In the latest development in the proposed merger of the Hong Kong Stock and Futures Exchanges, it has been suggested that HKEC will underwrite the value of trading rights by offering to buy them back from brokers, in addition to giving them shares in the new company. We explain how future technology will create a surplus of trading rights, and that HKEC will end up buying something that nobody else wants. We argue the case for nationalisation of the exchanges.

Icing on the Cake
26 July 1999

Before jetting off to South Africa this weekend, Financial Secretary Donald Tsang met with the Chairmen of the Hong Kong Stock and Futures Exchanges and banged their heads together (metaphorically, we hope) in an effort to reach a deal on the merger, apparently proposing a 70:30 deal in favour of the SEHK, or the alternative brute-force approach known as "Plan B".

Any man with a stick usually carries a carrot, and now we hear that HSBC, the Government's adviser, is considering a proposal under which the enlarged company (Hong Kong Exchanges & Clearing, or HKEC) would grant put options to the brokers, allowing them to sell their trading rights back to HKEC at a fixed price.

This is getting out of hand!

Remember that prior to the merger, members of SEHK hold a share in SEHK which pays no dividends and can only return capital on a liquidation. In the merger, they will get perhaps 70% of the  HKEC which in future will be allowed to make as much profit as regulations allow, and will distribute dividends to shareholders. In addition to owning 70% of HKEC, existing members of SEHK would get to keep their trading rights.

On top of this, HKEC will be allowed to profit in future from the clearing system. To recap from a previous article, the clearing company, HKSCC, through which nearly all trades on SEHK are settled, is a non-profit body whose customers have benefited from any surplus made by HKSCC in the form of reduced charges. These customers (ultimately investors) will receive no compensation for the loss of these future benefits, and HKEC will benefit from the profits of the clearing company, adding to the value of the shares in HKEC.

Minimum Commissions - Another Carrot?

In his much-mentioned but never-fully-explained "Plan B", the Financial Secretary has indicated that the Government could legislate to force the SEHK to scrap the minimum commission rule, allowing freely negotiated commissions. Attempts in earlier years to achieve this by negotiation have been stymied.

Scrapping minimum commissions is the one thing that would cause the most damage to the profit and loss accounts of small brokers, while bringing the stock exchange into the 21st Century and slashing transaction costs for investors. By way of reference, the Australian Stock Exchange scrapped minimum commissions in 1984, while London followed in 1986.

We can't help wondering whether the flip-side of the threat to scrap minimum commissions under "Plan B" is some understanding that the Government will back-pedal on the move if a smooth merger takes place. This could hold back the development of the markets for years.

What are Trading Rights Worth?

In its latest policy paper "Reinforcing Hong Kong's Position as a Global Financial Centre" the Government made an unusually astute observation when it wrote:

"When the SEHK launches its AMS3 in a year or so, the constraint of the number of seats that a member holds on the volume of trade that member could handle would be removed and the issue of seats redundancy would arise in practice anyway".

In other words, no broker will need more than one seat, currently represented by a share in the SEHK. In the past, the number of trades a broker could handle was physically limited by the human speed at which they could enter orders, by hand, into a terminal on the exchange floor (that's where you see all those people in red jackets reading newspapers these days). After a prolonged battle, the rules were changed to allow a second terminal in the broker's office, and then a third terminal, which is the current limit.

The latest revision of the Automated Matching System, AMS3, will allow straight-through ordering from the internet and from any in-house dealing system that a broker may have, so that the order flow per seat will be limited only by the speed of the data lines and computers that make up the system.

There are 929 seats in the Exchange but only about 500 brokers, some less active than others. In addition to those that close down in the face of competition, those that remain in business but hold more than one seat will be able to sell their spare seats, and we will find a glut of trading rights pushed into the market. It is quite likely that if seats remain transferable (as the Government has allowed, at least for 2 years) then the "secondary market" price will fall below the price for new admission. Allowing transferable trading rights also means that HKEC will have less revenue from selling them to new market participants.

The Put Option

If HKEC grants holders of existing trading rights a "put option" to sell their rights back to the Exchange, then the Exchange could end up the proud owner of rights that nobody wants. It is unrealistic to expect that there will actually be more brokers in future than there are at present. Instead, the number is likely to shrink dramatically from the current 500 as the market becomes more competitive and efficient. When minimum commissions are abolished and discount brokerages arrive, then the only way to succeed in broking will to be big and cheap. Make that very big, and very cheap. That way you get the economies of scale that make thin margins bearable.

If HKEC has to buy up these trading rights, then that will increase its borrowings  and reduce the value of its equity. The extra interest expense on its borrowings will reduce its future profits, and guess who will end up paying for that? Ultimately this will allow the SFC to be more flexible when approving increases in the fees charged to users by HKEC (including the clearing companies), or alternatively fees will come down more slowly than they would have done. The public pays.

However, in the short term, giving away put options to brokers should decrease the value of SEHK by reducing future profits. Ironically, this makes it harder for them to justify demanding 89%, or even 70%, of HKEC.

What are we achieving here?

It seems that the Government has given too much in its quest for a negotiated settlement. Since March, they have made the following concessions:

We are all for a peaceful life but not at any cost. If the Government really believes in the reform of the Hong Kong markets and the development of Hong Kong as a "Global  Financial Centre", then it should draw a line on these talks and consider more radical moves.

Nationalisation - the way to a Global Financial Centre

In our original article on the merger we argued that a flotation of the exchanges was against the public interest. In the light of subsequent events, our preferred alternative seems more attractive than ever: the Government should demutualise the exchanges by nationalisation. Pay off the brokers once and for all, and make the resulting HKEC a key part of our domestic infrastructure, just like the roads, the airport and the country parks. Incentivise the management to run HKEC efficiently, but at the lowest possible cost to the users, not the highest possible profit for shareholders. Continue to set listing rules by market consultation. We could then have an Exchange which attracts investors through lower dealing and data costs and attracts issuers through lower listing fees and investor attention, a virtuous circle.

In the case of the Stock Exchange, nationalisation at the purported value of $4m  per share would cost about HK$3.7bn. Based on the 70:30 split, the HKFE would cost another $1.6bn, taking the total to $5.3bn, a bit less than the Government paid HK Telecom for the removal of their IDD monopoly. The benefits to the economy of having a Global Financial Centre here are likely to be worth the money.

Perhaps the only reason against this is the perception that the Government might be "paying off" the brokers, or appearing to intervene in the "free markets" by forcing the sale. The latter point is mitigated by the fact that the exchanges are antiquated monopolies and (in the case of SEHK) protected by legislation. They are abusing this privilege by resisting modernisation and seeking to protect what has been described as a "private members club", against the public interest.

©, 1999

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