The Board of HKEx (0388) today decided to keep wide bid-offer spreads for stocks below $5, cancelling its plan to improve market efficiency after intense lobbying by some small brokers, who also campaigned against the elimination of minimum commissions in 2000-2002. Once again in Hong Kong, political expediency trumps logic and commitment. We call on good companies to now distinguish yourselves by consolidating your shares to get into the efficient price zone above HK$5.

HKEx keeps wide spreads
14 February 2007

At a board meeting today, Hong Kong Exchanges and Clearing Limited (HKEx, 0388) abandoned its plans to reduce the minimum bid-offer spread for stocks below $5 on the Stock Exchange.

The brief history is this: back on 6-Jan-02, Webb-site.com called for the exchange to cut trading spreads in the interests of market efficiency. Shareholders elected your editor to the Board of HKEx as an outside candidate in Apr-03. On 6-Aug-04, HKEx announced a consultation on reducing spreads in two phases, starting with shares priced above $30. On 4-Feb-05, HKEx announced conclusions on the consultation, and a decision to proceed. Phase 1 was implemented on 4-Jul-05, affecting 22 primary-listed stocks.

On 15-Feb-06, HKEx announced that, after reviewing the favourable results of Phase 1, it would proceed with Phase 2, to cut spreads across the rest of the board from $0.25 upwards (stocks below $0.25 already have the smallest possible increment of $0.001). HKEx said in that announcement:

"Statistical findings collected following the implementation of the Phase 1 proposal indicate that the initial reduction of minimum spreads has enabled investors to buy and sell securities at more price levels within a given price range than before. Findings also revealed that bid-ask spreads narrowed, increasing the chance of order execution at the marginal prices inside the previous spreads and thus improving market efficiency."

A broker backlash ensued, with threats of street protests by their staff. In the meantime, your editor stood for re-election to the board at the AGM, joined by a new candidate, Christine Loh, in a campaign that featured this policy issue centre stage. The broker-backed opponents of narrower trading spreads lost fairly and squarely, with your editor receiving the largest majority in any HKEx contested election yet. We had en electoral mandate, to do what we said we would do, both of which are quite rare in this town.

Despite this, on 2-Jun-06, the Board responded to pressure and decided to break Phase 2 into two phases, named 2A and 2B, as shown in this table. We disagreed with that, as we saw no reason for further delays. As an interim measure, with which we also disagreed, the spreads between $2 and $5 were only reduced to $0.01 rather than the original plan of $0.005, making it less obvious that we had just created a 2-tier market, between high and low efficiency, by having a medium inbetween.

No reason for U-turn

As the two-phase announcement of 2-Jun-06 made clear:

"HKEx will monitor the results of Phase 2A and will proceed in the first quarter of 2007 with...Phase 2B, subject to no systemic problems having arisen in Phase 2A".

It was agreed today that there had been no systemic problems in Phase 2A, so the condition was satisfied. In the summer doldrums, some brokers had claimed that the spread reduction had reduced turnover, but in fact the market hit record turnover levels in the second half of this year (not counting the Government intervention blitz of 28-Aug-1998) and the stocks in the $2-20 range were no exception.

Soon after Phase 2A took effect, a local academic and some brokers complained in the press that the spread reduction had reduced stock volatility, thereby damaging the value of warrants. Meanwhile other brokers claimed that the spread reduction had increased volatility. They couldn't even sing in harmony, although they tried, with a demonstration on the floor of the Stock Exchange. Of course, both claims were wrong. Volatility is a measure of risk, and if you could reduce investment risk simply by narrowing the trading spread of securities, then the 1990 Nobel prize for the capital asset pricing model would need to be returned, and all market prices would be re-rated upwards for the lower risk in the investment. Pure magic!

Before Phase 1, broker representatives had also claimed that they would find it impossible to keep up with the rate of modification of limit orders as people raised or lowered their bids or offers in our order-driven system. In fact, there was barely any change in the number of order modifications. What we did see was an increase in the trade-to-order ratio - the percentage of orders that were getting completed, and a reduction in queue size. This was because, when you have a narrower bid-offer spread, more buyers and sellers are willing to trade at the prices on offer or bid, rather than join the queue just to save an extra fraction on the price. Reducing queue size with faster service in this way is a good thing, just as shorter queues in the lift lobby or at the immigration counter are a good thing.

In fact, small brokers haven't suffered from this in terms of volume. The market share of brokers ranked 66th and lower, known as Category C, has increased from 11.02% in Jun-06, before Phase 2A, to 12.32% in Dec-06. At the same, average daily market turnover has increased 59% from $29.98bn in Jun-06 to $47.68bn in Dec-06, so Category-C turnover has grown by 77.8% to $5.87bn in that period. For sure, the bubble in the market has attracted a lot of retail investors, but these tend to be short-term traders which rather contradicts the claim that narrower spreads drove them away.

In our view, the opposition to greater efficiency comes from the same source as the opposition earlier this decade to the elimination of fixed minimum commissions. Some, but not all, small brokers, were then, and are now, simply unwilling to deal with greater competition. Narrower trading spreads would reduce other transaction costs, which means that their clients would become more sensitive to brokerage rates, and some will move to brokers who have cut rates by investing in technology to provide service at a lower price. In 2002, with a threat to organise street protests, the brokers succeeded in persuading the Government, who in turn persuaded HKEx, to delay scrapping minimum commissions by 1 year (see Government Backs Cartel, 24-Jan-02).

Political realities

If there was no systemic problem with Phase 2A, and if the benefits from spread reduction were obvious, and had been stated in the previous press releases announcing the plan, then why did the Board, including Government-appointed directors, do a U-turn? Perhaps they were thinking (with apologies to Shakespeare):

"2B, or not 2B: that is the question. Whether 'tis nobler in the mind to suffer the slings and arrows of outraged brokers, or not to take arms against a sea of market inefficiency..."

Of course, we cannot know what was going through the minds of fellow directors today, but that is our best guess. There is a pseudo-election for Chief Executive of Hong Kong in March, and the small brokers and their functional (or so we are told) legislator have 13 votes in the 800-member Election Committee. Like so many other special interests vested in the committee, they have the ability to create embarrassment, let alone the threatened street protests that were promised when it looked like Phase 2 would be adopted in one go back in Feb-06. The board stalled once in June, breaking it into two phases, and then again today, cancelling the second half.

The consequences

Of the 1175 listed ordinary shares, Phase 2B would have affected about 954 stocks (81% of companies) trading below $5, representing 23% of market capitalisation. That includes 206 stocks between $2 and $5 where the spread would have been halved from its interim level achieved in Phase 2A. The bar chart below illustrates where we stood before Phase 1 (we'll call it Phase 0, in pale blue), and the progressive effects of Phases 1 (yellow, Jul-05), 2A (burgundy, Jul-06) and the now-cancelled 2B (purple) on the maximum percentage spread in each range.

As that shows, putting things in real-estate terms that Hong Kongers love best, we now have low-rise buildings in the price range of $5 upwards, a medium-rise burgundy tower between $2-5, and three ugly pale-blue skyscrapers still standing between $0.25 and $2.00. Ridiculously, we have a 2% spread at $0.50 but only a 0.2% spread at $5.

The two-tier market

Now, there is nothing more we can do on this subject at HKEx. At least we can say that if we had not been on the board, you would probably only be looking at Phase 1, because that is all that management initially proposed to do. By logical persuasion and academic evidence, we broadened the target and ended up with Phase 2A, and now listed companies have a choice of two market tiers. They can either price their stock above $5, and have a spread of not more than 0.2%, or they can stay in the inefficient zone below $2, where there are far more "junk stocks" which are subject to market manipulation and where the companies who issue them often have appalling governance.

Good companies should respond

We urge all respectable listed companies with prices below $5 to address this problem by raising your share price into an efficient zone above $5. You should do this by consolidating your shares. For example, if you run a company with shares priced at 50 cents, you can consolidate 10 existing shares into 1 new share, resulting in a price of $5, and if you are concerned about creating fractional "board lots" (the minimum size for automated trading on the exchange) then you can simultaneously cut the board lot by the same factor, eliminating the problem. A 2,000-share board lot would then become a 200-share board lot, with the same value as before. Investors will take you more seriously, particularly if you have a price which translates to more than one US dollar per share (HK$7.80) which many overseas investors regard as the penny-stock boundary.

A reminder of Hong Kong's unique system

Today's episode should remind us all of two things:

Trading spreads are widely regarded as a component of transaction costs. By failing to implement the remaining cuts in trading spreads, HKEx has undermined its own calls for the Government to cut or eliminate stamp duty (currently 0.2% on each stock transaction, split 2 ways) to improve market efficiency.

© Webb-site.com, 2007

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