Chairman of The Stock Exchange of Hong Kong, who initiated this study. The support and active participation of The Better Hong Kong Foundation, The Securities and Futures Commission of Hong Kong, The Stock Exchange of Hong Kong, and the Hong Kong Futures Exchange were essential to the study's success. The creativity of Professor Donald R. Lessard contributed in many important ways to its conclusions and recommendations.

Professor Henry Birdseye Weil

The importance of the financial services industry to the economy of Hong Kong and China cannot be over-emphasized. As a major financial centre in the region, if not also in the world, Hong Kong's financial market infrastructure must stay at the most advanced level. This will not only ensure that Hong Kong remains competitive, it will also assist the Special Administrative Region to fulfil its role as the conduit to the formation of capital both for companies within Hong Kong and for mainland China.

Innovation in technologies has brought many good things to our well being. One of the most important evolutions in technology is no doubt the development of the Internet. Before many of us in Hong Kong can come to terms with the wonders of the Internet, financial market practitioners in other parts of the world are developing on-line products and services. It is timely that a study is conducted on Internet Investment Services in Hong Kong by an internationally renowned academia and practitioner specializing in the relevant fields of business strategy, information technology and financial products.

The study was co-sponsored by The Better Hong Kong Foundation, The Securities and Futures Commission of Hong Kong, The Stock Exchange of Hong Kong and the Hong Kong Futures Exchange. A Project Committee was formed comprising representatives from these four organizations.

The Project Committee wishes to thank the author, Professor Henry Birdseye Weil, for his inspiring work. Professor Weil is President of Weil & Company, Inc. and Senior Lecturer at the Massachusetts Institute of Technology Sloan School of Management.

This report can also found at the following websites:

The Better Hong Kong Foundation http://www.betterhongkong.org

Securities and Futures Commission http://www.sfc.hk

The Stock Exchange of Hong Kong Limited http://www.sehk.com.hk

Hong Kong Futures Exchange Ltd. http://www.hkfe.com

The Project Committee

Hong Kong, November 1998

1. Executive Summary

This report analyzes the impacts of Internet technology on key sectors of Hong Kong's investment services market. It presents our conclusions from these analyses and recommendations for enhancing Hong Kong's position as one of the world's leading financial centers. And it provides a vision of where Hong Kong needs to go, what is required to get there, and how exchange members can adapt and benefit.

The report focuses primarily on two over-arching questions:

Apart from some proprietary on-line service used by professional and institutional investors, the development of on-line services will be mainly on the Internet platform. On-line services will have a major impact on Hong Kong's markets and brokers. The most important outcomes will be:

But if Hong Kong seizes the initiative, this technology offers it the opportunity to be one of the key financial centers for the 21st century.

On-line services exist in Hong Kong now, and an increasingly broader range will become available over the next few years. Young, sophisticated, computer-literate people will become the predominant retail investors in Hong Kong. They will have high requirements for convenience and control over their finances. Many will be active investors, intensive users of information, and interested in a wide range of securities, composites, and derivatives. 30 per cent or more of Hong Kong retail investors will be potential users of on-line services by 2010. The potential could be even higher in the long-term.

The costs of on-line investment services are dramatically lower than traditional services. Relatively little new investment will be required to introduce these services into Hong Kong. On-line services from the US and other markets can be provided in Hong Kong at a small fraction of their original development costs. The operating costs of on-line services decline steeply as volumes grow. Data from the US indicate that their cost/transaction and annual cost/account are a tiny fraction (20 per cent or less) of these costs for traditional services.

Whatever Hong Kong does major US brokers will offer on-line trading in US and London listed stocks, bonds, and mutual funds to Asian investors. The large US retail financial services groups, e.g., Fidelity, Schwab, and Morgan Stanley Dean Witter, are seeking global economies of scale. They view Hong Kong as a high-potential market with local competition weakened and distracted by the region's economic and financial problems. Some of them already are active in Hong Kong.

A significant minority of Hong Kong investors representing a disproportionate of retail trading volume will shift to on-line services. Early users of on-line services will have three to four times the average trading volume, but this difference will erode as on-line services build share. In terms of numbers of retail investors, 20 to 30 per cent will shift to on-line services by 2010. On-line services then will represent 30 to 40 per cent of Hong Kong's total retail trading volume.

Basic transactional and information services will become low margin commodities. Because of heightened competition the average commission for traditional brokerage services will fall dramatically. Hong Kong's retail investors will become increasingly "sophisticated", but in a narrow sense. They will be much more aware of and sensitive to price differences than to the strength, experience, and quality of service providers. Thus many will respond to the aggressive pricing of on-line services. In other service markets (e.g., telecommunications, airlines, banking) the advent of very low price competitors has forced established providers to cut their prices. The average commission for traditional brokerage services will decline to less than half of its current level by 2010.

Brokerage and trading will erode into a low price, no frills service. Margins for basic transactional and information services will evaporate. Relationship-based differentiation will become increasingly difficult. Customer loyalty will be low, and they will move frequently among alternative service providers. Competitive advantage in basic services will come from cost leadership, combined with adequate quality.

There will be a substantial shake-out and consolidation among Hong Kong brokers. Overall the profitability of traditional brokerage services will be seriously damaged. The traditional service providers who proactively anticipate and exploit the new technologies will fare well. But many brokers will be slow to react. They will be at first unwilling, and later unable, to adapt to the new market conditions. And although successful in building market share, some on-line service specialists also will encounter serious financial problems.

Transactional revenues (e.g., commissions) and some asset-driven revenues (e.g., for fund management, custody and administrative services) will become severely commoditized. The primary profit sources will be liability-driven (e.g., margin lending) and the result of innovative service bundling. The most successful competitors will offer fully-integrated services (i.e., brokerage, banking, pensions) through multiple channels (i.e., traditional, on-line).

On-line services will provide Hong Kong investors with easy access to foreign issues and markets. Poor financial market conditions in Hong Kong and a loss of investor confidence will depress retail trading volume during 1998-99. There will be a flight to quality among Hong Kong's retail investors, who increasingly will look beyond Hong Kong to invest in world-class blue chips (e.g., major US and European companies). On-line services will stimulate interest in and facilitate a shift to foreign issues, composites, and derivatives. This shift initially will apply to a small group of sophisticated retail investors, but over time it will become a broadly-based phenomenon.

Results from the project contain a very clear message. It is essential for Hong Kong to seize the initiative. And the exchanges, supported by the regulators, must show the way. Otherwise many of Hong Kong's brokers will miss the opportunity to transform themselves. The high-leverage action arenas are:

Hong Kong's exchanges must provide leadership, infrastructure, and support . Starting immediately they should aggressively encourage members of all categories to anticipate the impacts of on-line services. This is a crucial leadership role. Time is of the essence, because the window of opportunity to seize the initiative is of limited duration. It is clear that the risks of moving too slowly far outweigh the risks of being too early.

The exchanges should collaborate with technology partners to develop a system platform for members to provide on-line investment services to their customers. The infrastructure should be based on open Internet standards and technologies. In the US proprietary systems for connecting customers to brokers and brokers to markets are being displaced by systems based on Internet protocols. For example the National Association of Securities Dealers is planning to move the NASDAQ network on to the Internet. NASDAQ envisions itself becoming an Internet portal, linking investors to a wide range of exchanges and trading systems and thus offering "a market of markets". On-line brokers have discovered that most of their customers prefer to access them through the Internet rather than proprietary systems.

This approach will make it as easy as possible for anyone to link to and build-upon the basic system platform. It will encourage innovative developments, for example, electronic forums where investors can "meet", exchange information, and receive news from companies and advice from experts. It also will enable the Hong Kong platform to be easily "exported" to investors throughout the region and appropriate markets world-wide.

The exchanges should take maximum advantage of expedient off-the-shelf solutions, particularly for customer-facing "front-end" systems. Tailor-made solutions may be required for some "back-end" systems because of unique characteristics of Hong Kong's markets and regulations. Adherence to international standards and use of proven technology reduce risks. This also anticipates the movement towards electronic integration of exchanges, as is already underway in Europe. In a rapidly evolving technological and market environment over-engineered, expensive, time-consuming solutions are a misuse of time and money. And they often lead to being locked into an approach which, with the benefit of hindsight, is "wrong". The name of the game will be to learn rapidly from the marketplace, and continually refine the platform based on this feedback.

Development of a system platform for on-line investment services offers an historic opportunity to re-think and refine the basic architecture of Hong Kong's markets. Hong Kong exchanges should extend their central clearing house function to provide an on-line "central server" and unified clearing accounts. This would be similar in concept to the Singapore Central Depository (CDP) but more sophisticated in both functionality and technology.

Both information technology and legal foundations must be established for these unified clearing accounts. There should be standard protocols for disclosing information about unified accounts, e.g., to financial institutions or regulators. Incentives and benefits for voluntary acceptance of unified clearing should be defined. Examples of possible benefits include lower interest rates for margin borrowing (because an integrated picture of the borrower's situation reduces risk) and lower commissions (because the transaction costs would be less).

The exchanges should initiate discussions with potential partners about the technical and commercial feasibility of an innovative "mobile investor" product that would provide fully-integrated access to investment and banking services in Hong Kong. If the idea looks good, a collaborative venture could develop wireless access as a key enhancement of the initial on-line system platform.

An example of a new wireless investment service is Reuters "MarketClip", launched in the US earlier in the year. It provides wireless access to real-time quotes, company fundamentals and news headlines for a specified portfolio of stocks, market alerts (based on criteria such as price, volume, and/or news), and both intraday and historical charts. The service is a joint venture of Reuters, 3Com, AT&T, and Aether Technologies. Using Internet technology information is delivered to wireless versions of the popular 3Com PalmPilot PDA or Hewlett-Packard HPC.

The exchanges also should develop new products aimed at on-line investors. As described above Hong Kong investors will behave with greater conservatism, e.g., with more emphasis on quality, hedging, and diversification. With the decline of access and information barriers Hong Kong's retail investors will become increasingly interested in foreign issues, composites, and derivatives. This shift will be motivated by a strong desire to diversify away from local and regional risks.

Hong Kong exchanges will lose significant volume to foreign markets unless local products can fill these needs. Depository receipts for popular foreign issues ("HKDRs") should be created. A second category of derivative products is new futures and options on major foreign market indices. They include the Dow Jones Industrial Average and S&P 500 in the US and the FTSE 100 in London. These products should be designed for local retail investors. Large institutions already have access to a wide range of such products. HKDRs and index futures and options also would attract investor interest and capital throughout the region. The recommended on-line system platform would enable foreign investors to access these products through either their local brokers or Hong Kong brokers.

Appropriate regulatory measures must support these initiatives. The regulatory environment can slow or accelerate and distort or refine the changes driven by economic, technological, and market forces. The critical regulatory issues will include price competition, off-exchange transaction matching, and integration of brokerage and banking. The integration of financial services will make minimum commissions unenforceable and irrelevant. There will be too many avenues for rebating commissions to customers through the pricing of other services.

Hong Kong requires an effective forward-looking approach to regulating investment services. Effective regulation has been, and must remain, the foundation of Hong Kong's position as one of the world's leading financial centers. On-line services will pose new challenges, for example, to understand and anticipate the implications of information, transactions, and capital flowing at electronic speeds. The Securities and Futures Commission ("SFC") should embrace change but be vigilant. Far better to move decisively and comprehensively to anticipate the new market environment than to respond piecemeal.

Moreover, the development of fully-integrated financial services will require an integrated framework for regulating financial institutions and markets. Recent problems with finance affiliates of brokers and the custody of shares highlighted what, arguably, are gaps in the current framework. As with communication and information services, once separate financial services are converging. Historical differences between banking and brokerage, pensions and investments, derivatives and underlying assets are becoming increasingly meaningless. The UK is moving to consolidate regulation of financial services under one super-authority. In Hong Kong, the immediate requirement is for coordinated banking and securities market regulation. Hong Kong must consider how it will achieve regulatory integration in the longer-term.

The project illuminates several possible future for Hong Kong. Depending on how the exchanges, their members, and the regulators anticipate and respond to the various scenarios under consideration Hong Kong could emerge as the leading financial center in the region, or at the other extreme it could become marginalized.

If Hong Kong seizes the initiative, its position as one of the world's leading financial centers, and the regional leader, would be significantly strengthened. Distance will collapse because of on-line systems. The death of distance could precipitate a large-scale shift of assets out of Hong Kong, but alternatively Hong Kong investors could achieve greater diversification and quality within Hong Kong markets. Investors should be able to access global markets without ever leaving Hong Kong, e.g., through depository receipts and other derivatives.

Indeed this easy and secure global access will attract investors to Hong Kong. Its markets should be accessible to investors everywhere who are interested in Hong Kong issues, the liquidity and transparency of the Hong Kong market, and the "Hong Kong style" of investing. This critical mass of investors, volume, capital, and liquidity are essential for ensuring that Hong Kong remains the global specialist for "Chinese" issuers and issues.

Business as usual is not an option for Hong Kong! A cautious, or complacent, wait-and-see attitude will cause Hong Kong to be marginalized. Without the proactive initiatives described above, Hong Kong faces a very serious threat that its retail market will be "cherry picked" by foreign financial services groups. These groups will target wealthy, active investors. Hong Kong's retail investor base would shrink steadily as traditional investors age and the younger, more sophisticated ones defect.

If nothing is done erosion on the demand side will lead to reactions on the supply side, and vice versa. Red chips increasingly would list in London and the US. More and more fund managers would shift their base out of Hong Kong. As a result, Hong Kong would lose very substantial trading volume and asset balances to other financial centers (particularly ones specializing in on-line services). These relationships are highly circular and self-reinforcing. They can form a virtuous or vicious circle, depending on the conditions which prevail.

What factors make the difference among those outcomes? There are several parts to the answer:

When Hong Kong brokers have their own on-line option available at an early enough stage they can migrate customers they otherwise would lose. They may fear cannibalizing their own customer base, but the US experience shows quite clearly that it is better to retain customers on-line than lose them. The ability to migrate traditional brokerage customers to captive on-line services will substantially mitigate price competition.

Hong Kong inevitably will lose some customers and volume to foreign issues, markets, and brokers. But on-line services combined with innovative investment products (e.g., HKDRs) can attract new business to off-set those losses.

Moreover more rapid emergence of new applications (e.g., fully-integrated brokerage and banking) and reduced switching costs (e.g., from the convenience and confidence of being able to stay with your current broker) will mean that on-line services do not need to be sold exclusively on price. As a result of these factors the profitability of both traditional and on-line services is far better.

The outcome for Hong Kong is positive, even under extreme market scenarios:

By proactively embracing and exploiting Internet technology, Hong Kong will lead the development of a virtual financial market and will position itself as one of the major hubs.

Markets for investment services will change dramatically during the next five to ten years. A major driver of these changes will be Internet technology (including the World-Wide Web and "Intranets", i.e., private networks based on Internet standards). Many participants will be caught unprepared and off-balance. The objective of this project is to anticipate impacts of the Internet on Hong Kong's investment services market and suggest future strategies.

Internet technology is revolutionizing investment services markets. Share trading, investment information, and IPOs on the Internet are a reality. A wide range of new possibilities for linking market participants, disseminating information, transacting business, serving customers, and regulating markets are emerging. And virtual exchanges that transcend borders and regulatory regimes loom on the horizon. Internet technology will have very significant effects on the dynamics of Hong Kong's investment services market and on the competitiveness, value added, and profitability of various participants.

The impacts on Hong Kong will be dramatic. But what exactly will they be? And what strategies should be followed in Hong Kong to use Internet technology for maximum advantage? This classic disruptive technology offers great opportunities to those with the foresight to understand its potential and position themselves appropriately.

The first step in the project was to define the structure and dynamics of Hong Kong's investment services market. Basic information was gathered, e.g., transaction volumes and mix, commissions and fees, turnover, cost structure, customer mix, customer needs and values, competition within Hong Kong, competition with other markets, procedures and systems, and regulation. This occurred through a combination of interviews, assembly of a historical data base, and review of many documents.

Internet-based investment services have developed faster and farther in the US than any other market. The second step in the project was to take a close look at what is happening there and why.

Detailed information has been gathered about on-line investment services in the US, e.g., patterns of growth, the leading players and their approaches, the range of services offered, pricing policies, costs, how competition is developing, the reliability and quality of these services, their effect on the marketing of IPOs, impacts on the structure of the industry, and the issues and problems that have arisen. A wide range of sources was used including reports from the principal securities markets and regulators, company annual reports, the marketing materials of on-line service providers, articles from the financial press, on-line information services, academic research reports, evaluation of the Internet "websites" of each major service provider, and hands-on trial use of several leading services.

The third step in the project was to formulate a Base Case scenario for the evolution of Hong Kong's investment services market. The Base Case describes the most likely economic, technological, and competitive environment (i.e., in the absence of contingencies which are less probable). Thus it provides a baseline for evaluating the effects of potential strategies and actions (e.g., by the exchanges, current members, new entrants, the SFC).

The Base Case was produced in several stages. First, a purely qualitative scenario was developed. Next, a computer simulation model was used to generate projections of the number of retail investors, transaction volumes, commission and fee levels, turnover, and profitability for both traditional and on-line brokerage services. The model took as inputs a set of Base Case assumptions about the future economic and financial environment, technological developments, changes in regulation, and competitive conditions. Then, analysis and discussion of the simulation results generated further ideas.

The next step in the project was to consider alternative futures and their implications. History shows that any particular scenario is likely to be wrong in important respects. Multiple scenarios are more likely to bracket the actual future . For example:

As with the Base Case, the alternate scenarios were produced in several stages. First, purely qualitative scenarios were developed. Next, the computer simulation model was used to generate projections. The model showed the impacts of alternate sets of assumptions about the future economic and financial environment, technological developments, changes in regulation, and competitive conditions.

The final step was to formulate conclusions and recommendations. This report summarizes the results from earlier stages of the project, but focuses primarily on two over-arching questions:

The report builds logically, starting with a review of the development of on-line services in the US. Then a Base Case scenario for the evolution of Hong Kong's investment services market is presented. This scenario assumes "business as usual", and the results are very threatening for Hong Kong. Next an alternate scenario is explored wherein Hong Kong seizes the initiative to proactively exploit the opportunities offered by on-line services. A series of actions are recommended to enhance Hong Kong's position as one of the world's leading financial centers. The final section summarizes the conclusions from this project for Hong Kong.

Our report is intended to stimulate thinking "outside the box", bring disagreements to the surface, provoke debate, and lead to agreed action plans. How can Hong Kong's guild of relationship-based brokers survive and prosper in the new environment described by these scenarios? How can Hong Kong retain the assets and liabilities of its retail investors, rather than have them migrate to other markets? How can Hong Kong sustain the revenues and vitality of its exchanges? How can on-line technology be used to bring key regional and global markets to Hong Kong and bring Hong Kong markets to investors around the world? These crucial questions are addressed by the project. The report contains our conclusions and recommendations.

3. On-line Services in the US

On-line investing is a large and rapidly growing business in the US. At the end of 1996 there were 1.5 million on-line brokerage accounts containing US$100 billion of customer assets. A year later the number of on-line accounts was 100 per cent larger, i.e., about 3 million (5 per cent of total retail brokerage accounts). And on-line accounts doubled again to nearly 6 million, with well over US$200 billion of assets, in the first half of 1998.

On-line trading volume has surged. Current trends indicate that 25 to 30 per cent of total retail trades will be made on-line in 1998, up from 17 per cent in 1997. The phenomenal growth of on-line investing is expected to continue unabated. One recent study estimated that there will be over 14 million on-line brokerage accounts, with nearly US$700 billion in assets, by 2002. Another study predicted 25 million on-line accounts at the end of 2003.

The leaders are a mixture of large full-service firms (e.g., Donaldson Lufkin & Jenrette and Morgan Stanley, Dean Witter, Discover) well-established discount brokers (e.g., Fidelity and Charles Schwab), and new on-line specialists (e.g., E*Trade). Market shares (in terms of on-line trading volume) in the first quarter of 1998 were estimated at: Schwab 32 per cent; E*Trade; 12 per cent; Waterhouse 9 per cent; Fidelity 8 per cent; Datek Online 7 per cent; Ameritrade 6 per cent; and DLJ Direct, Quick & Reilly, and Discover all at 4 per cent. Thus just nine brokers dominate on-line trading with a cumulative 86 per cent market share. Notably absent are major full-service brokerage firms such as Merrill Lynch and PaineWebber.

In the first quarter of 1998 Schwab handled 48 per cent of its daily trading volume on-line vs. 33 per cent a year earlier. Its on-line trading volume now exceeds US$2 billion per week. Schwab has 1.8 million active on-line accounts holding balances of US$128 billion. The shift at Fidelity was even more extreme. During the first four months of this year 60 per cent of Fidelity's commissionable trades were done on-line, compared with only 17 per cent in the comparable period of 1997.

Price is the overriding factor leading people to trade on-line. Commissions for on-line trading declined steadily during 1997, and a price war at the end of the year drove some commissions down quite dramatically. In recent months the price war has cooled. According to one analyst the average commission charged by the top on-line brokers fell by only 3 per cent in the first quarter of 1998. But at US$15.53 per trade it was more than 50 per cent lower than a year earlier.

The commission for trading 1,000 shares on-line through one of the market leaders ranges from US$8.00 to US$29.95. For example, Ameritrade's commission is US$8.00 per trade, Fidelity currently charges "active traders" US$14.95, while Schwab's commission for on-line stock trades is US$29.95. This compares to the average commission charged by full-service brokers of US$284.00.

The basic commission rates for on-line and discount brokers appear to be converging. However their underlying costs can be substantially different. Most of the established firms have very extensive "legacy baggage", in particular their large staffs, extensive branch offices, old computer systems, high overhead expenses, and traditional corporate cultures. By comparison the new start-up on-line specialists such as E*Trade have state-of-the-art technology and bare-bones costs.

On-line investment services in the US now include information about and marketing of Initial Public Offerings. Several major investment banks are extending their distribution channels to small investors. These moves are an attempt to compete with the likes of Merrill Lynch and Morgan Stanley, Dean Witter, Discover which have vast retail distribution arms.

Some on-line brokers already are moving into banking. E*Trade now offers mortgage loans, with an on-line application. Virtually all of the top on-line brokers provide money market accounts with cheque-writing facilities and most offer credit cards. Internet brokers affiliated with retail banks, for example, Quick & Reilly is now owned by Fleet Financial Group, plans to sell bank products on-line and provides consolidated electronic account statements. Waterhouse received a bank charter from the US Comptroller of the Currency even before its acquisition by Canada's Toronto-Dominion Bank. Waterhouse National Bank is a "virtual bank" with no branches and about 200,000 customers. Ameritrade is carrying the concept another step forward. It will offer on-line customers a choice of providers of banking products.

Consolidation among on-line brokers seems inevitable. Banks are logical buyers of on-line brokers. There is little legacy baggage compared with acquiring a traditional brokerage firm. The on-line brokerage market is becoming quite crowded. Increased competition, and the large advertising expenditures and strong brand recognition of some players, are raising the bar for the rest. In the longer-term, the market is likely to segment into super-cheap, completely DIY brokers and a mid-tier that provides high-tech on-line "advice" (based on personalized market information and access to investment experts).

On-line investment services are positioned quite differently depending on whether the company also provides traditional (either full-service or discount) brokerage services or is an on-line specialist. The former have a far more complex positioning problem, because they have to manage the coexistence of two quite different delivery channels. The latter, by comparison, have a simpler job. They primarily must make themselves look attractive relative to the established traditional brokers.

These two different challenges are illustrated by the positioning of Charles Schwab's on-line service e.Schwab vs. E*Trade. E*Trade is the first and most prominent electronic broker. Its proposition emphasizes low cost, convenience, and sophistication. E*Trade puts great emphasis on innovative and value-added services, and having leading edge technology. Thus E*Trade walks a fine line. On the one hand it is the paradigm buster, with in-your-face advertising shouting "Your broker is obsolete!" and "Boot your broker!" But on the other hand E*Trade strives to be perceived as a highly professional, credible, trustworthy company on par with any of the traditional brokers.

e.Schwab is offered by the pioneer discount broker. Its proposition emphasizes trustworthiness, certainty, and one-stop shopping. e.Schwab is positioned for do-it-yourself investors. To reduce the risk of losing price-sensitive customers to a competing on-line service, Schwab makes it easy to switch an existing Schwab account to e.Schwab. To increase lock-in Schwab pushes a prospective customer to use its proprietary e.Schwab software. There is subtle undermining of the new Internet-based services. Customers are prompted to worry about the risks.

E*Trade started with nothing and thus has everything to gain. Schwab by comparison starts with almost 5 million customers and a large organization, and thus has much to lose. The positioning of e.Schwab is inherently defensive. Its first goal appears to be preventing the likes of E*Trade from strip-mining Schwab's customer base. Better to retain customers at lower commissions than lose them to a competitor.

E*Trade and the other on-line specialists are dwarfed by the capital and marketing power of the major brokerages (e.g., DLJ, Dean Witter, Schwab, and Fidelity). Thus they are vulnerable as the majors decide to aggressively market on-line trading at comparable prices. They also are vulnerable to imitators who offer a comparable service at a lower price and to leapfrogging (e.g., by electronic mutual funds supermarkets or fully-integrated on-line brokerage and banking services).

On the plus side, the new on-line specialists have a huge cost advantage over traditional brokers. Their cost per transaction is less than 25 per cent of the typical discount broker, and probably below 10 per cent of a full-service broker's cost. At price levels where E*Trade and the other purely on-line brokers can be profitable the traditional brokers (both discount and full-service) could not possibly cover their fully-allocated costs.

A major challenge facing E*Trade and other on-line specialists is to build new revenue streams. Their primary revenue driver is trading volume, not account balances. It is quite likely that the average volume/customer will deteriorate with growth, just as in mobile telephony. Another big challenge is managing rapid growth. E*Trade and the others must ensure adequate system capacity and performance, customer service, quality of their customer base, and financial controls whilst growing at 50 to 100 per cent per annual. They need to avoid a collapse of system performance, and the inability of customers to access their accounts and make desired trades, caused by massive capacity over-loading. Frustration with poor service is a major cause of customer churn.

By offering an on-line service, Schwab and the other traditional brokers are competing with themselves, and this creates lots of confusion. They push their proprietary interface software, but its advantages to the customer vs. accessing them through the Internet's World-Wide Web are unclear. Complex and confusing pricing of on-line services is another problem for Schwab and the other traditional brokers. This could be seen as misleading and alienate customers, thus adding to churn.

Far more significant, their on-line channels compete with their traditional brokerage service. Schwab and the other traditional brokers seem very worried about cannibalizing their existing customer base. It is unclear which service is targeted to which market segments (e.g., to their own customers vs. their competitors' customers) and what strategic objectives each service supports (e.g., customer retention vs. acquisition).

The traditional discount brokers' defense strategy depends on a major repositioning from "maverick" to "established". The full-service brokers must likewise transform their image from "expensive, and we advise you what to do" to "competitive, and you are in charge". This is a huge challenge for both groups, particularly as they obviously are stuck with lots of awkward legacy baggage. Raising and playing on customer apprehensions easily could backfire.

The US experience with on-line investment services is instructive. While it is unlikely that Internet-based services will impact the Hong Kong market in exactly the ways, competition in the US between on-line and traditional services raises a number of important questions for Hong Kong. These questions were considered in later stages of the project.

4. The Base Case Scenario - "Business as Usual"

A key step in the project was to formulate a Base Case scenario for the evolution of Hong Kong's investment services market. The Base Case scenario serves several purposes:

The Base Case scenario is described below. It is a synthesis of results from the computer simulation model and judgements which go well beyond the scope of the model. It was shaped through discussions with the project Steering Committee, interviews in Hong Kong, and assessment of developments in the US, Singapore, and Europe. Effort also was devoted to reviewing literature on competition among financial markets, innovation in financial services, the impacts of economic crises on financial markets, and the behavior of retail investors. This very substantial body of information supported scenario development and modeling the growth of on-line services in Hong Kong. Think of the Base Case scenario as a preview of the future, that is, what to expect unless Hong Kong proactively seizes the initiative.

Over time the assumptions about the future economic and financial environment, technological developments, changes in regulation, and competitive conditions described in the Base Case scenario will lead to a series of market outcomes. These outcomes will involve changes in the size and nature of the market, in the financial services value chain, and thus in the accrual of "economic rents" (i.e., profits and their translation into business value and owner wealth).

On-line services will have a major impact on Hong Kong's markets and brokers. The most important outcomes will be:

But if Hong Kong seizes the initiative this technology also offers it the opportunity to be one of the key financial centers for the 21st century.

4.1. Significant Shift to On-line Services

On-line services exist in Hong Kong now, and an increasingly broader range will become available over the next few years. Internet brokers are preparing to descend on Hong Kong. Those already active include local firm Boom Securities and the US broker Charles Schwab. DLJ Direct plans to offer trading in US shares on-line in Hong Kong later this year and add Hong Kong shares in 1999. Schwab has experienced an even faster take up of on-line services in Asia than in the US. In Asia about 70 per cent of its trades are made on-line (vs. 50 per cent in the US).

Several trends will combine to reinforce the potential demand for these services:

Young, sophisticated, computer-literate people will become the predominant retail investors in Hong Kong. They will have high requirements for convenience and control over their finances. Many will be active investors, intensive users of information, and interested in a wide range of securities, composites, and derivatives. 30 per cent or more of Hong Kong retail investors will be potential users of on-line services by 2010. The potential could be even higher in the long-term.

New applications (e.g. fully-integrated brokerage and banking services) will drive growth in the expectations and service requirements of Hong Kong's retail investors. Continual innovation and rapid migration of ideas amongst markets will lead to a exciting array of new investment services. And movement from proprietary systems to Internet standards and use of the World-Wide Web will make it easy for investors to use on-line services.

The costs of on-line investment services are dramatically lower than traditional services. Relatively little new investment will be required to introduce these services into Hong Kong. On-line services from the US and other markets will be cloned in Hong Kong at a small fraction of their original development costs. Most of the early users will be fluent in English, and thus Chinese language interfaces are not an immediate requirement. But even here investments already are being made. E*Trade currently offers marketing materials and system interfaces in Chinese.

The operating costs of on-line services decline steeply as volumes grow. Data from the US indicate that their cost/transaction and annual cost/account are a tiny fraction (20 per cent or less) of these costs for traditional services.

Whatever Hong Kong does major US brokers will offer on-line trading in US and London listed stocks, bonds, and mutual funds to Asian investors. They will offer both very low cost transactional services (as E*Trade does) and relationship-based services (in the style of DLJ). The large US retail financial services groups, e.g., Fidelity, Schwab, and Morgan Stanley Dean Witter, are seeking global economies of scale. They view Hong Kong as a high-potential market with local competition weakened and distracted by the region's economic and financial problems. Their strategy will emphasize on-line services as the means for achieving cost leadership, pricing aggressively, throwing local competitors off balance, and rapidly building volume.

Many large Hong Kong brokers also will launch on-line systems. These systems will offer extensive financial information, access to brokerage accounts, and order entry capabilities. In some cases Hong Kong brokers will partner with US on-line service providers. E*Trade already has entered the Canadian and Australian markets in partnership with local brokers, and just announced plans to do so in the UK.

The development of on-line investing systems will accelerate the growth of Hong Kong retail brokerage accounts and stimulate additional trading volume after 1999. There will be 900,000 to 1.1 million active Hong Kong retail investors in 2010. Average trading volume/investor will grow at a rate of 10 to 11 per cent per annual during 1997-2010.

A significant minority of Hong Kong investors representing a disproportionate of retail trading volume will shift to on-line services. Early users of on-line services will have three to four times the average trading volume, but this difference will erode as on-line services build share. 20 to 30 per cent of retail investors will shift to on-line services by 2010. On-line services then will represent 30 to 40 per cent of Hong Kong's total retail trading volume.

The technology of investment services is developing very rapidly. This will impact Hong Kong in several inter-connected ways. Wide-spread availability of on-line services in Hong Kong is inevitable. They will intensify competition, not only among brokers but also between Hong Kong and other financial centers. Moreover on-line technology will facilitate unprecedented levels of convenience, access to information, and opportunities for integrating services, e.g., brokerage, banking, pensions, and smart cards. Technology will profoundly affect the cost structure of investment services. Some elements in Hong Kong will resist these developments, others will fail to understand their significance, but a few will be early movers and will gain great advantage from doing so.

4.2. Accelerated Commoditization

Basic transactional and information services will become low margin commodities. Because of heightened competition the average commission for traditional brokerage services will fall dramatically. Hong Kong's retail investors will become increasingly "sophisticated", but in a narrow sense. They will be much more aware of and sensitive to price differences than to the strength, experience, and quality of service providers. Thus many will be responsive to the aggressive pricing of on-line services. The average commission for traditional brokerage services will decline to less that half its current level by 2010. The average on-line commission will end up at about 30 per cent of the commission for traditional service.

The clash of market share objectives between traditional and on-line brokers will be quite extreme. The on-line brokers will aim to win substantial market share, but the traditional service providers will not be prepared to concede very much. This clash of goals will drive increasingly intense price competition.

Most of the larger traditional service providers will be drawn into price wars. They will respond quite aggressively to the low prices of on-line specialists, and subordinate their profitability to defending market share. A few will try to remain aloof, as Merrill Lynch has done so far in the US. The smaller brokers will attempt to compete on relationships rather than price. They will lose significant accounts and trading volume, and will end up in destructive price competition.

As described above many of the large Hong Kong brokers will offer their own on-line services. Their traditional services will be cannibalized by their own low-margin on-line services. Some will have an unresolved schizophrenia, i.e., are they part of the "establishment" or the "new wave". This ambiguity has hurt Fidelity, Schwab, and Dean Witter Discover, among other, in the US.

There will be a substantial shake-out and consolidation among Hong Kong brokers. Overall the profitability of traditional brokerage services will be seriously damaged. The traditional service providers who proactively anticipate and exploit the new technologies will fare reasonably well. But many brokers will be slow to react. They will be at first unwilling, and later unable, to adapt to the new market conditions. And although successful in building market share, some on-line service specialists also will encounter serious financial problems.

4.3. Threats to Hong Kong's Position

On-line services will provide Hong Kong investors with easy access to foreign issues and markets. Macro-economic conditions in Hong Kong, mainland China, and the Southeast Asian region will have a profound influence on the evolution of Hong Kong's investment services market. These conditions will affect growth in the number of Hong Kong retail investors, their transaction volumes, their investment approaches, and the amounts they invest in Hong Kong and other markets. The macro-economic environment also will affect the supply side, i.e., the number and mix of securities listed in Hong Kong, the volume of initial and secondary offerings, and the range of derivatives and composites available.

The macro-economic environment directly impacts the performance of Hong Kong's financial markets. The near-term outlook is for a continuation of the conditions which has prevailed since last October. However Hong Kong's economy and financial markets are fundamentally stronger than others in the region. As the local economy shows signs of recovery, both Hong Kong and mainland investors will respond with renewed enthusiasm. There will however be a greater conservatism, e.g., more emphasis on quality, hedging, and diversification.

Poor financial market conditions and a loss of investor confidence will depress retail trading volume during 1998-99. There will be a flight to quality among Hong Kong's retail investors including a strong interest in world-class blue chips (e.g., major US and European companies). On-line services will stimulate interest in and facilitate a shift to foreign issues, composites, and derivatives. This shift initially will apply to a small group of sophisticated retail investors, but over time it will become a broadly-based phenomenon.

Hong Kong exchanges will lose volume both to foreign markets and off-market electronic order matching systems. By 2010, under the Base Case "business as usual" scenario, overall exchange volumes will down by as much as 40 per cent compared with the recent peak. Approximately half of this loss will be to foreign markets, and the rest to off-market order matching.

Competition in investment services occurs in many forms. The competition between on-line and traditional services is one manifestation. Competition among on-line service providers (and of course among traditional brokers, too) is another. Competition between Hong Kong and other financial centers for transaction volumes, investor assets, listings, and offerings is still another. These competitive dynamics are interdependent. Hong Kong's attractiveness to both investors and issuers depends on its liquidity, investor focus (e.g., China-related opportunities), turnover, product breadth, and availability of information. The dynamics are shaped by the characteristics of Hong Kong retail investors, the players in the Hong Kong investment services market, and the goals and strategies of those competitors.

The Base Case scenario leads to some dramatic results for Hong Kong. These results are being driven by a powerful combination of forces, i.e., the impact of on-line services on prices and investor expectations, commoditization of unbundled services, increasing investor sophistication, availability of new derivatives and composites, and increased integration of financial markets. In this scenario on-line technology is far more than "just another channel for order entry". The ability of on-line technology to facilitate innovative bundling of services is the key to preserving profitability and relationships.

Having lost substantial capital and trading volume, the major challenge for Hong Kong will be to make it easy and attractive for investors to come back and to win new investors as the market takes off.

5. An Alternate Scenario - "Seize the Initiative"

Analyse with the simulation model revealed factors that: (a) in many instances have a highly leveraged impact on market conditions and the performance of competing players; and (b) cannot be specified with a high degree of certainty and confidence. The combination of significant leverage on outcomes and planning uncertainty defines the most value-adding elements for scenario development. Why? Because the economic rents accruing to Hong Kong and its future position as a financial center are at risk from these factors. Moreover they are the leverage points for enhancing Hong Kong's performance and shaping the future. Developing scenarios for several combinations of these factors stimulated creative thinking about their strategic implications, how Hong Kong can prepare for such futures, early signs of which future actually is happening, and how Hong Kong can most effectively contend with and succeed in that environment.

Two major alternatives to the Base Case scenario were analyzed. One describes a significantly more challenging market environment than the Base Case. The other defines a far more effective management strategy for Hong Kong than business as usual. The first alternate scenario is called "The Wild, Wild East" because it is reminiscent of the tumultuous, free-for-all, cowboy environment of the American wild west. The second scenario is called "Seize the Initiative". It denotes a strong proactive effort by Hong Kong to turn on-line investment services from a dire threat into a historic opportunity.

The simulation model was used to analyse the implications for Hong Kong of four combinations of market environments and management strategies: the Base Case environment; The Wild, Wild East; the Business as Usual strategy; and Seize the Initiative. The Base Case scenario described in the preceding section is, to be precise, the combination the Base Case environment plus Business as Usual strategy.

The differences are very substantial and highly informative. The impacts of on-line services, in terms of market growth and financial outcomes for Hong Kong brokers, vary from devastating to strongly positive. And under both the Base Case and Wild, Wild East environments Seizing the Initiative is a far superior strategy to Business as Usual.

Depending on how the exchanges, their members, and the regulators anticipate and respond to the scenarios considered Hong Kong could emerge as the leading financial center in the region, or at the other extreme it could become marginalized. The conditions under which each outcome is most likely are shown in the matrix below.

Results from these analyse contain a very clear message. It is essential for Hong Kong to seize the initiative. And the exchanges and the SFC must show the way. Otherwise many of Hong Kong's brokers will miss the opportunity to transform themselves. The high-leverage action arenas are:

5.1. Proactive Platform Development

Hong Kong's exchanges must provide leadership, infrastructure, and support. Starting immediately they should aggressively encourage members of all categories to anticipate the impacts of on-line services. This is a crucial leadership role. Time is of the essence, because the window of opportunity to seize the initiative is of limited duration. It is clear that the risks of moving too slowly far outweigh the risks of being too early.

The exchanges should collaborate with technology partners to develop a system platform for members to provide on-line investment services to their customers. The infrastructure should be based on open Internet standards and technologies. This approach will make it as easy as possible for anyone to link to and build-upon the basic system platform. It will encourage innovative developments, for example, electronic forums where investors can "meet", exchange information, and receive news from companies and advice from experts. It also will enable the Hong Kong platform to be easily "exported" to investors throughout the region and appropriate markets world-wide.

Being in a "learning mode" is essential, because there will be many unknowables. The exchanges should get started fast with an initial prototype system. The first step would be to hold a series of roundtable discussions with exchange members. A complete picture must be assembled of their current plans for on-line services and their priorities for a system platform. Additional information on the current use of on-line services by Hong Kong investors also would be enlightening. The exchanges should initiate discussions with potential technology partners, and seek their proposals. Potential partners include Hongkong Telecom, MCI (developer of the NASDAQ infrastructure), and Microsoft. An informative experiment would be to proactively invite E*Trade and other US on-line specialists into Hong Kong and then watch what happens.

The initial on-line system platform should be operational in 1999. It should provide the capabilities for exchange members to offer extensive financial information, access to brokerage accounts, and order entry.

While they may initially feel threatened by on-line services, many brokers would exploit the Internet platform. Most of the largest brokers will launch their own on-line systems. The on-line services of the largest brokers will be aimed toward wealthy, very active retail investors. Other brokers will provide small investors with on-line access.

Development of a system platform for on-line investment services offers an historic opportunity to re-think and refine the basic architecture of Hong Kong's markets. Hong Kong exchanges should extend their central clearing house function to provide an on-line "central server". This would be similar in concept to the Singapore Central Depository (CDP) but more sophisticated in both functionality and technology.

All securities traded on-line would be registered and held electronically on the server. The server would facilitate for investors:

Both information technology and legal foundations must be established for this unified clearing account. There should be standard protocols for disclosing information about unified accounts, e.g., to financial institutions or regulators. Incentives and benefits for voluntary acceptance of unified clearing should be defined. Examples of possible benefits include lower interest rates for margin borrowing (because an integrated picture of the borrower's situation reduces risk) and lower commissions (because the transaction costs would be less).

Hong Kong also has the opportunity to anticipate the convergence of communication and information technologies. In the course of the project many systems for electronic access to retail financial services were reviewed, but none of them seem "right". For example in Singapore retail investors can trade shares, transfer money in and out of their brokerage account, apply for IPOs, and check on their share allotment via bank ATMs. This is awkward because the customer has to go to the ATM, and the functionality is quite limited. In the US electronic access to both banking and investment services was first by telephone and now by PC (increasingly through the Internet). There PC penetration is high and the services are developing very rapidly, but the customer usually must be at his or her desk. In the UK banks are introducing electronic access via mobile phones, but through proprietary systems.

For Hong Kong and many other markets Internet access via mobile phones and other wireless handheld devices, e.g., personal digital assistants (PDAs) and handheld personal computers (HPCs), could be an important solution. Mobile penetration is far ahead of home PCs. At least one mobile handset manufacturer is actively developing a "mobile ATM" product for wireless banking. There is no reason in principle why wireless access to a broad range of investment services should not also be considered. These services would include access to financial information, order entry, checking on orders, reviewing brokerage accounts, transferring money, etc. Smart cards could manage the verification and security problems.

Here, too, off-the-shelf solutions should be pursued using open standard technologies. Hong Kong must move quickly to become the leader in technology exploitation. In 2000 Hong Kong should aim to have world-class on-line services , offering retail investors fixed line and wireless access to securities, derivatives, composites, IPOs, banking services, and a huge range of investment information.

5.2. New Derivative Products

The exchanges should develop new products aimed at on-line investors. As described above Hong Kong investors will behave with greater conservatism, e.g., with more emphasis on quality, hedging, and diversification. There will be a flight to quality among many of Hong Kong's retail investors including a strong interest in world-class blue chips (e.g., major US and European companies). This shift also will be motivated by a strong desire to diversify away from local and regional risks. On-line services will stimulate and facilitate the shift to foreign issues, composites, and derivatives.

Hong Kong exchanges will lose significant volume to foreign markets unless local products can fill these needs. Depository receipts for popular foreign issues ("HKDRs") should be created. It is significant that Deutsche Bank is developing a program of depository receipts for US stocks for the Buenos Aires Stock Exchange. HKDRs on well-known international companies, e.g., Boeing, Coca Cola, Daimler-Benz, IBM, Intel, LVMH, Microsoft, Shell, and Sony, would be popular with Hong Kong investors.

A second category of derivative products is new futures and options on major foreign market indices. They include the Dow Jones Industrial Average and S&P 500 in the US and the FTSE 100 in London. These products should be designed for local retail investors. Large institutions already have access to a wide range of such products.

HKDRs and index futures and options also would attract investor interest and capital throughout the region. The recommended on-line system platform would enable foreign investors to access these products through either their local brokers or Hong Kong brokers.

5.3. Regulatory Changes

The regulators should embrace change but be vigilant. Far better to move decisively and comprehensively to anticipate the new market environment than to respond piecemeal:

These changes should be implemented quickly and evenhandedly. There must be no blank cheque, favoritism, or cronyism.

The growth of on-line investment services is likely to increase local volatility in several ways. Experience in the US indicates that on-line service users increase their trading frequency. They follow the performance of mutual funds more closely (relying on Morningstar and other fund rating services) and shift in and out of specific funds with greater frequency. Recent studies show that US retail investors behave in ways that amplify market movements, i.e., they shift into aggressive equity funds after markets have developed strong upward momentum (thus propelling them higher) and shift to cash after markets have fallen substantially (thus driving them lower). The SFC should monitor the effects of on-line services on the volatility Hong Kong's markets and make appropriate adjustments to capital and margin requirements.

Moreover the development of fully-integrated financial services will require an integrated framework for regulating financial institutions and markets. Recent problems with finance affiliates of brokers and custody of shares highlighted what, arguably, are gaps in the current framework. As with communication and information services, once separate financial services are converging. Historical differences between banking and brokerage, pensions and investments, derivatives and underlying assets are becoming increasingly meaningless. The UK is moving to consolidate regulation of financial services under one super-authority. In Hong Kong the immediate requirement is for coordinated banking and securities market regulation. Hong Kong must consider how it will achieve regulatory integration in the longer-term.

If Hong Kong seizes the initiative its position as one of the world's leading financial centers, and the regional leader, would be significantly strengthened. Distance will collapse because of on-line systems. The death of distance could precipitate a large-scale shift of assets out of Hong Kong, but alternatively Hong Kong investors could achieve greater diversification and quality within Hong Kong markets. Investors should be able to access global markets without ever leaving Hong Kong , e.g., through depository receipts and other derivatives.

Business as usual is not an option for Hong Kong! A cautious, or complacent, wait-and-see attitude will cause Hong Kong to be marginalized. Without the proactive initiatives described above Hong Kong faces a very serious threat that its retail market will be "cherry picked" by foreign financial services groups. These groups will target wealthy, active investors. Hong Kong's retail investor base would shrink steadily as traditional investors age and the younger, more sophisticated ones defect.

Erosion on the demand side will lead to reactions on the supply side, and vice versa. Red chips increasingly would list in London and the US. More and more fund managers would shift their base out of Hong Kong. As a result Hong Kong would lose very substantial trading volume and asset balances to other financial centers (particularly ones specializing in on-line services). These relationships are highly circular and self-reinforcing. They can form a virtuous or vicious circle, depending on the conditions which prevail.

What factors make the difference among those outcomes? There are several parts to the answer:

When Hong Kong brokers have their own on-line option available at an early enough stage they can migrate customers they otherwise would lose . They may fear cannibalizing their own customer base, but the US experience shows quite clearly that it is better to retain customers on-line than lose them. The ability to migrate traditional brokerage customers to captive on-line services will substantially mitigate price competition.

Moreover more rapid emergence of new applications (e.g., fully-integrated brokerage and banking) and reduced switching costs (e.g., from the convenience and confidence of being able to stay with your current broker) will mean that on-line services do not need to be sold exclusively on price. As a result these factors the profitability of both traditional and on-line services is far better.

The outcome for Hong Kong is positive, even under extreme market scenarios:

By proactively embracing and exploiting Internet technology, Hong Kong will lead the development of a virtual financial market and will position itself as one of the major hubs.