The Stock Exchange of Hong Kong

So much has been said and written about the impact of Internet and on-line technology on all types of business. But I cannot suppress feelings of excitement and concern when I look at what is happening to the securities industry. Excitement because of the speed of change and the opportunities it is throwing up, both commercially and socially. Concern, because organizations and certain old and tested ways of doing business are disappearing or being forced to change radically. For those willing and able to adapt, however, the potential benefits created by on-line technology greatly exceed the threats and discomfort.

On-line Technology and Securities Trading

Why is the securities industry so greatly affected by on-line technology? Firstly, because it is an information-based industry and its processes lend themselves particularly to treatment by computers. Secondly, because securities trading and distribution are among the most global economic activities. On-line communication permits clarity and affirmation in writing at high speed over a wide geographical area. These factors make on-line technology an excellent tool to replace human coordination of market intermediaries' services.

The integration of on-line technology with the securities market has reduced many of the disputes, delays and risks inherent in traditional stock transactions. On-line technology also increases the efficiency and sharply reduces the cost of securities transactions. Retail and institutional investors have been quick to recognise these benefits and market intermediaries who anticipated this are generally prospering. Securities trading has been expanding its reach in the US at a fascinating speed, thanks to on-line technology. Those who fail to adapt to the new environment, risk being discarded by evolution.

Today I propose to look first at the changes that on-line technology is bringing to the business of market intermediaries and service providers, including stockbrokers, before looking at those affecting the role of exchanges. I will then say something about what we at the Stock Exchange are doing to meet the challenges and seize the opportunities which face us.

Let us look at the changes to financial intermediaries brought about by on-line technology.

Technology is Replacing Human Services

The nature of services now provided by market intermediaries can be broadly divided into two categories - professional advice and transaction coordination. On-line technology is increasingly being applied to replace human transaction coordination. The greater efficiency of technology reduces the time and cost of completing a stock transaction. It also increases the ability of brokers to manage client risk. Sophisticated systems can also help to expand service coverage to include labeled or personalized advisory services.

Endorsement by Users

The growing number of regular and new users provide strong endorsement of the benefits of on-line technology. In the past five years, the number of on-line investors in the United States has risen from nearly zero to 25 million. They now account for over 20 per cent of retail trade volume.

The overriding factors that lead investors to trade on-line are price, time and security. Commissions for on-line trading are down to less than a tenth of the previous charge to a retail client by a traditional full-service broker. Some of the world's largest brokerage houses were originally opposed to internet broking, for fear of eroding their traditional business. They have now fully embraced the Internet and are helping their clients to set up on-line accounts.

In addition to on-line brokers, we are now seeing the emergence of on-line investment banks such as Wit capital and E-offering. They conduct new offerings of securities entirely on-line, putting the issuer in direct contact with investors and by-passing traditional investment banks and underwriters.

The Revolution has started in Hong Kong

Inevitably, the revolution has started to spread to Asia. Hong Kong, as the most open market in the region, and a city where the rate of PC and Internet penetration is relatively high, is naturally one of the first places in Asia to recognise the opportunities.

Some enterprising brokers and businessmen have set up on-line operations in order to service the growing number of young, sophisticated, computer-literate retail investors with significant assets. Some of the North American on-line brokerages, such as Charles Schwab, E-trade and TD-Waterhouse, have tapped into the appetite of local investors for US securities and are now beginning to penetrate the market in H.K.-listed shares. The intense price competition witnessed in North America is only just starting to be felt here, but it will surely come.

The capital costs of establishing an on-line service are not high, and the operating costs decline steeply as volume grows. Investors also value the convenience and control over their own finances afforded by on-line trading. All this will increase the number of active retail accounts in Hong Kong and stimulate additional trading volume.

Change in Mode of Service and Cross-Border Business

On-line technology is also changing the range of products and services offered by brokers. In addition to traditional services, technology enables brokers to provide customized or personalized portfolio management services, and brings the broking and fund management industries closer together. Technology is also creating wider opportunities for financial institutions to integrate services, previously supplied by different types of provider. These include securities trading, banking, pensions, life assurance and smart cards.

Technology is helping to create and manage an array of new financial instruments, including derivatives, composites and synthetic securities, to meet the demand from increasingly sophisticated investors.

All of this is likely to lead to a substantial shake-out and consolidation of Hong Kong financial institutions, as it is doing elsewhere. For Hong Kong as a financial centre, it creates both threats and opportunities. One of the threats is that the easy access to foreign issues and markets afforded by on-line technology will divert the interest of Hong Kong investors to overseas markets. One of the opportunities is to attract more overseas investors, and the management of their assets, to the Hong Kong market by improving cross-border communication and reducing transaction costs.

It is sometimes wrongly assumed, that cross-border business will inevitably flow to large international firms. There is equal scope for cross-border cooperation between market intermediaries. Smaller domestic brokers, with their lower overhead costs can also attract cross-border trading. In the near term, on-line technology may accelerate the trend towards dis-intermediation in the brokerage industry. However, in the longer term, re-intermediation is quite likely, as new forms of facilitators, advisors and infomediaries evolve.

Impact on exchanges

Now let us look at the impact of on-line technology on the business of exchanges. Progress in information technology during the last decade or so has permitted an increasing volume of cross-border listings and trading. This has inevitably created competition between exchanges which were previously compartmentalised geographically. Already, intense competition has arisen between exchanges within Europe and North America, and caused fundamental changes in their role and governance.

It was in anticipation of similar changes in Asia that the Hong Kong Government took the initiative earlier this year to promote the demutualisation and merger of our stock and futures exchanges and clearing houses. One of the main purposes is to permit the new merged body, Hong Kong Exchanges and Clearing Limited, to operate like a commercially-run business and respond more effectively to international competition. I look forward to the greater freedom, flexibility and opportunity to innovate which the new body will enjoy.

ECNs

Exchanges in North America and Europe face competition from other exchanges, and also from a growing number of electronic communication networks, or ECN. They originally evolved out of information dissemination systems which sought to match institutional orders without involving brokers.

Large brokers are now keen to become involved in order to retain order flow in their own hands. Examples of ECN include Island, a subsidiary of on-line broker Datek; Archipelago, in which J.P. Morgan, E-trade, Goldman Sachs and CNBC have taken stakes; Posit, the electronic order-matching system launched in Europe last year by International Technology Group with Societe Generale; and Instinet, the largest of them all, which is owned by Reuters. Reuters, together with Morgan Stanley, JP Morgan and Warburg, also recently acquired a controlling interest in Tradepoint.

Like more advanced exchanges, these organisations capture order flow and match prices electronically. But they have much lower operating costs than traditional exchanges. They do not have regulatory responsibilities and are free to cherry-pick the most actively-traded stocks, while ignoring those that offer smaller turnover and less revenue.

So far, ECNs have not made serious incursions into Asian markets outside Japan, but there is little to stop them when trading volumes make the effort worthwhile for them. The recent recovery of prices and trading volumes in Asian markets has probably brought that time closer.

Exchanges are beginning to fight back. One strategy being considered by several exchanges is to build their own in-house ECN.

Reintegration

In the near term, the likely effect of all this is increased fragmentation of securities markets. A good example is the division which is occurring of NASDAQ volume among ECN; and the rumoured intention of the New York Stock Exchange to join several ECN to create an alternative market for the largest Nasdaq stocks.

But fragmentation creates problems, including the splitting up of liquidity and inconsistent prices. In the longer term, reintegration of markets by one means or another is likely. This could be driven by cross-linkages between ECN , or by the creation of centralized electronic orderbooks and the merger of exchanges with ECN.

The demutualization of and listing of many exchanges has made it possible for these mergers to occur. Whatever happens, exchanges will be moving to provide investors with easy and more direct access to markets.

Empowered Trading Systems and Straight Through Processing

In the longer term, on-line technology is likely to lead to an expansion of trading system functions. The present services provided by exchanges or ECN only cover order matching and coordination of regulated clearing and settlement. New technology will enable trading systems to handle a wider range of products, and provide additional market facilities, including market making, auctions and cross-market portfolio trading.

Designers of trading systems will no doubt expand the system functions to pre-trade and post-trade services. Future trading systems will be connected to electronic initial public offering systems and will be able to identify and solicit investment decisions and the appetites of particular investors, in order to optimize trading activity and market liquidity.

After matching orders, trading systems will be connected directly to clearing and settlement systems, custodians, registrars, stock borrowing and lending facilities and portfolio management service bureaux. More and more exchanges are realizing the importance of efficient and cost-competitive post-trade services. These services may become the determining factor of where transactions are conducted.

A straight-through-processing system, providing a full range of cost-effective services under one roof, will be a crucial ingredient in any successful market. Eventually, the systems that generate the most liquidity, and offer the best quotations and prices, will become the dominant ones.

There are also likely to be increasing electronic linkages between national exchanges in the same time zone in order to increase their market liquidity and meet the challenge from ECN, becoming regional markets.

Action by the Exchange

Action taken in recent years by the Exchange follows the global trend and can be seen as a series of steps leading towards the provision of straight-through-processing of all securities market services.

In 1993, the Exchange established an electronic trading interface between floor traders and the Exchange. In 1996 we established an electronic trading interface between brokers' offices and the Exchange which allowed parallel stock trading to take place both on-floor and off-floor.

The introduction of AMS/3 next year will significantly expand the functions of the trading system and provide for various trading modes, including matching, market making and single price auction. It will also establish an electronic trading interface between investors, their brokers and the Exchange, which will allow investors direct access to the Exchange trading system.

Looking further ahead, the Exchange will expand the functions of its trading system to support new trading modes. We will continue to increase the accessibility of the Exchange system to investors in order to identify, solicit and capture investment decisions and trading intentions , and further increase liquidity.

The Exchange's Future Role

Competition will intensify between Hong Kong and other financial centres for transaction volumes, investor assets, listings and offerings. Our attractiveness as a market will depend on our liquidity, transaction costs, range of products, availability of information, and investor focus, including the focus on China-related opportunities.

The positioning of the Exchange is central to the creation of these conditions. The task of achieving them will be greatly helped by the planned demutualizing and merger of the Exchanges and their clearing houses; and the listing of Hong Kong Exchanges and Clearing Ltd.

The new entity will be forward-looking, cost efficient and well equipped to seize the opportunities presented by new technology. It will be a fully competitive commercial enterprise, alert to the opportunities presented by new technology and, totally focussed on satisfying its customers, the investors and listed companies. We are determined to take full advantage of this opportunity.

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