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Enhancement of the Financial Infrastructure in Hong Kong

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Enhancement of the Financial Infrastructure in Hong Kong

    Report on the

    Enhancement of the Financial Infrastructure

    in Hong Kong

An eFrastructure for a Leading eEconomy

    Steering Committee on the

    Enhancement of the Financial Infrastructure

    Hong Kong

    September 1999

    REPORT ON THE

    ENHANCEMENT OF THE FINANCIAL INFRASTRUCTURE IN HONG KONG

    “An eFrastructure for a Leading eEconomy”

    TABLE OF CONTENTS

     Chapters

    1. Introduction

    2. Embracing Market Challenges and Opportunities

    3. Vision for Success

    4. The eFrastructure

    5. Journey to the Future

Acknowledgements

Appendix

    A. SCEFI Terms of Reference

    B. Members of SCEFI and Working Groups

    SCEFI 1999

     1. Introduction

    CHAPTER ONE

    INTRODUCTION

    n his Budget Speech on March 3, 1999, the Financial Secretary I announced a comprehensive financial market reform to strengthen Hong Kong’s competitiveness and to enable Hong Kong to remain in the premier league of international financial centers.

    The Financial Secretary recognized, while Hong Kong’s securities and derivatives markets have achieved tremendous growth and success in the last decade, recent developments in the global market, such as the rapid advent of the eEconomy, emergence of alternative electronic trading systems, increasing sophistication of investors, and the globalization of markets and investments, have created increasing competition and challenged the position of Hong Kong as a leading regional and international financial center.

    Responding to these global market challenges, the Financial Secretary announced a three-prong reform program for the securities and futures “We need to embrace markets in Hong Kong: state-of-the-art

    technology to remain (1) Fundamental change in the market structure accomplished in the premier league of

    through the demutualization and merger of the exchanges and world financial centers.

    clearing houses; The reforms of our

    securities and futures (2) Enhancement of the financial infrastructure to improve risk markets are substantial management, increase efficiency, and reduce cost; and and their implications

    far-reaching.” (3) Regulatory and legislative reform to improve the supervisory

    framework and protection of market participants. The Financial

    Major reforms are on-going in the demutualization and merger of the Secretary

    exchanges and clearing houses. The Composite Securities and Futures Bill is in the final stages of drafting and will be submitted to the Legislative Council by early December 1999. To address the strengthening of the technology base in the securities and futures market, the Financial Secretary appointed a Steering Committee on the Enhancement of the Financial Infrastructure in Hong Kong (“SCEFI”), chaired by Mr. Andrew Sheng, the Chairman of the Securities and Futures Commission (“SFC”), in March 1999 to study and recommend the necessary improvements to the financial infrastructure in Hong Kong. The terms of reference and a list of members of SCEFI are included in Appendices A and B respectively. Over the period from March to September 1999. SCEFI met 12 times. The SCEFI study is aimed to specifically address the following issues with the objective of enhancing the competitiveness of Hong Kong as an international financial center in terms of risk management, increased efficiency and cost reduction:

    Page 1 SCEFI 1999

     1. Introduction

    ; Setting up of a single clearing arrangement for securities, stock

    options, futures and other exchange-traded transactions;

    ; Enhancing the financial technology infrastructure to facilitate

    straight-through processing of transactions across financial

    markets; and

    ; Moving towards a secure, scripless securities market. In order to understand the perspectives of the industry and relevant parties, and to obtain their input, the SCEFI set up a User Working Group (“UWG”) and a Technology Working Group (“TWG”). Over the period from March to September 1999, the UWG met 7 times and the TWG 13 times. They have provided invaluable contributions to the study. A list of members of the two working groups is included in Appendix B.

    This report documents the findings and recommendations of the SCEFI study. The market challenges and opportunities, and the vision for success will be discussed. The target financial infrastructure for Hong Kong will be elaborated in terms of the proposed single clearing arrangement, straight-through processing, scripless securities market, and technology structure. Finally, infrastructure initiatives are recommended for the journey to the future.

    Page 2 SCEFI 1999

     2. Embracing Market Challenges and Opportunities

    CHAPTER TWO

    EMBRACING MARKET CHALLENGES AND OPPORTUNITIES

    ong Kong has emerged as one of the leading service economies in H the world, with a “service sector value added”-to-GDP ratio of 84%.

    The World Bank estimates that from 1994-97, exports of services world-wide grew by more than 25%. After the Asian financial turmoil, however, with significant currency devaluations in the region, Hong Kong faces growing competition in terms of prices as well as in the range and quality of financial services offered by other Asian centers. Global markets and 24-hour trading also imply that competition for financial services comes from not only the Asia Pacific time zone, but also from centers in Europe and America.

Meeting competition through technology

    While rents and wages have adjusted significantly, Hong Kong recognizes that it must continue to upgrade the quality and range of its services, especially the value added through technology, innovation and user friendly access. Recent surveys suggest that the presence of advanced infrastructure, particularly in transport, communications, legal, accounting and commercial services, is the most important consideration in the location of regional headquarters, service and sourcing operations, and is the second most important factor in siting production. Recent developments in the United States demonstrate how relentless improvements in technology can compensate for high costs. The U.S. Department of Commerce’s report on “the Emerging Digital Economy II” (June 1999) indicated that the decline in U.S. inflation despite three years of robust GDP growth of 4% per annum was attributable to the massive price declines in the IT-producing industries. For example, in 1997, the falling prices of IT goods and services (a 7.5% decrease) offset the 2.6% price increase for the rest of the economy to give an overall inflation rate of 1.9%. This demonstrates that it is imperative for Hong Kong to use IT to help boost productivity, reduce costs and enhance competitiveness (Exhibit 2.1).

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     2. Embracing Market Challenges and Opportunities

    4.0%

    2.0%

    0.0%

    -2.0%ActualEstimated

    -4.0%

    Price changes

    -6.0%

    -8.0%

    -10.0%

    1992199319941995199619971998

    IT-Producing IndustriesRest of the EconomyOverall GDP

    Source: U.S. Department of Commerce / ESA

    Exhibit 2.1 Price Changes in IT-Producing Industries & the Rest of the

    Economy

Recent developments in eCommerce and eTrading

    The Informal Working Group on Financial Technology Infrastructure’s Report of December 1997 recommended that “With worldwide growth in electronic commerce and electronic payments developed and pushed by the private sector, Hong Kong must take advantage of its superb telecommunications infrastructure to adapt technology toward the provision of superior services.”

    Since 1997, growth in eCommerce and eTrading (electronic commerce The emergence of

    and transactions encompassing trading, payments, procurements, and the Internet has

    broken free the all other components of the supply chain, etc.) has expanded beyond all

    constraints of time, expectations. The Gartner Group forecasts that, for the Asia Pacific

    space and form, and region, business-to-business eCommerce will grow from US$8b in 1999 spurred the to US$280b in 2003 (about a 34-fold increase); and business-to-consumer explosion of eCommerce will grow from US$5b in 1999 to US$40b in 2003 (about a 7-eCommerce. fold increase) (Exhibits 2.2 & 2.3).

    Page 4 SCEFI 1999

     2. Embracing Market Challenges and Opportunities 300

    250

    200

    34-fold increase

    150

    US$ (billion)

    100

    50

    0

    1997199819992000200120022003

    Source: Gartner Group

    Exhibit 2.2 Business-to-business eCommerce in Asia Pacific

    50

    40

    30

    7-fold increase

    20US$ (billion)

    10

    0

    1997199819992000200120022003

    Source: Gartner Group

    Exhibit 2.3 Business-to-consumer eCommerce in Asia Pacific

    The Yankee Group forecasts that the number of Internet users in the Asia

    Pacific region will surpass 374 million by 2005, up from just over 39

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     2. Embracing Market Challenges and Opportunities

    million in 1998 (almost a 10-fold increase). The Yankee Group also predicts that China will become the leading Asia Pacific nation in terms of Internet users in 2001, with about 40 million people online; and by 2005, China should surpass the United States in having the most users in the world.

    The exponential growth of eCommerce and eTrading enabled and facilitated by the Internet has brought fundamental and irreversible changes to how businesses are being conducted. The marketplace is no longer bounded by geography. Traditional franchises are under threat, as new players, especially small and medium sized enterprises, can start up electronically to compete with minimal investment. A new breed of customers, groomed in the sophistication of the information age and Internet, demand virtual channels for services.

    Online trading in securities has witnessed explosive growth, especially in the United States. By the end of 1998, there were an estimated 7.3 million online brokerage accounts; and by mid-1999 this number reached the magnitude of 11 million. More than one-quarter of the trades in Nasdaq and NYSE are now channeled through the Web. In Europe, over 900,000 investors trade online. In Asia, trading in Korean equities has been stimulated by the emergence of nearly one million online accounts, compared with an estimated 100,000+ online accounts in Japan (Exhibits 2.4 & 2.5).

    10U.S.14

    0.05U.K.1.9

    0.6Germany3.6

    0.1Japan0.5 (Year 2001)

    0246810121416

    Number of online share trading accounts (million)

    Mid-1999Projected (Year 2002)

    Sources: Forrester Research, DLJdirect, IDG

    Exhibit 2.4 The trend of online share trading

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     2. Embracing Market Challenges and Opportunities

    Online BrokersYearNo. of OnlineAverage % ofAverage % of

    TraderTrades PlacedTrades Placed

    over the PhoneOnline

    Charles Schwab199775064%36%

    199875050%50%

    Ameritrade199715053.5%46.5%

    199820026%74%

    E-Trade199717518%82%

    199820011.3%88.7%

    Quick & Reilly1997503.5%96.5%

    19981003.5%96.5%

    DLJdirect19971208%92%

    199818012%88%

    Source: IDG

    Exhibit 2.5 Online share trading vs traditional order placement

    The rapid advance of eCommerce in recent years has also enabled the creation of a new breed of very powerful, low cost and highly competitive intermediaries, the Electronic Communications Networks (“ECNs”) in the securities market (e.g., Instinet, Island ECN, Archipelago, Primex, Tradepoint), and similar online networks in the derivatives market (e.g., BrokerTec, International Securities Exchange). These alternative markets have increasingly eroded significant trading volumes from the traditional markets. For example, by 1999, nine of the ECNs account for about 25% of the total equity trading volume in the U.S. Facing up to these market challenges, exchanges and clearing houses in many financial centers (e.g., Amsterdam, Sydney, Frankfurt, Singapore) are taking or planning to take strategic steps to transform into customer-centric and market-driven commercial organizations. The NYSE and London Stock Exchange are also contemplating demutualization and the eventual listing of their exchanges. In addition, exchanges and clearing houses are establishing strategic alliances to better enable their development of cross-market products and to realize economies of scale on their technological investments. Examples of these alliances include the use of the NSC trading system by the GLOBEX Alliance of CME, MATIF, SIMEX and the recently joined Brazilian futures exchange BM&F; use of the Eurex system by DTB/SOFFEX, CBOT & HEX; as well as

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