Legislative Council Panel on Financial Affairs, Report on " A Healthy Market for Informed Investors - A Report on the Derivative Warrants Market in Hong Kong (Nov 2005)" issued by SFC -- 5 Jan 2006
Release Date: 2006-01-04
Legislative Council Paper No. CB(1)661/05-06(01)
January 4, 2006
Comments on the “Report on the Derivative Warrants Market in Hong Kong”
The union welcomes the government's and relevant authorities' attention to the derivative warrants market. However, the“Report on the Derivative Warrants Market in Hong Kong” issued by the Securities and Futures Commission in November does not comprehensively address the issues and lacks broad engagement. It is said that the report mainly compiles the views of two major vested interest groups, the Hong Kong Stock Exchange, and issuers, without responding to the concerns and opinions of the public, investors, industry, and academics. The content is clearly biased, which is why the media and academics criticize the report as "much ado about nothing," avoiding fundamental issues of derivative warrants and only repeatedly mentioning the complexity of derivatives, fearing excessive regulation might risk Hong Kong's status as an international financial center, and worrying about reduced trading volume. The report completely ignores how to protect investors' funds, disregards investor losses in the derivative warrants market, and fails to discuss strengthening the monitoring of issuers. Overall, the report disappoints the union.
Regarding the six main recommendations in the report: 1) liquidity providers, 2) issuance of additional and identical warrants, 3) commission rebates, 4) marketing guidelines, 5) plain language, and 6) investor education, the union agrees with five of them but has opinions on the second point concerning the issuance of additional and identical warrants.
Unfairness and high risk in the additional issuance system:
The union believes that the additional issuance system is inherently unfair and poses significant risks.
a. The current mechanism theoretically allows issuers to issue unlimited quantities of a particular warrant without hedging, making the total street volume and market value potentially larger than the underlying stock. If the stock trend is one-sided, the risk can be considered infinitely large.
b. Market prices should be freely adjusted by the market to be considered fair. If prices deviate, naturally, investors will release their warrants, and no one would want to buy at high prices, reducing buying power, and prices will naturally decline. The argument of "cornering" is completely fallacious. Additional issuance puts investors in an even more unfair position.
c. Currently, investors cannot short-sell in the derivative warrants market, creating unfair rules of the game. Establishing a fair short-selling system can prevent cornering and be fairer, so why must issuers be allowed additional issuance?
Monitoring of issuers:
Additionally, the Securities and Futures Commission has overlooked strengthening monitoring of issuers:
a. Most current issuers of derivative warrants are foreign merchant banks. Under the "dual regulation" system, which institution formally regulates the issuers? The Monetary Authority? The Securities and Futures Commission? If an issuer encounters problems, which institution is responsible?
b. Issuers must have net assets exceeding HKD 2 billion, but this does not mean that assets or liquidity are sufficient. Theoretically, the unlimited issuance of warrants can make their market value exceed HKD 2 billion. How does the Securities and Futures Commission monitor this risk under the risk of issuer bankruptcy? Has it established---liquidity requirements? Business conduct codes? Related or associated company activities? Financial resource statements? How to handle contingent liabilities?
c. Do issuers engage in hedging, or are they simply betting against investors? How does the public know? Does the Securities and Futures Commission have the information? Can it be disclosed? Is transparency enough?
According to media reports, Warren Buffett has publicly stated that "derivatives are like time bombs, with enormous credit risks concentrated in the hands of a few derivatives dealers. Weak regulation makes derivatives like a flood, to be avoided." At the end of last year, Joseph Yam, Chief Executive of the Hong Kong Monetary Authority, expressed concerns in "Viewpoint" about the potential impact of derivative warrants on the stock market, mentioning that "financial instruments are diverse and penetrate different parts of the financial system, and advanced derivatives make financial markets more unpredictable. Theoretically, derivatives have a stabilizing effect on the market, but these effects are often not apparent, and derivatives instead tend to overshadow the stock market, causing concern about their potential impact." These remarks are worth consideration by the relevant authorities in Hong Kong and should prompt reflection when reviewing the development of the derivative warrants market.
Hong Kong Securities and Futures Industry Staff Union
January 4, 2006
Comments on the “Report on the Derivative Warrants Market in Hong Kong”
The union welcomes the government's and relevant authorities' attention to the derivative warrants market. However, the“Report on the Derivative Warrants Market in Hong Kong” issued by the Securities and Futures Commission in November does not comprehensively address the issues and lacks broad engagement. It is said that the report mainly compiles the views of two major vested interest groups, the Hong Kong Stock Exchange, and issuers, without responding to the concerns and opinions of the public, investors, industry, and academics. The content is clearly biased, which is why the media and academics criticize the report as "much ado about nothing," avoiding fundamental issues of derivative warrants and only repeatedly mentioning the complexity of derivatives, fearing excessive regulation might risk Hong Kong's status as an international financial center, and worrying about reduced trading volume. The report completely ignores how to protect investors' funds, disregards investor losses in the derivative warrants market, and fails to discuss strengthening the monitoring of issuers. Overall, the report disappoints the union.
Regarding the six main recommendations in the report: 1) liquidity providers, 2) issuance of additional and identical warrants, 3) commission rebates, 4) marketing guidelines, 5) plain language, and 6) investor education, the union agrees with five of them but has opinions on the second point concerning the issuance of additional and identical warrants.
Unfairness and high risk in the additional issuance system:
The union believes that the additional issuance system is inherently unfair and poses significant risks.
a. The current mechanism theoretically allows issuers to issue unlimited quantities of a particular warrant without hedging, making the total street volume and market value potentially larger than the underlying stock. If the stock trend is one-sided, the risk can be considered infinitely large.
b. Market prices should be freely adjusted by the market to be considered fair. If prices deviate, naturally, investors will release their warrants, and no one would want to buy at high prices, reducing buying power, and prices will naturally decline. The argument of "cornering" is completely fallacious. Additional issuance puts investors in an even more unfair position.
c. Currently, investors cannot short-sell in the derivative warrants market, creating unfair rules of the game. Establishing a fair short-selling system can prevent cornering and be fairer, so why must issuers be allowed additional issuance?
Monitoring of issuers:
Additionally, the Securities and Futures Commission has overlooked strengthening monitoring of issuers:
a. Most current issuers of derivative warrants are foreign merchant banks. Under the "dual regulation" system, which institution formally regulates the issuers? The Monetary Authority? The Securities and Futures Commission? If an issuer encounters problems, which institution is responsible?
b. Issuers must have net assets exceeding HKD 2 billion, but this does not mean that assets or liquidity are sufficient. Theoretically, the unlimited issuance of warrants can make their market value exceed HKD 2 billion. How does the Securities and Futures Commission monitor this risk under the risk of issuer bankruptcy? Has it established---liquidity requirements? Business conduct codes? Related or associated company activities? Financial resource statements? How to handle contingent liabilities?
c. Do issuers engage in hedging, or are they simply betting against investors? How does the public know? Does the Securities and Futures Commission have the information? Can it be disclosed? Is transparency enough?
According to media reports, Warren Buffett has publicly stated that "derivatives are like time bombs, with enormous credit risks concentrated in the hands of a few derivatives dealers. Weak regulation makes derivatives like a flood, to be avoided." At the end of last year, Joseph Yam, Chief Executive of the Hong Kong Monetary Authority, expressed concerns in "Viewpoint" about the potential impact of derivative warrants on the stock market, mentioning that "financial instruments are diverse and penetrate different parts of the financial system, and advanced derivatives make financial markets more unpredictable. Theoretically, derivatives have a stabilizing effect on the market, but these effects are often not apparent, and derivatives instead tend to overshadow the stock market, causing concern about their potential impact." These remarks are worth consideration by the relevant authorities in Hong Kong and should prompt reflection when reviewing the development of the derivative warrants market.
Hong Kong Securities and Futures Industry Staff Union