LCQ11: Issuance and trading of derivative warrants
************************************************** Following is a question by the Hon Albert Cheng and a written reply by the Secretary for Financial Services and the Treasury, Mr Frederick Ma, in the Legislative Council today (October 19):
Question:
It has been reported that the Hong Kong stock market saw abnormal and sharp movements on 18 August this year, with the index once dropping over 300 points during the day. The incident had aroused suspicion of market manipulation involving false prices. In the wake of the incident, some small investors published an open letter in newspapers to appeal for regulation of covered warrants (commonly known as warrants) by the Government, and the Securities and Futures Commission and the Independent Commission Against Corruption also intervened by investigating the incident. In this connection, will the Government inform this Council whether:
(a) it knows the reasons for the Stock Exchange of Hong Kong (SEHK) relaxing the restrictions on the issuance of warrants in 2001 so that issuers may issue unlimited number of warrants; whether SEHK will review the merits and demerits of the relaxation and whether the market-making system will be abolished;
(b) it knows how SEHK will prevent market manipulation by issuers, including their participation in transactions on a substantial scale, and their suppression of the prices of underlying shares before the warrants are due to expire, resulting in small investors being unable to deliver such shares upon exercise of the warrants; and
(c) it has assessed if the practice of allowing SEHK, as the regulating body, to gain profits from charging listing fees has given rise to a conflict of interest; if assessment has been made, of the results?
Reply:
Madam President,
In response to the questions raised by the Honourable Albert Cheng, the Administration has sought information from the Securities and Futures Commission (SFC) and the Hong Kong Exchanges and Clearing Limited (HKEx). Our reply to the three-part question is set out below.
(a) Prior to 2002, the Stock Exchange of Hong Kong (SEHK) operated a quota system which limited the issuance of derivative warrants over a company's shares to the lower of 20% of its issued share capital or 30% of its public float. In May 2001, the HKEx carried out a public consultation on the listing and trading rules of SEHK on derivative warrants and noted that other exchanges internationally did not adopt a quota system to limit the issuance of derivative warrants. The HKEx also noted that if a quota system was to be imposed to limit the issuance of derivative warrants over the shares of a particular company, the quota system would in certain instances restrict the ability of issuers to launch warrants to meet demands. As a result, pricing anomalies (i.e. when the price of a derivative warrant reaches unreasonably high level when compared with its theoretical value which is determined by factors such as the price of the underlying stock, time to maturity, implied volatility, etc.) might occur in the derivative warrants. To help eliminate pricing anomalies when there is a supply and demand imbalance, the HKEx adopted a number of measures in 2002 after the market-wide consultation, including abolishing the quota system, requiring issuers to provide liquidity in their warrants, and relaxing rules to facilitate further issues.
In view of recent public as well as market concerns over a number of issues related to the derivative warrants market in Hong Kong, the Administration has requested the SFC and HKEx to look into the concerns raised. The review being conducted by the SFC is expected to complete by the end of November this year. On the other hand, the HKEx has issued a public consultation document on the issuance and trading of derivative warrants on 10 October 2005. A copy of the consultation document is attached at Annex.
(b) Since 1998, all derivative warrants listed on SEHK have been settled in cash and not the underlying shares. To guard against possible market manipulation at expiry, the Listing Rules stipulate that cash settlement at expiry should be calculated using the average closing price of the five days preceding the expiry date. This measure helps to minimize potential manipulative action by issuers or anyone to influence the price of the underlying stock of a derivative warrant and reduce market volatility. Moreover, only liquid stocks with large market capitalisation (i.e. a public float capitalisation of $4 billion or above) can be qualified as underlying stocks for single stock derivative warrants. This also makes it difficult for anyone trying to manipulate the market.
It should be noted that active or bulk trading by issuers may not necessarily be related to market manipulation as issuers are required to provide liquidity. Both the SFC and HKEx have a surveillance team to monitor any suspicious or manipulative activities. Where appropriate, HKEx will refer suspicious cases to the SFC for follow up. The SFC will take necessary enforcement action against market misconduct. The SFC is currently investigating a number of suspected market manipulation derivatives warrants trading activities.
(c) To address potential conflict of interest and ensure that HKEx's interests coincide with those of the public, adequate statutory safeguards have been put in place in the Securities and Futures Ordinance, which include -
(i) A requirement for HKEx to act in the interest of the public, having particular regard to the interest of the investing public, and to ensure that the interest of the public prevails over any other interests;
(ii) Authority of the Government to appoint independent directors to the Board of Directors of HKEx in the interest of the investing public or in the public interest;
(iii) Authority for SFC to approve all fees and charges related to HKEx's regulated activities including listing fees;
(iv) Power for SFC to give direction to HKEx if it considers that a conflict of interest has arisen; and
(v) Authority for the SFC to approve any amendments by HKEx to the listing and trading rules of SEHK.
************************************************** Following is a question by the Hon Albert Cheng and a written reply by the Secretary for Financial Services and the Treasury, Mr Frederick Ma, in the Legislative Council today (October 19):
Question:
It has been reported that the Hong Kong stock market saw abnormal and sharp movements on 18 August this year, with the index once dropping over 300 points during the day. The incident had aroused suspicion of market manipulation involving false prices. In the wake of the incident, some small investors published an open letter in newspapers to appeal for regulation of covered warrants (commonly known as warrants) by the Government, and the Securities and Futures Commission and the Independent Commission Against Corruption also intervened by investigating the incident. In this connection, will the Government inform this Council whether:
(a) it knows the reasons for the Stock Exchange of Hong Kong (SEHK) relaxing the restrictions on the issuance of warrants in 2001 so that issuers may issue unlimited number of warrants; whether SEHK will review the merits and demerits of the relaxation and whether the market-making system will be abolished;
(b) it knows how SEHK will prevent market manipulation by issuers, including their participation in transactions on a substantial scale, and their suppression of the prices of underlying shares before the warrants are due to expire, resulting in small investors being unable to deliver such shares upon exercise of the warrants; and
(c) it has assessed if the practice of allowing SEHK, as the regulating body, to gain profits from charging listing fees has given rise to a conflict of interest; if assessment has been made, of the results?
Reply:
Madam President,
In response to the questions raised by the Honourable Albert Cheng, the Administration has sought information from the Securities and Futures Commission (SFC) and the Hong Kong Exchanges and Clearing Limited (HKEx). Our reply to the three-part question is set out below.
(a) Prior to 2002, the Stock Exchange of Hong Kong (SEHK) operated a quota system which limited the issuance of derivative warrants over a company's shares to the lower of 20% of its issued share capital or 30% of its public float. In May 2001, the HKEx carried out a public consultation on the listing and trading rules of SEHK on derivative warrants and noted that other exchanges internationally did not adopt a quota system to limit the issuance of derivative warrants. The HKEx also noted that if a quota system was to be imposed to limit the issuance of derivative warrants over the shares of a particular company, the quota system would in certain instances restrict the ability of issuers to launch warrants to meet demands. As a result, pricing anomalies (i.e. when the price of a derivative warrant reaches unreasonably high level when compared with its theoretical value which is determined by factors such as the price of the underlying stock, time to maturity, implied volatility, etc.) might occur in the derivative warrants. To help eliminate pricing anomalies when there is a supply and demand imbalance, the HKEx adopted a number of measures in 2002 after the market-wide consultation, including abolishing the quota system, requiring issuers to provide liquidity in their warrants, and relaxing rules to facilitate further issues.
In view of recent public as well as market concerns over a number of issues related to the derivative warrants market in Hong Kong, the Administration has requested the SFC and HKEx to look into the concerns raised. The review being conducted by the SFC is expected to complete by the end of November this year. On the other hand, the HKEx has issued a public consultation document on the issuance and trading of derivative warrants on 10 October 2005. A copy of the consultation document is attached at Annex.
(b) Since 1998, all derivative warrants listed on SEHK have been settled in cash and not the underlying shares. To guard against possible market manipulation at expiry, the Listing Rules stipulate that cash settlement at expiry should be calculated using the average closing price of the five days preceding the expiry date. This measure helps to minimize potential manipulative action by issuers or anyone to influence the price of the underlying stock of a derivative warrant and reduce market volatility. Moreover, only liquid stocks with large market capitalisation (i.e. a public float capitalisation of $4 billion or above) can be qualified as underlying stocks for single stock derivative warrants. This also makes it difficult for anyone trying to manipulate the market.
It should be noted that active or bulk trading by issuers may not necessarily be related to market manipulation as issuers are required to provide liquidity. Both the SFC and HKEx have a surveillance team to monitor any suspicious or manipulative activities. Where appropriate, HKEx will refer suspicious cases to the SFC for follow up. The SFC will take necessary enforcement action against market misconduct. The SFC is currently investigating a number of suspected market manipulation derivatives warrants trading activities.
(c) To address potential conflict of interest and ensure that HKEx's interests coincide with those of the public, adequate statutory safeguards have been put in place in the Securities and Futures Ordinance, which include -
(i) A requirement for HKEx to act in the interest of the public, having particular regard to the interest of the investing public, and to ensure that the interest of the public prevails over any other interests;
(ii) Authority of the Government to appoint independent directors to the Board of Directors of HKEx in the interest of the investing public or in the public interest;
(iii) Authority for SFC to approve all fees and charges related to HKEx's regulated activities including listing fees;
(iv) Power for SFC to give direction to HKEx if it considers that a conflict of interest has arisen; and
(v) Authority for the SFC to approve any amendments by HKEx to the listing and trading rules of SEHK.
Ends/Wednesday, October 19, 2005
Issued at HKT 12:30
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