Government Concessions Widen Value Gap
13 July 1999
U-Turn on HKSCC
Limit on Shareholdings
The merger of the Stock and Futures Exchanges has predictably degenerated into a bragging match about relative values of the two bodies, with each adviser duty-bound to obtain the highest valuation for their client. On the one hand, Morgan Stanley thinks members of it's client, the Hong Kong Futures Exchange, should get 48% of the new Hong Kong Exchanges & Clearing (HKEC), while on the other hand, Merrill Lynch tells the Stock Exchange they should get 89%, leaving the Futures Exchange with 11%.
In this article we'll bring you up to date on the latest policy paper "Reinforcing Hong Kong's Position as a Global Financial Centre" issued by the Government on 8-Jul-99, and on the issues behind the valuation dispute. We'll explain how the Government has given a string of concessions to the stockbroker community in an effort to achieve an approved deal, but first we cover the valuation problem at the root of the dispute.
The basis on which both sides will most likely be valuing their businesses is known as "discounted cash flow" (DCF), which basically involves predicting future earnings and then stating them in present-day dollars. The key variable in the discounting exercise is the "discount rate" - which reflects long term interest rates, together with the market risk involved in the business of the exchange.
Before you can discount future cashflow, you have to agree on what that cashflow will be. So even if both sides can agree on the same rate of discount, they will argue about how much profit each is expected to make in the future. This in turn depends, amongst other things, on how lax the Government (through the SFC) is in policing the fees and charges that the HKEC will propose for its monopoly businesses. We'll come on to that later. A second factor is just how much business there will be. It is no coincidence that the HKFE is now heavily pushing its non-HSI products (such as the Property Sub-index Futures) in an effort to show that there is potential income from as yet unlaunched futures products. At the same time, the SEHK will be arguing that GEM will be a money-spinner, ahead of its launch in October. It will also probably project future revenue from a listed bond market and from linking with other exchanges and trading their products, such as stocks on NASDAQ which are not yet traded on the SEHK. Perhaps it will look forward to convertibility of the Yuan and trading of mainland "A" and "B" shares in Hong Kong.
Each side will find plenty of room for disagreement on what the shape of the profits will be like in even 3 years' time, and bear in mind that DCF calculations usually project earnings for at least 10 years before concluding with a "terminal value" of what the business will be worth at the end of the projection period.
Valuing HKSCC (or not)
One of the key areas of dispute is over the value of Hong Kong Securities Clearing Company (HKSCC), which clears almost all stock trades on the Hong Kong Exchange. HKSCC is a company limited by guarantee, so it has no issued shares and, accordingly, no shareholders or owners in the normal sense. The "members" of HKSCC are the limited guarantors, with the Stock Exchange holding 50%, and five banks (Bank of China, Bank of East Asia, Hang Seng Bank, HSBC and Standard Chartered Bank) each holding 10% of the total guarantee of HK$50m. Under its articles of association, none of the members of HKSCC has any right to receive any dividends or other distributions of profit nor has a right to receive anything on a solvent liquidation. In short, HKSCC is a not-for-profit entity.
This has been reflected in the way that it has progressively reduced its charges to its customers (including brokers, custodians and investor participants) as it has become more efficient. For example, the stock settlement fee has been reduced by 80% to 0.002% of each trade since CCASS (the clearing system run by HKSCC) was introduced in 1992, to the benefit of the investing public. In fact, we find the clearest explanation in the following extract from the March 1999 issue of Cleartalk, the HKSCC magazine, which says:
"Hongkong Clearing is a non-profit distributing company. It uses accumulated surpluses, less amounts put aside to reserves that are used to finance infrastructure and future development, to fund fee discounts. As of 31 December 1998, the cumulative discounts provided to Participants since the implementation of CCASS amounted to $1,549 million."
Immediately after the March budget speech, the Government published a Policy Paper on Securities and Futures Market Reform which formed the template for the proposed merger. In this, they wrote:
"As there is no financial value in the membership of HKSCC it is reasonable that its members would not receive any allocation of shares in Newco in respect of HKSCC."
Indeed, Deputy Secretary for Financial Services Rebecca Lai told the Legco Financial Affairs Panel on 6-Jun-99 that "Under HKSCC Rules the asset of the non-profit -making HKSCC can only be transferred to non-profit or charity houses".
However, confusingly, the March policy paper also states that HKSCC will be allowed to distribute profits via Newco (now HKEC) and that "[HKSCC's] inclusion in the merged business of Newco will enhance the value of Newco as a whole".
Couldn't be clearer, could it?
In order for the Exchanges to merge voluntarily, they must each receive at least 75% approval of shares voted in a general meeting to approve what is known as a "Scheme of arrangement" whereby HKEC will issue shares to all members in exchange for their shares in SEHK or HKFE. These votes are scheduled to take place by 30-Sep-99. The Government is keen to avoid either side voting it down, and has threatened to use an undefined "Plan B", which presumably means forcible merger by legislation, if approval is not given. Nevertheless, they would rather not have to use force if negotiation can win the day. They don't want to appear interventionist, although we think on this occasion using a little brute force might bring spoilt monopolists into line.
The most vocal group has been the 500-strong broking sector, dominated by the small brokers, many of whom have held their shares in the Stock Exchange since its last reform in 1986, when the 4 previous exchanges were merged together.
Item by item, the brokers have won concessions from the Government. Instead of having a "big bang" merger, when any applicant with suitable qualifications and capital can obtain trading rights, the Government has agreed that no new trading rights will be issued for 2 years after the merger. This should allow existing brokers who feel unable to face the heat of competition to sell their seats as well as receiving shares in HKEC. In effect, they started out with a share in the Stock Exchange which they could not sell without closing their business, and which was not allowed to pay dividends, and they end up with shares in HKEC which they can sell, as well as a seat which they can sell before the music stops.
Now we hear that they are lobbying for an exorbitant entry fee for new trading rights, in order to preserve the transfer value of their existing trading rights indefinitely. The cumulative effect of these concessions will set back the development and opening of Hong Kong's market and start to defeat the very purpose of the reforms.
U-Turn on HKSCC
The greatest concession appears to be that the Government is allowing HKSCC to be included in the valuation of the Stock Exchange. Indeed, they have signalled this by allowing the word "Clearing" to feature in the name of the new body. We cannot think of any other exchange in the world which describes its bodily functions in its title - why not call it "Hong Kong Exchanges, Clearing, Data and Listing"?
So we can wave goodbye to the policy of passing all savings on to the customers of HKSCC - at least some of these savings will in future go to its shareholders as profit. In the process of this policy U-turn, the Government has widened the gap between the two valuations.
HSBC, which is advising the Government on the merger, is a 10% member of HKSCC, and so is Hang Seng Bank, which is a subsidiary of HSBC. It remains unclear whether the bank members of HKSCC will get their share of the "valuation" over which the two exchanges are now haggling. Until this is ruled out, it represents a potential conflict of interest for HSBC.
Press briefings (usually on a "sources" basis) on early meetings of the Co-ordinating Committee on Market Structure Reform (CCMSR) indicate that they were heading towards consolidating regulation under the SFC, in a similar way to that in which the SEC regulates US companies and brokers. The section of the new policy paper on market regulation indicates a degree of discord in the committee. It says:
"the working groups [of SEHK, HKFE and HKSCC] felt unable to make any recommendation as to which of the options in their respective reports was best for the future"
"the Exchanges and HKSCC also thought they were not well placed to consider the future business strategy of HKEC, and that as the future division of the regulatory functions between the SFC and HKEC would feature in such business strategy, this should properly be left to another authority"
In the end it seems that the Government has traded off the role of broker supervision (which will be absorbed into the SFC) for that of Listing regulation, which will continue as at present. This concession means that listing fees paid by listed companies will stay with the Stock Exchange, a key part of their future revenue and hence beneficial to the valuation model.
The new policy paper inadvertently hints at the problems of leaving regulation within a profit-making entity. It talks of making "improvements in efficiency" within the SEHK Listing Division, involving a "re-examination of the allocation of resources". In other words, fewer people means less costs means more profits, but is this the way to go about improving regulation? The paper struggles with this issue in the section on business structure, which shows the regulatory function as being outside the 5 "business units" but within the overall HKEC profit-making group. That's just playing with box diagrams.
In our experience of dealing with the SEHK Listing Division, with a few exceptions, their overall level of industry experience and commercial judgement is too low and reflects the difficulty of attracting people away from more lucrative careers in investment banking, the legal profession and accountancy. The Listing Division also appears over-stretched and under-resourced to cope with the constant manoeuvrings of our listed companies. All this points to the need for the SFC to take on a consolidated regulatory role, and leave the HKEC to focus on providing an efficient and modern trading platform. The Listing Division should be transplanted to the SFC and merged with its Corporate Finance Division (which already regulates takeovers). It would then be funded out of listing and document fees paid by listed companies and/or stamp duty on transactions. As an arm of Government, the regulator's principal concern would be to protect investors and avoid the embarrassment of regulatory failures, not to maximise profits.
In a section entitled "Checks and Balances for Public Interests" the new policy paper deals weakly with the question of tariffs. It seeks to rely on the existing framework rather than create anything new. It says:
"fees and charges of the two Exchanges and HKSCC are set out in their respective rules. The making of or changes to these rules require the approval of the SFC. We believe this system will provide a reasonable safeguard against abuse"
"In exercising such approval power, the SFC will develop non-statutory guidelines setting out the factors to be taken into account.... these factors will include... the comparative transaction costs of Hong Kong and other markets."
That's it? The whole thing? Based on that level of regulation, we think the only safeguard against this will be to buy as many shares in HKEC as we can afford.
The point here is that the framework only allows for approval of changes to fees, but imposes no requirement to lower them. Remember, for example, that HKSCC has reduced stock settlement fees by 80% since 1992. The new framework imposes no such obligation to hand savings back to customers. There is no suggestion that the SFC would actually intervene and force the HKEC to lower charges. We can therefor expect HKEC to maintain charges at current levels and allow profits to expand as volume and technology savings take their effect. For new products, they will always be able to find comparisons that allow favourable pricing in the absence of competition.
We had hoped, perhaps idealistically, that the Government would recognise that they are proposing to float a monopoly utility and that as such it should make no more than utility rates of return, such as a 10% margin on revenue, with tariffs set to change at "CPI minus X" where CPI is Consumer Price Inflation and X is the rate at which costs should come down in real terms, and would be set by an independent regulator. This is the way other Governments have handled flotations of utility monopolies such as British Gas. Equally, where the newly-floated companies enter competitive markets and have non-dominant status then they are free to set tariffs to compete.
Limit on shareholdings
The new policy states:
"A shareholding limit of 5% will be put down in law to prevent control of HKEC by any individual parties or parties acting in concert"
Um, right. Has anyone realised that the biggest group of shareholders in HKEC will be the small brokers, particularly if the current SEHK members get the lion's share of HKEC? Clearly you cannot disenfranchise them (prohibit them from voting) just because they all happen to vote the same way - after all, there are only two ways you can vote. The definition of acting in concert for these purposes will be entertaining.
The whole area of corporate governance of HKEC will require heavy-handed legislation to be effective. For example, normally it is the shareholders of a company who appoint the board, but in order to provide a Government-appointed majority, the law or the articles of association will have to make it so. Otherwise there is little to stop shareholders in HKEC from requisitioning an Extraordinary General Meeting, removing all the directors from the board, or flooding it with their own appointees. If necessary, shareholders would be able (by 75% voting majority) to amend the articles of association of HKEC to allow this. So HKEC is going to be a very unusual animal. The Government will either need its rights to be set in law (through an "HKEC Ordinance"), or it will have to create a "golden share" in a class of its own, which will have rights in the articles of the company which cannot be changed without the approval of the golden shareholder.
One of the key battles yet to be fought is who is actually going to run this thing. The proposed business structure in the new policy paper includes hot seats for a Chief Executive and a Chief Operating Officer. We wait to see whether any of the incumbents (who according to the paper, "thought they were not well placed to consider the future business strategy of HKEC") will be up to the job of drawing the combined entity together and integrating the separate cultures, or whether fresh blood will be brought in.
In a tantalising single sentence of the new policy paper, the Government says:
"It should be noted that with the removal of the membership structure... the level of commission charged by traders should be a matter essentially between traders and their clients"
Negotiated commissions are the key to lowering transaction costs in Hong Kong. With the advent in "a year or so" of straight-through processing with AMS3, it will be possible for orders to be passed directly from the internet through brokers' systems (with automated credit checking) to the exchange. It will no longer require a human being to re-key the orders into a terminal on the Exchange's closed system. Unless the bandwidth is artificially limited, the number of terminals a broker has will become irrelevant to the volume he can handle through AMS3, so there will be plenty of spare "dealing rights" for sale. Currently each share in the SEHK gets you three terminals (one on the floor and two in the office), and many houses hold more than one share to get the extra terminals. At least this should provide an ample supply of dealing rights in the secondary market if brokers are successful in forcing a high entry price for new dealing rights.
When minimum commissions are scrapped, we can expect the retail market to quickly find a flat fee level for execution-only trades, perhaps as little as HK$88 per trade, up to a certain size. Broking will become a volume game with wafer thin margins, and cash-client retail broking in particular will be dominated by a few large on-line firms who can afford to invest in the necessary software systems. With slim pickings in broking, margin lending will become a more dominant form of revenue for retail houses, favouring banks and larger firms with lower cost of capital. People who want flat fee broking but also want independent research will start paying fees to online hybrid news/research services, similar to Briefing.com or TheStreet.com.
A truly liberalised, discount broking market depends on minimum commissions being abolished.The sole reference to the subject in the new policy paper is couched in a way which leaves it open to negotiate a time frame for the abolition. Another concession in the making, perhaps?
© Webb-site.com, 1999