Securities lending and short selling can boost Hong Kong stock exchange’s liquidity push

Amid efforts to improve the Hong Kong stock market’s liquidity and bolster the city’s status as a financial hub, securities lending must not be overlooked
The new task force could consider making all stocks eligible for short selling and increasing the quantity of securities available for lending

Jason Wells

Published: 2:30pm, 14 Sep 2023

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With Hong Kong’s stock market liquidity task force meeting for the first time, the discussion on how the city’s stock market can boost trading turnover has focused on measures to attract more high-quality listings and reducing the cost of trading by cutting stamp duty. More initial public offerings and lower-cost trading can certainly help attract capital to Hong Kong over time, but the task force should not overlook the contribution that securities lending and borrowing can make to increasing trading volumes.

Securities lending and borrowing involves the owner of shares or bonds transferring them temporarily to a borrower. The borrower typically collateralises the loan and pays a borrowing fee to the ultimate owner.

About US$2.6 trillion of securities were on loan globally at the end of June, according to the International Securities Lending Association, and securities lending is widely recognised as supporting liquidity and price discovery in capital markets.

Hong Kong is a leading market for securities lending and borrowing, founded on long-established practical and pragmatic rules. This area of financial markets enables investors to hedge risk and express a view on the direction of stocks through short selling.

The city’s regulators have long understood the importance of this market to generating liquidity. Securities lending thrives in Hong Kong because short selling is transparent and well-regulated. However, there are several ways that these practices could be enhanced to help unlock additional liquidity for the broader market.

Short selling is not primarily a speculative activity, contrary to the popular perception of it being used to bet against certain stocks. Rather, its main application is in risk management. The Securities and Futures Commission noted in its latest Half-yearly Review of the Global and Local Securities Markets that “exchange-traded products [ETPs] have become a dominant component of the daily short selling turnover, and the majority of the short selling activities of ETPs were conducted by market makers”.

Hong Kong Exchanges & Clearing is an outlier among major stock exchanges with its “tick rule”, which restricts short sales below the prevailing asking price for a stock during the pre-open auction and closing auction session. Photo: Reuters

The commission pointed out that the short-selling ratio reached the second-highest level on record on June 5 this year at 23.4 per cent, with 56 per cent of the day’s short-selling accounted for by major ETPs. The market-makers who create new exchange-traded fund (ETF) units – the main type of ETP – also need to manage the risk of exposure to the shares they must buy to create ETF units by taking short positions.

Because these short positions are also usually very short term and offset by purchases, the effect is typically market-neutral and positive for overall liquidity. In Hong Kong, then, a large proportion of short-selling activity is driven by risk management activity that is essential to the provision of popular, low-cost investment products – not by speculators looking to express a view on a company.

The average daily turnover of Hong Kong-listed ETFs reached 15.5 per cent of the market’s total turnover in July, up from 9.8 per cent a year earlier and 4.6 per cent in July 2021.

The dollar value of this activity has also increased even as overall market turnover declined in the same period. Average daily trading volume in Hong Kong-listed ETFs in the first half of 2023 was HK$13.9 billion (US$1.8 billion), up from HK$12 billion in 2022 and HK$7.7 billion in 2021. But the main board’s overall average daily trading volume in July was down by 15 per cent year on year and 18.7 per cent on two years earlier.

These figures show that securities lending and short selling are intrinsic to the growth of products that buck the broader trend of declining liquidity in Hong Kong. It follows that the task force should examine ways to further encourage these activities in Hong Kong as part of its efforts to boost market turnover.

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There are several specific measures this group could consider. First and foremost, Hong Kong could make all stocks eligible for short-selling. At present, according to the Hong Kong stock exchange website, the designated securities eligible for short selling are limited to around one third of all listed securities in the Hong Kong market.

Hong Kong’s “tick rule”, which restricts short sales below the prevailing asking price for a stock during the pre-open auction and closing auction session, could also be removed. Removing this requirement would be well received by high-frequency traders, who add significant liquidity to markets.

The government could also explore ways to increase the quantity of securities available for lending in Hong Kong. This could be achieved, for example, through the development of a lending platform with centralised clearing for securities owned by southbound Stock Connect investors – mainland China-based investors trading in Hong Kong shares – or individual investors in Hong Kong. As well as adding to overall liquidity by choosing to make their shares available for loan, both groups would benefit from additional income from lending their securities.

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Liquidity could likewise be increased by reducing the amount of time for which a listed company can suspend itself from trading. Alternatively, a grey board, or over-the-counter mechanism, that allows buyers and sellers for suspended stocks to be matched could be created.

Finally, the dual-counter system set up in June to allow investors to trade Hong Kong-listed shares in renminbi could be enhanced to allow for the instant transfer of securities between counters. This would smooth settlement obligations in securities lending transactions.

Introducing measures such as these would build on the city’s deserved reputation as one of the world’s most sophisticated capital markets and could be important components of a broader strategy to increase liquidity. As well as looking at ways to encourage IPOs and cut transaction costs, we hope the task force will also consider ways to enhance securities lending and short-selling in Hong Kong as they have a proven ability to generate additional liquidity.

Jason Wells is chairman of the Pan Asia Securities Lending Association (PASLA)