The Stock Exchange of Hong Kong
(the "Exchange")

Speech by Alec Tsui, Chief Executive of The Stock Exchange of Hong Kong, at a conference with the theme of Price Discovery and Management of Market Risks in the Capital Markets:

Ladies and Gentlemen,

It's my great pleasure to be here in Beijing to talk to you on the development and the role of stock exchanges. With recent release of the Securities Law and the support of President Jiang Zemin and Premier Zhu Rongji, in-depth study of this subject matter is particularly timely.

History of Stock Exchanges

Let me start with a bit of history. The first stock exchange evolved in London, in the mid 17th century, about 100 years' after the invention of the joint stock company. It was basically a club of brokers who got together to establish rules for the operation of a marketplace permitting the transfer of ownership of shares in trading companies.

Similar institutions eventually sprung up in the USA and elsewhere. These "clubs" developed a system of self-regulation, recognising that it was in their own self-interest to operate an orderly market. It was not until the 20th century (following the 1929 crash) that governments started to get involved in imposing external rules for the operation of stock exchanges.

Although self-regulation worked successfully for many generations, it was inevitably accompanied by a large element of self-interested regulation. Regulation was mainly designed to protect the interests of club members, often at the expense of other market users, such as investors. Thus, as the 20th century progressed, governments increasingly passed laws to impose public interest responsibilities on stock exchanges. In this way, exchanges evolved into quasi-public institutions, though many preserved vestiges of the "club" structure and mentality.

The first stock exchange in Hong Kong was founded in 1891. Since then Hong Kong has followed a similar evolutionary process. Today, the SEHK is still owned by its broker-members (a relic of the "club" days), but in most important respects it is a public institution with a primary duty to serve the interests of investors.

Exchanges as Geographical Animals

Another feature of the early evolution of stock exchanges is their geographical nature. They were invariably developed to serve the needs of market users within particular geographical areas. In larger countries, or nations with more federal systems of government, several exchanges often grew up, serving different parts of the country. Over time, one dominant exchange generally emerged serving the country as a whole. A pattern of "national" exchanges thus evolved in most parts of the world, which is still largely in place.

The Growing Economic Role of Exchanges

As the 20th century progressed, the role played by stock exchanges within national economies also grew enormously. Initially, the users of exchanges were mainly a limited circle of wealthy individuals. Today, there are many millions of individual investors placing a large part of their savings directly or through mutual funds in the stock market. The value of their pension funds or life insurance policies often depend on the market. As instruments for capital formation, stock exchanges have emerged as the most efficient means yet invented of directing equity capital within an economy to its most productive use. The market determines which enterprises get the funding, and what their cost of capital is. The deciding factor is the efficiency with which individual enterprises use that capital. Thus stock exchanges have assumed a central role in the macro-economic development of nations.

The Current Environment for Exchanges

You might think, from this very brief historical sketch, that we have now reached a stable period in the evolution of exchanges. It seemed that they have found a new role as quasi-national institutions for performing an essential public service into the indefinite future. The opposite is the case. Never has the role of a stock exchange been subject to such potential change as today. The two factors which in the last few years have dramatically altered the operating environment for stock exchanges are: first, the globalisation of securities markets and, second, the spectacular advance of information technology.

Globalisation of Markets

The growth of cross-border investment worldwide over the past ten years has been as remarkable as it was unforeseen. Overseas portfolio investment by US residents in 1998 totalled a staggering $89 billion. The figure for Japan is $100 billion, and for the UK $59 billion. Asian countries have been significant recipients of these capital flows. Some critics would say that this is the devil which caused the Asian financial crisis of 1997-98. This is not the place to debate the merits of free cross-border capital flows. I merely note that they have within a decade internationalised many stock markets which were previously domestic affairs. In Hong Kong, 33% of our trading volume in 1998 was generated by overseas buyers or sellers. Our top 14 securities houses (nearly all of which are international financial conglomerates) now account for over 39% of our turnover. Our issuers have become more mobile as they seek to lower their cost of capital. We attracted 41 H-Shares from the Mainland and 25% of the trading in HK-listed stocks now takes place in London.

As I have said, one consequence of globalisation is that individual stock markets have become more volatile - in response to the waves of capital that now surge backwards and forward across the globe. This has placed a premium on the risk management capability of exchanges and their associated clearing houses; also on their ability to monitor closely the financial position of their members and intervene where necessary.

Another consequence of globalisation has been increased competition between exchanges for both trading and listings. Exchanges in one country can now reach across borders and take turnover and liquidity from another, thanks to technology, differentials in transaction costs and the invention of new instruments such as ADR's or GDR's. This has led to the dismantling of the "club"-based cartels which used to fix the level of brokerage commissions in many markets. This competition between exchanges has been at its most intense in Europe and North America, but it is now beginning to spread to Asia.

The Impact of Technology

The impact of globalisation on exchanges goes hand in hand with that of new technology. It is now a simple matter to trade HK stocks from Mexico or Manchester. Discount brokers and Internet-based trading have slashed transaction costs in the developed markets. The function of stockbrokers per se is rapidly becoming obsolete; investors can access exchanges or trading systems directly through the Internet. New kinds of institution are springing up which compete directly with the market-making function of exchanges. These are sometimes called Proprietary Trading Systems (PTS's) or Electronic Communication Networks (ECN's). Like an exchange, they collect orders, route and match them. Examples are Instinet (which operates internationally), Island in the USA, and Posit in the UK. It is a moot point whether such bodies constitute exchanges. The US SEC is considering recognising them as such. Their advantage over traditional exchanges is that they can focus on one activity only (thus minimising overhead costs) and "cherry pick" the most actively traded stocks, or the larger-ticket deals. By doing so, they undercut traditional exchanges in the most valuable parts of their business. Some large securities houses also handle a sufficient volume of orders that they are able to match buyers and sellers in-house, thus by-passing official exchanges.

The reason traditional stock exchanges are still able to compete with ECN's is that they still constitute the largest pools of liquidity. Investors are drawn to liquid markets. But liquidity can be "stolen" by a competing marketplace much more rapidly today than in the past. Witness the way London captured market share from Frankfurt in the early 1990's, only to lose it again a few years later. In principle there is nothing to stop ECN's doing the same thing. It is just a question of being able to connect, communicate and network with enough investors to create an efficient and orderly market. Many investors today are sufficiently sensitive to relative levels of transaction costs that they are quite willing to switch.

A potentially even more fundamental threat to the market-making role of exchanges resides in the Internet. This could, in due course, call into question the main function of exchanges for the past 350 years. It is already possible to envisage investors creating cyberspace markets of their own, cutting out brokers, underwriters and exchanges.

Clearing and Settlement

Let me turn to the other service components of traditional stock markets. Apart from matching buyers and sellers, many exchanges also provide clearing and settlement facilities. It is hard to envisage ECN's incurring the expenditure necessary to replicate clearing and settlement facilities. But they can (and do) link up with other organisations such as the National Securities Clearing Corporation in the USA, Cedel and Euroclear in Europe. The key attributes where these organisations compete with each other are reliability and efficiency of their clearing and settlement operations, and risk management. Mr Stewart Shing of the Hong Kong Securities Clearing Company Limited will discuss this subject matter in further details.

Listing

The third core function of many exchanges is regulation of listed companies - both the initial approval of listings and the monitoring and enforcement of compliance with listing rules. This activity is in substantial part a public service, usually performed under some form of statutory delegation. ECN's or PTS's make no pretence at taking over this function. Indeed they are happy to leave traditional exchanges carrying this regulatory "burden", while they poach the trading in stocks listed by the traditional exchange. A risk for many exchanges is that the cost of this listing function will exceed the associated revenues, or that Governments decide to transfer this role to the statutory regulator for other reasons (as happened in the USA in the 1930's). This is most likely to happen if exchanges fail (or cannot afford) to perform the function diligently, efficiently and objectively.

Demutualisation and Mergers of Exchanges

Each of the main traditional functions of a stock exchange (trading, clearing/settlement and listing) is therefore under actual or potential competitive threat. To meet such threats, exchanges are increasingly being driven to organise themselves and behave like commercial enterprises - becoming highly cost-efficient and focussing on the need to satisfy their customers (i.e. investors and listed companies). In many exchanges, this calls for a major change of organisational culture.

In those which are still based on a traditional membership structure (a vestige of the "club" era) constitutional reform is also necessary. Ownership of an exchange (which inevitably influences its governance) by members who enjoy exclusive trading rights has been found to be an inefficient model. The interest of members (i.e. brokers) to maximise their profits and protect themselves from competition increasingly conflicts with the interest of the exchange as a business. The exchanges need to meet the demand from its customers for lower transaction costs, more efficient services and new products. This is often achieved through investing in new technology which reduces the role of brokers. For this reason, numerous exchanges in Europe and elsewhere have gone through a process called "de-mutualisation" - separating ownership of the exchange from the right to trade on it. Some exchanges (e.g. the Australian Stock Exchange) have gone one step further by themselves becoming listed companies. This completes the process of turning the exchange into a commercial entity, competing in the market on equal terms with ECN's and other providers of services similar to those of exchanges.

A parallel trend which has swept through the exchange industry in recent years has been consolidation - as happens in any industry which faces increased competition. Consolidation is taking place both through cross-border mergers and strategic alliances of stock exchanges and through mergers between stock and derivative exchanges. This is particularly the case in Europe, with the advent of a common currency.

Merger is a trend I would like to dwell a bit further into. They are driven by a desire to achieve rationalisation and economies of scale (particularly in the development of new technology) and to offer a wider range of products and services under one roof to institutional investors. Market participants are increasingly integrating vertically or horizontally, combining different roles within one larger and more global institution. Product boundaries are also becoming less clear, with structured and synthetic products favouring arbitrage trading, which influences liquidity and price discovery across markets.

Hong Kong is following these trends. In March of this year, the SAR Government announced its wish to see the demutualisation of both the Stock Exchange and the Futures Exchange and the merger of these two bodies, to be followed next year by the listing of the merged entity. This represents a massive change in the institutional framework of our market, packed into a very short time-frame. But international competition is such that we could not afford to delay.

The Future

As you have seen, the role of stock exchanges has thus gone through several phases of evolution, with the pace quickening in recent years. And all of this is happening in a world where national borders hold rapidly decreasing significance and competition comes from organisations operating supra-nationally or from cyberspace.

Where is this all going to lead, then? Ultimately, exchanges (like stockbrokers) will only survive to the extent that they add economic value in proportion to their costs. The technology to by-pass exchanges already exists. The question is, therefore, how exchanges will add that value. Their strongest weapons are still the ability to offer maximum liquidity and to guarantee safe and efficient execution, clearing and settlement. These two roles are interrelated, but they can also be disaggregated. So can the function of regulating listings. At the end of the day, the extent to which exchanges survive in will depend on the efficiency with which they operate. This in turn will depend increasingly on the success of the investments they make in trading and settlement technology. These often represent very large bets. Only big institutions can afford to take the risks associated with such investments. This is one factor which will drive a continuing process of consolidation among stock and derivative exchanges.

Looking ahead, it is possible to envisage several different scenarios for the evolution of exchanges. One plausible scenario is the emergence of regional super-exchanges through the merger of different national exchanges within time-zones. This is already happening in Europe. It may not come quickly to Asia unless we also move towards currency convergence. But it could well start to happen quite soon. If it does not, super-exchanges in other time zones may suck business away from Asian exchanges through their gravitational force.

An alternative scenario would be one in which the present functions of exchanges become disaggregated and dominant organisations emerge specialising in different parts of the transaction chain - regulation, order routing and trade execution, clearing and settlement, etc. Whether such organisations would still be exchanges is open to question.

A third possible scenario would be the formation of alliances and cross-shareholdings between exchanges or trading systems in different time-zones. This would lead to the emergence (as in the airline industry) of several competing networks, each offering an integrated global service. Investors could access stocks on one exchange via the network of another one to which they have easier access. I find this scenario also quite plausible.

No doubt reality will not conform exactly to any of these models. It may be a mixture between them. Whatever happens, exchanges in their present form will undergo a fundamental transformation. Maybe they will be called something else, like "Securities Dealing Service Providers". One thing is certain, however : the economic function which exchanges perform will continue to be needed on a growing scale - because securities markets will continue to play an increasing role in the formation and allocation of capital within national economies.

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