HKEx has reportedly approved a new rule which will make it the only market in the world to have no price caps in regular trading but a limit on movements during the closing auction, thereby locking in any manipulation that occurs just before the auction. Many developed markets have adopted random auction closing-times to deter manipulation, which HKEx did not even allow for in its recent consultation.

HKEx invents square wheel
12 February 2009

In a capitulation to the demands of small brokers, who account for a small fraction of turnover on the exchange, the government-controlled board of Hong Kong Exchanges and Clearing Limited (HKEx, 0388) has reportedly approved rule changes which will restrict price movements during the Closing Auction Session (CAS), the last 10 minutes of trading each day (between 16:00 and 16:10), to not more than 2% up or down, thereby locking in any price-fixing which occurs just before 16:00. A formal announcement is awaited, and the SFC has to approve the rule change.

The reported rule is a uniquely Hong Kong contraption. Rather than adopt the round wheels of other developed markets, HKEx is inventing a square one. Following allegations of price manipulation during the CAS, HKEx published a consultation paper on the CAS on 28-Nov-08, but did not include the option of a random closing time, a refinement which and others had called for. Indeed, your editor David Webb had called for that when he was a director of HKEx before the CAS was even introduced. A random closing time during an auction makes it much more expensive for someone to manipulate the closing price, particularly if the randomness period is long enough.

In its Exchange newsletter of July-2008, HKEx said:

"As part of its efforts to continuously improve the securities market's infrastructure, HKEx is seeking comments from all segments of the market and is considering suggestions on possible enhancements to the closing auction mechanism. HKEx is open to various options including the possibility of adopting the random closing approach, allowing short selling during auction sessions, changing the combination of order types during auction periods and revising the matching priorities. These issues will be covered in a market-wide consultation paper to be released in the third quarter of this year." (emphasis added)

Well, that wasn't true. The paper came out in the 4th quarter, and when it did, it excluded the random closing option, although this had reportedly been included in earlier drafts as late as 13-Nov-08, two weeks before it was published.

The questionnaire accompanying the consultation made clear that HKEx had its heart set on some form of price control or abolition of the CAS - there was no option for "status quo". The first question in the questionnaire was "Do you support Approach 1, Approach 2, Approach 3 or suspending the CAS as a whole?". And of course, the 3 approaches were all forms of price controls, while suspending CAS would be a return to the price manipulation often seen in the last minute of regular trading before the CAS was introduced. The remaining questions tended to exclude the investing public, or at least retail investors, by asking questions such as "how much lead time would your firm require for its implementation?". Such a narrow consultation, both in scope of proposals and in target audience, was not worthy of our response, so we didn't.


If the rule is changed as reported, then it will have the following results:

  1. For shares priced between $0.010 and $0.049, no price movement would be permitted, because a single tick ($0.001) is more than 2%. For shares priced between $0.05 and $0.099, the price movement would be restricted to one tick ($0.001), because 2 ticks would be more than 2%. Similarly, for shares priced between $0.255 and $0.99, the price movement would be restricted to 1 tick ($0.01), because 2 ticks would be more than 2%. As of last night (11-Feb-09), of the 1264 equity shares listed on HKEx, 814 (64%) had share prices below $1.00. They account for about $388bn of market value. The largest was Shougang Concord International Enterprises Ltd (0697) with a market value of $6.1bn.
  2. Companies with share prices between $1.00 and $1.49 would be restricted to a movement of 2 ticks ($0.02). There were 93 stocks in that price range last night, with a combined market value of $141bn. The largest which is not currently suspended is China Travel International Investment Hong Kong Ltd (0308), with a market value of $6.9bn.
  3. Incidentally, if you are wondering why the rule would limit price movements in low-priced stocks to so few ticks, it's because of the U-turn HKEx did over the final phase of spread reductions, which were abandoned in 2007, again after heavy political lobbying by small brokers. Tick sizes between $0.25 and $2.00 were due to be reduced by 80%, but this was dropped, leaving a 2-tier market.
  4. To make any sense, the Exchange would have to delete at 16:00 any outstanding orders on the bid and offer queues which fall outside the allowed price range, as these will be impossible to fill, and might otherwise present a misleading picture.
  5. These price restrictions would have a chilling effect on liquidity in the CAS.
  6. It is unclear whether the rule would apply to leveraged instruments, such as company warrants, derivative warrants, and callable bull/bear certificates. If it does, this would be highly restrictive, because by their nature, the percentage price movements of such instruments are normally multiples of the movements in the underlying stocks.
  7. Finally, the amended rule would actually defeat the intention of the amendment, by making it easier and less costly to manipulate the closing price, because anyone who pushes up or drives down a price in the last minute of the Continuous Trading Session (between 15:59 and 16:00) can be certain that it will not move against them by more than 2% in the CAS, and probably not at all. For example, if you push the price up by 6%, then it won't fall back by more than 2% in the CAS, leaving at least a 4% increase. In many cases, nobody would be willing to buy during the CAS at the elevated price, so no IEP (Indicative Equilibrium Price) would be established in the CAS, and under existing rules, the average price in the last minute (taken at 15-second intervals) would then become the closing price, giving the price-fixer his 6% gain.

In the latest consultation paper, it was pointed out that some Asian markets have price caps in their regular trading session (Tokyo, Korea, Taiwan and Shenzhen). For these, they naturally carry on with the same price caps in the closing auction. These are wide limits - the smallest is 5% for certain Shenzhen stocks, the largest is 15% in Korea, and Taiwan has a 7% limit, in each case relative to the previous day's close.

But for what we can fairly call the more modern markets, there are no price controls (Australia, NYSE, NASDAQ, London, Euronext and Deutsche Bourse), and hence none in their closing auction either. Three of those markets: Australia, London and Deutsche Bourse, have random closing times, as shown in Appendix I of the original consultation paper issued on 21-Mar-07. This information was not included in the Nov-08 consultation, presumably because HKEx did not want to consider the random closing route.

Even the Stock Exchange of Thailand has a random closing time "to prevent the manipulation of closing prices", it says on its web site. In Europe, other exchanges with random closes include Milan in Italy, Madrid in Spain, Vienna in Austria, Budapest in Hungary and Athens in Greece.

If the rule is approved, HKEx will become the only market we know which has no price caps in the continuous trading session but has price caps in its closing auction. Why is it, do you think, that no other market has chosen this? Perhaps because no other market has a Government which is so beholden to special interests, such as the small brokers who hold 13 seats in the Chief Executive's election committee, including 1 seat in the Legislative Council. The Government in turn appoints 7 of the 13 directors of HKEx, currently including 3 members of Hong Kong's cabinet, the Executive Council.

©, 2009

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