“How does Hong Kong position itself for the future? As an international financial center like London? As a super-connector for China? As something else? Or as all of these?” Ashley Alder, CEO of Hong Kong Securities and Futures Commission (SFC) highlights three areas where Hong Kong can remain a structurally sound platform and capture opportunities as a result of China’s growing participation in the global financial markets – as a place to manage onshore China risks, as a listed market and as a fund management center
By Kenny Lau
Much has happened in the financial markets over the past 18 months, and it has been a year of turbulence in stock markets globally, including the Shanghai and Shenzhen stock exchanges in China where its currency, renminbi, was no less volatile. The Hang Seng Index in Hong Kong, meanwhile, dropped by about a third in value within a five-month period from a peak in April 2015.
The global market is undoubtedly facing significant headwinds, but an equally important question is how Hong Kong can remain an international financial center ready for “many of the underlying secular trends [which] have continued unchanged, including China’s opening up,” said Ashley Alder, CEO of Hong Kong Securities and Futures Commission (SFC), speaking in a recent luncheon at the Hong Kong Securities and Investment Institute (HKSI Institute).
“We can see this in the recent liberalization of the domestic bond markets for foreign institutional investors – free of any quota restrictions,” Alder highlights. “There is also the probable launch of the Shenzhen leg to Stock Connect, and the recent expressed wish of the China Securities Regulatory Commission (CSRC) to establish domestic commodity futures markets which are open to international investors.”
“Now at the SFC we believe that the key to our continued success is to synchronize the sophisticated markets and services which Hong Kong has to offer with the accelerated development and opening up of the Mainland markets,” he says. “In essence, we should do what we have done ever since the first H-share in 1993. This is to enable the world to access China via a regulatory, legal and market environment which ensures very high levels of confidence in fairness, resilience and security.”
But China’s market is also very different today from how it was in 1993, Alder notes. “Most of the big state-owned enterprises have now all listed. Although Hong Kong’s initial public offering (IPO) market was again number one in the world last year, questions are now being raised about relative valuations and other factors which may attract companies to list in other markets. In short, it is a far more competitive environment, and we need to be agile.”
“So how does Hong Kong position itself for the future? As an international financial center like London? As a super-connector for China? As something else? Or as all of these?” he says, highlighting three areas where Hong Kong can remain a structurally sound platform and capture opportunities as a result of China’s growing participation in the global financial markets. “First, Hong Kong as a place to manage onshore China risks. Second, Hong Kong as a listed market. And third, Hong Kong as a fund management center.”
Hong Kong as a risk management center
While Hong Kong is already a “connector” as the leading offshore renminbi center through the Shanghai-Hong Kong Stock Connect program and more recently through cross-selling of Mainland and Hong Kong funds in each other’s markets under the Mutual Recognition of Funds (MRF) scheme, being a center for managing the more difficult risks arising from overseas institutional investment in the Mainland markets is a significant prospect, Alder believes.
“In large part it is about the further development of derivatives, futures and other hedging or risk management instruments which require both sophisticated regulation and world-class, secure pre- and post-trade market infrastructure,” he explains. “China clearly remains keen to attract greater onshore participation from overseas institutional investors and, despite concerns about the currency and capital flows, in the longer term to allow Mainland investors to put more of their savings to work outside the Mainland.”
For China, Hong Kong can serve as a market with the full range of hedging and arbitrage options, together with the right regulatory and institutional framework to manage the risk profiles of a range of exchange-traded and over-the-counter (OTC) risk management financial instruments, Alder says.
“This is largely about the way in which institutional investors were perceived to have had access to onshore derivatives to hedge or speculate on falling prices whilst retail investors were excluded, leading to what were seen to be unfair outcomes,” he points out. “This perception led to new restrictions in the derivatives markets, especially A-share futures. This has meant that investors have fewer choices to manage their long positions effectively.”
Hong Kong, Alder says, can therefore play a major role as place which originates and clears futures and other derivatives that are more precisely calibrated to manage onshore Mainland risks. “This could create a virtuous circle by enabling investors – mainly foreign institutions – to increase their domestic Mainland exposures on the long side. And this, in turn, should increase the volume of risk management activity in Hong Kong – where we are in the right time zone and have the right experience to do this.”
“Of course, an expansion of our markets to offer more sophisticated hedging and similar tools will also require the SFC, as regulator, to manage the more complex inherent risks that come with this activity,” he stresses. “But we think we are well positioned to succeed as we are moving forward with the implementation of the new legislation focusing on the clearing of OTC derivatives, and we are also participating in international work concerning the resilience of the central counterparties which clear derivatives trades.”
“In recent months we have been looking hard at how our market is functioning, focusing on some apparent anomalies. For example, we have investigated whether some sharp market movements in individual stocks have been a consequence of legitimate capital flows or something else,” Alder notes.
These sharp market movements were discussed at the SFC Regulatory Forum 2016: the market capitalization of 860 listed companies in Hong Kong had doubled within a six-month period between 2013 and 2015. The share prices of 56 of these companies (which had a collective market capitalization of close to HK$400 billion by the end of 2015) had increased by more than 10 times within six months. Out of these 56 companies, 39 were loss-making and 10 had price/earnings ratios of over 50 times. And some of these companies were included in other major market indices.
“The question is whether there are any common themes or causes behind instances of extreme volatility and, if so, whether this should prompt regulatory action,” Alder says. “Of course, when a stock is included in major market indices, many institutions are compelled to buy, and this tends to have a snowball effect on the stock price. But a fair number of these companies were also subject to SFC high shareholding concentration warnings.”
“Given their market size, any single instance of misconduct related to their share price performance could seriously dent investor confidence, threaten our market reputation and even raise issues about systemic risk,” he explains. “And we were not the only ones who were concerned. FTSE in December 2015 and MSCI early this year introduced new rules to exclude from their indices stocks which are subject to SFC high shareholding concentration warnings.”
While the extreme price volatility of newly-listed stocks in the Growth Enterprise Market (GEM) is a concern, the questions need to be answered are more fundamental. GEM was initially to cater to high-growth companies such as those in technology but re-positioned in 2008 as a stepping stone to the Main Board with a streamlined process. At the moment well over 80% of GEM companies are traditional businesses. Moreover, Alder notes that “we have seen that newly-listed GEM companies are often associated with extreme price fluctuations, small public floats and high shareholding concentrations.”
“In many cases, IPO proceeds are minimal – far too small to justify the expense and effort of an IPO. We have been very concerned about these and other developments in our listed market. Hence, we have been working with HKEX on an overall review of a range of listing policies, including a holistic review of GEM, backdoor listings, shells and prolonged suspensions, because getting on top of these issues is critical to preserve the quality of Hong Kong’s market.”
The current listing regulatory structure, in which the SFC and the Exchange have separate but overlapping functions and powers, was conceived more than two decades ago.
“There is a compelling case for a far more coordinated approach towards listing regulation. We believe that this requires greater interaction between listing policy and the Listing Rules, which are administered by the Exchange, and the regulation of listed companies and intermediaries by the SFC under the Securities and Futures Ordinance,” Alder elaborates.
The launch of MRF was ground breaking because it allowed cross-selling of Mainland and Hong Kong mutual funds in each other’s market for the first time. Today, 37 Mainland funds and six Hong Kong funds have been approved to operate since the launch of MRF at the end of 2015.
“Like early H-shares and Stock Connect when first launched, the cross-border traffic under the MRF scheme is not large,” Alder says. “But this was to be expected. Markets have been difficult, and we know it takes time to develop distribution capacity and new products. The important thing is that Stock Connect and MRF have operated smoothly and have paved the way for more market integration and connectivity. For Stock Connect, we are looking to extend connectivity to Shenzhen, and for MRF we will continue to deepen and broaden the scheme.”
More importantly, several initiatives are underway to tackle a number of structural issues as part of a larger, ongoing strategy of promoting Hong Kong as a global hub of asset management, he points out, noting a bill recently passed by the Legislative Council to create a legal framework enabling the introduction of a new open-ended fund company (OFC) structure in Hong Kong where funds will be given an extra option to be structured in corporate form rather than as unit trusts.
Fund distribution, Alder notes, is another area due for enhancement. Right now, roughly 80 percent of funds are sold through banking institutions and only three percent by brokers. The issues are limited shelf space, high costs and limited choices for investors, and alternative distribution platforms are necessary in order to encourage greater diversification. As such, SFC supports the idea of an exchange-sponsored platform to enable brokers to buy and sell funds for their clients in the primary market.
“We have discussed with HKEX whether their clearing and settlement system can accommodate primary subscriptions and redemptions, and HKEX has agreed to incorporate a capacity to handle fund distribution in its next generation system upgrade,” he says. “Separately, we want to encourage the growth of in-house or third-party online platforms, and an SFC working group on suitability, platforms and advice (SPA) was formed earlier this year to clarify how the requirement to ensure that financial products are suitable for clients operates across different business models.”
With a shift to passive management in the global funds industry, there has been a rapid growth of exchange-traded funds (ETFs) in Hong Kong, particularly in the last few years alongside the expansion of Renminbi Qualified Foreign Institutional Investor (RQFII) quotas. But there is also a need for more diversification and innovation in the current low-yield environment, Alder says. “So in April and May we saw the listing of two crude oil futures ETFs, an asset class which was previously confined to institutional money.”
“The final but most important limb of our asset management strategy is about regulation,” Alder stresses. “Over the last few months, we have consulted the industry about a revamp of the Fund Manager Code of Conduct as well as about a liquidity risk management circular. The liquidity of the underlying assets [in mutual funds], particularly if they are emerging-market bonds, is fair at the best of times, and poor in times of stress.”
“The conventional wisdom that equity markets are liquid is also being challenged. So in this part of the world, we have seen a number of liquidity issues in the A-share market, most recently as a result of the circuit-breaker mechanism, and of course the events of last summer which led to widespread suspensions of A-shares in which funds are invested.”
“As a fund manager, how do you actually manage the risk of mismatch between redemption pressure and the liquidity of your fund assets? Is your portfolio structured to be resilient to shocks? And have you been monitoring the liquidity profile of your funds on a continuing basis?” he says. “Our new liquidity risk management circular aims to provide principles-based guidance in these areas.”
“And we are continuing to look at the feasibility of identifying market orders directly at a client level rather than at a broker level,” he adds. “At the SFC, we are keenly aware that our regulation must take Hong Kong’s unique position into account. As recent events have shown, our regulatory regime must be resilient under fast-moving and challenging market conditions, but also adapt to changes in the markets and the broader economic environment.”
“Hong Kong has had a long track record of successful adaptation, and we’ve come a long way since the listing of the first Mainland business in Hong Kong in the early 1990s,” Alder reflects. “Now 70 percent of the trading on our exchange is centered on Mainland companies. Over the past five years or so, the introduction of RQFII and QFII, the growth of offshore renminbi and other initiatives such as Stock Connect and MRF are transforming our market once again.”
“So, it is up to all of us to make sure that Hong Kong’s competitive advantages are cultivated and advanced and to reinforce our reputation as a place where international and local investors can operate with confidence,” he says.