Why HK has no retail bond market
13 May 2018
One of the stupidest things in the HK Government's 2018-19 budget has now been launched by the Hong Kong Monetary Authority: the Pilot Bond Grant Scheme (PBGS). Yes, if you and your affiliated companies have not issued bonds (of any currency) in HK in the last 5 years, then the Government will now pay half of your issue costs, up to HK$2.5m, or $1.25m if you don't have a credit rating. And after you've done that, you can do it again, because the Government will subsidise up to 2 bond issues for each group. PBGS appears to be an almost exact copy of Singapore's Asian Bond Grant Scheme, but one intervention doesn't justify another.
This will not improve Hong Kong's image as a financial centre, It will do the opposite, demonstrating the increasing tendency of the HK Government to intervene in free markets and manipulate the economy. Corporate welfare is never right - welfare should be reserved for poor people, not for companies. Whatever next - will the HK Government start subsidising Initial Public Offerings of shares on the stock market? Will they do so if Singapore does?
Perhaps the Government has been asking itself why there is no liquid retail bond market in Hong Kong. They should look in the mirror - it's their own fault. There is certainly no shortage of bond issues, many of which are listed on the Stock Exchange of Hong Kong Ltd (SEHK) owned by Hong Kong Exchanges and Clearing Ltd (HKEX, 0388), but these bonds hardly ever trade on the exchange. Bonds are traded by banks in the so-called "Over The Counter" (OTC) market, which in practice means by phone or electronically.
There are two main reasons for the lack of retail access to the bond market, but they are both manifestations of the same vested interests.
First, unlike stockbrokers on the stock exchange, there is practically no "best execution" obligation on banks to seek out the best bond price for a customer who wishes to sell or buy bonds. The SFC and HKMA pay lip-service to best execution (see the recent Report on the Thematic Review of Best Execution and circular to licensed corporations asking them to try harder), but the reality is that when there is no visible traded market, no public transaction reports, and any (rare) published quotes are non-binding, banks instead contractually "carve out" the obligation and tell customers that they are on their own. They tell customers that the price the bank offers is not necessarily the best price they could get if they shop around, but then there will be fees for moving the bonds to another bank or broker.
So if you subscribe to say, the latest PRC bond through a bank, then they will keep it for you, and you are pretty much stuck with it until redemption, unless you are willing to accept the price the bank offers you, which is a price much worse than the interbank market, with a wide bid-offer spread. Imagine instead walking into a bank and saying "I want to sell my shares in blue-chip company X". The bank cannot say "well we'll offer you $10 per share for those, or you can buy some more from us for $11 per share". They must go to the market and get you the best price.
How bad is it? Take for example, the RMB4.3bn 2-year PRC RMB bond maturing 4-Dec-2019 (stock code 86650), which has never traded on SEHK. And it's not just RMB bonds - for example, the HK$4.8bn HKSAR Government 10-year bond maturing 17-Jan-2023 (stock code 4215) has trades reported to SEHK on just 6 days in over 5 years since issue, with turnover totalling just HK$13.82m, or less than 0.3% of the issue in over 5 years.
The HKMA's Central Moneymarkets Unit (CMU) has a "Bond Price Bulletin" where banks and brokers can indicate non-binding bids or offers, but if we take that HKSARG bond (CMU code 10GB2301) as an example, there is currently only 1 bid price from a bank, and no offer price. Only banks can post quotes on the bulletin - you can't post your own, and if banks have no stock then they can't offer it. It is not a market, just a bulletin board.
Clearing and settlement
The second impediment to retail investor access to the bond market is that most bonds issued in HK are deposited into the HKMA's CMU, where OTC trades are settled. To trade bonds on SEHK, you have to first get them moved into the Central Clearing and Automated Settlement System (CCASS) operated by Hong Kong Securities Clearing Co Ltd (HKSCC) which is also owned by HKEX. There are 2 ways to hold securities in CCASS, either as a direct Investor Participant, or via a broker. Either way, the bonds would then by held by HKSCC as a "recognised dealer" (like a bank) in CMU. Unlike CCASS, the CMU does not allow direct investor accounts, so you have to hold bonds via a recognised dealer in CMU.
Your bank would charge fees for the transfer from a recognised dealer to a CCASS account, and it would take time. Without a seamless interface between the OTC bond market and SEHK, the pool of available bonds stays in the CMU and can only be traded by banks. What we need is an obligation on banks (recognised dealers) to post all retail bids and offers to an exchange, and a system for SEHK (if that is the exchange) to accept those orders based on a CMU confirmation that the bank holds the bonds (for sell orders) or has the funds (for buy orders).
You might well wonder why regulators from two different jurisdictions were able to work out a "Stock Connect" scheme to connect stock exchanges in mainland China and HK and even a subsequent "Bond Connect" scheme to connect the two markets, but have failed over decades to efficiently connect the OTC bond market to SEHK. Connecting the systems efficiently really can't be that difficult, with no cross-border issues or capital controls to work out.
Of course, running the bond exchange through SEHK isn't the only option - the HKMA could instead set up a dedicated bond exchange at the CMU, with live, competing, binding bids and offers and trade reporting, and require the banks to run all client orders through it, vastly improving market transparency and efficiency. Tenders could be invited for the supply of software and systems for the platform - no need to reinvent a basic wheel. With a proper exchange running, best execution would then be unavoidable. This approach has the advantage that it wouldn't expand HKEX's rent-seeking monopoly any further, and the bond exchange could be run like HKSCC originally was until it was gifted to HKEX in 1999, as a not-for-profit utility that returned surpluses to users by lowering its fee tariff over time.
So why hasn't this happened already?
It's all a question of political will to overcome vested interests. The banking sector enjoys cheap money from retail depositors, who for nearly a decade have received only 0.01% p.a. on savings accounts, and have always received substantially less than commercial money-market rates. The HKMA is a prudential regulator, so its main interest is in preserving stability of the banking system. Banks are generally more stable if they are more profitable, so the HKMA's interest is in helping banks to make profits, not customers to get better deals. And banks are more profitable if they have less competition for funding, so the HKMA's interest is in avoiding greater competition for funding.
Banks are also more profitable if they can make wide spreads on any bonds they sell to, or buy from, their customers. This is not just for smaller depositors, but for larger individual customers to whom banks provide a so-called "private banking" service. They will buy bonds for you, but at a juicy mark-up or commission to the bank. The customer has no reference point to check the price he gets, as there is no publicly traded market.
Meanwhile, let us not forget that the banks and their insurance affiliates have 2 seats in the Legislative Council and 38 seats (including the 2 legislators) on the 1200-member Election Committee that selects HK's Chief Executive. That may not seem like much, but members from other sectors work together to reciprocate favours and preserve each other's interests. It's the same system that deferred the abolition of minimum commission at the Stock Exchange until 2003. So the inaction is partly down to the banks' influence in the political structure and partly down to the HKMA's interest in banking profits and stability. The latter could be resolved to some extent if HK adopted a "twin peaks" regulatory model, with the HKMA supervising capital adequacy (for banks and insurers) and the SFC (renaming it the Financial Services Commission) supervising all client-facing activity (including insurance sales and broking).
For these reasons, the Government and its HKMA have not been motivated to provide HK citizens with access to a liquid, publicly traded bond market. Such a market would mean that customers would move some of their cheap deposits out of banks and into the bond markets, and the "private banks" would have to wave goodbye to the juicy spreads and commissions on retail bond trades. The vested interests have, until now, triumphed over the public interest. That's a shame. A retail bond market would allow investors to diversify their risk and effectively park their savings in loans to commercial entities that they trust, at a more senior and less risky level than buying shares or even warrants on shares of the same entities. Remember that creditors (including bondholders) rank ahead of shareholders in a liquidation.
Instead of properly connecting the OTC market to SEHK or setting up a dedicated bond exchange, the Government indulges in gimmickry like the Pilot Bond Grant Scheme, which will do nothing to address the real problem. HK Chief Executive Carrie Lam should show some much-needed leadership and order the HKMA to "make it happen".
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