Hong Kong Brokerage Industry – Challenges and Reform Mr. Andrew Sheng Chairman Securities and Futures Commission 8 August 2003
Outline Two-tier industry structure Change of competitive landscape Challenges of the brokerage industry Our regulatory approach Structural reform Concluding remarks 2
HK’s brokerage industry is a two-tier structure (end May 2003) Large international brokers (mainly Cat A + some Cat B brokers) and local small retail brokers (mainly Cat C brokers) Cat A Cat B Cat C Total Number of Exchange Participants 14 51 390 455 Market Share in Turnover (Jan-May 2003, %) 52% 32% 16% 100% Average Monthly Turnover (Jan-May 2003, HK$ mn) 10.0 1.7 0.1 0.6 Average Number of Clients 640 3,946 580 959 Shareholders’ funds / total assets (%) 24% 32% 56% 37% Remark: The number of exchange participants here only includes those who report the FRR, and does not include those who have ceased (or indicated to cease) business or those who have not commenced business. 3 Source: SFC, FRR Returns and HKEx
Number of brokers in major markets (US$ bn, end 2002) No. of exchange Market Avg market turnover participants turnover per exchange participant HKEx 481 194 0.4 NYSE 337 10,311 31 LSE 300* 4,001 18 TSE 109 1,564 14 ASX 80** 295 3.7 SGX 59*** 63 1.1 Remark: The number of exchange participants in Hong Kong here only includes those who report the FRR, and does not include those who have ceased (or indicated to cease) business or those who have not commenced business. * Estimated figure based on LSE annual report 2002/03 ** May-03 figure *** Jul-03 figure Sources: Websites of various exchanges, commissions and broker associations, World Federation of Exchanges 4
Changing market share % Share in Market Turnover by Category of Participants 60% Category A Category B Category C 49% 49% 50% 47% 42% 40% 39% 40% 36% 35% 34% 33% 32% 32% 32% 32% 32% 31% 31% 30% 30% 30% 28% 27% 23% 19% 20% 17% 10% 1996 1997 1998 1999 2000 2001 2002 May-03 5 Source: HKEx
Source: SFC, FRR Returns Net Commission Income ($ mn) 100 150 200 250 300 350 400 450 50 Jan-01 Feb-01 Mar-01 Commission income of brokers Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Category A Apr-02 May-02 Jun-02 Jul-02 Aug-02 Category B Sep-02 Oct-02 Nov-02 Dec-02 Jan-03 Category C Feb-03 Mar-03 Apr-03 May-03 6
Consolidation is happening – worldwide and local Number of NYSE Members Number of SEHK Participants 700 900 650 850 600 800 550 750 700 500 650 450 600 400 550 350 500 300 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Jun 03 1930 1940 1950 1960 1970 1980 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 7 Source: NYSE Source: HKEx
Market turnover since 1990 18 Average Daily Turnover (HK$ bn) 15.5 16 14 12.3 12 10 8.0 7.8 8 7.0 6.9 6.5 5.7 6 4.9 4.6 3.3 4 2.8 2 1.3 1.2 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 (1-6) 8 Source: HKEx
Challenges of the brokerage industry Since 2000, when the SEHK demutualized, the number brokers has declined by approximately 70 Most of these brokers ceased business voluntarily Only 4 brokers ceased business because of default or fraud, of which only 2 involved Unified Exchange Compensation Fund Two types of risks in industry Integrity risk Pooling risk 9
Integrity risk Last 15 months, 11 cases of misappropriation of client assets. Total loss amounting to $190.4 million covered by fidelity insurance or firms themselves. 3 cases involved fraud by sole proprietors, of which 2 involved Compensation Fund. To mitigate integrity risk, the SFC requires brokers to: Properly segregate duties and functions Ensure adequate internal controls are in place and effectively function closely supervise and monitor staff However, no regulatory regime can totally prevent deliberate acts of fraud 10
Pooling risk Involves the common market practice of pooling and re- pledging client collateral, when margin financing allowed in contract between client and broker As of the end of May 2003, 239 brokers and 8 securities margin financiers engaged in securities margin financing Total margin loans: $11.8 bn Securities collateral: $42.8 bn Average liquid capital ratio as % of total assets was about 28% The practice is entrenched by past practices and has been apparently convenient to investors and their brokers, 11 not an easy risk to ameliorate
Example of CA Pacific When CA Pacific and its finance arm collapsed in January 1998, Total investor loss exceeded $900 mn The Compensation Fund paid out $300 mn Over $600 mn remains uncompensated Total liquidation costs to date: about $120 mn At the time of its collapse, the finance arm of CA Pacific had a capital base of only $16 mn, but it had borrowed $548 mn against client collateral. 12
Our regulatory approach Risk-based regulatory approach Strengthening monitoring of brokers by risks Working with brokers to mitigate identified risk factors such as: strengthening capital base of brokers ring-fencing clients’ assets tightening internal controls Increasing investor education 13
Investor Compensation Fund (ICF) Since 1 April 2003, maximum compensation per investor formalized at $150,000 To ensure a safety net for investors, a market levy of 0.002% has been paid to the compensation fund since September 2001 The ICF now has accumulated about $1 billion The Investor Compensation Company under the SFO began operations on 1 April 2003 14
Review of Capital through Financial Resources Rules (FRR) changes In October 2002, we implemented 2 interim measures by amending the FRR to try to help brokers manage down their margin financing risks. These measures are: an 80% “illiquid collateral” haircut on stocks and warrants pledged as margin collateral firms that heavily re-pledge clients’ collateral are required to finance at least 35% of their margin loans with their own capital The interim measures help but long term review is necessary 15
Working Group on the Business Environment of the Stockbroking Industry In April 2003, the Working Group made a list of recommendations to enhance business environment. Major recommendations:- develop a user-friendly and cost-effective Investor Participant (IP) account model and straight-through processing capabilities examine the tiering capital requirement for brokers according to their risk and nature of business enhance transparency of fees and charges imposed by brokers and banks minimise compliance burden on small and medium- sized brokers enable brokers to diversify their product range 16
Consultations and Consensus Reform requires consultations and consensus by everyone – investors, brokers, the regulator and the legislature Feedbacks from the industry suggest the following reforms are necessary:- User-friendly Investor Participant (IP) Account Rationalization of the capital framework Help brokers to diversify their business (e.g., financial planning) Step up investor and broker education on market and industry risks 17
New IP Account A user-friendly IP Account will facilitate such changes by: giving investors direct control over their stocks reducing systemic risk of the brokerage industry enabling brokers to compete with banks If the new IP Account is widely accepted, integrity risk can be largely mitigated the capital requirement for brokers not holding client assets can be lowered HKEx is close to finding a model and will discuss it with the Commission and consult the industry 18
Rationalization of financial capital framework In May 2002, a Working Group was established to re- examine the capital and financial requirements of brokers given changing business environment Major recommendations on the fundamental principles:- Capital level of brokers should be commensurate with their risks Capital should be lower for brokers who do not hold client assets and higher for those who do It is international practice to require brokers to be well capitalised to buffer against risks Pooling risk should be properly addressed by segregation of assets There should be a reasonable transitional period for the industry if any proposal is to be implemented, after 19 wide consultation
International comparison Hong Kong’s capital requirements ($5M and $10M) are the lowest in the region Capital requirements in other markets : Mainland: HK$47M – 470M Singapore: HK$22M Taiwan: HK$45M – 90M 20
Structural reform Demographics, consumer needs and technology have changed market There must be fundamental changes in infrastructure and business model of the brokerage industry Facilitating brokers to diversify their business to financial planning services is a possible route Through providing financial planning services with quality advice, brokers can find another source of income mitigate their risks because they do not need to handle clients’ assets 21
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