Price distortions and sales incentives are targeted to reduce market volatility The stock exchange has called on the securities watchdog to review its rules for a form of investment suspected of contributing to market turmoil that sent the Hang Seng Index plunging 300 points early last month. Hong Kong Exchanges and Clearing (HKEx) has expressed concern about practices in the warrant market that it said could contribute to, or be seen as, market manipulation. The heavily traded warrant market, which can account for as much as 25 per cent of total exchange turnover, is already the subject of a market manipulation investigation by the Securities and Futures Commission (SFC). Warrants, which give investors the right to buy or sell an underlying security at a fixed price, is one of the so-called derivative products some see as the market equivalent of exotic bets at the Jockey Club. In its own review issued last night, HKEx noted concerns about two practices: 'Wash sales' - in which investment banks sell warrants to brokers at a discount or offers them incentives such as commission rebates. A rule that no new warrants can be issued until 80 per cent of a given tranche has been taken up, which pushes up the price for the remaining 20 per cent. The 'wash sales' can appear to boost trading activity when their real intent is to entice less knowledgeable retail investors to pile in. 'Discounted commissions and other sales incentives may be part of normal competition and consistent with market rules,' the exchange said. 'However, market feedback indicates that some trading in derivative warrants may be generated solely to receive sales incentives. 'HKEx management questions whether it is appropriate for derivate issuer incentives or commission rebates to be the only reason derivative warrant trades are conducted and intends to discuss this further with the SFC.'' The exchange study also highlighted how existing issuing rules could squeeze liquidity, temporarily distorting warrant prices. At present, an issuer can offer more warrants only after 80 per cent of a given tranche is taken up. That process, however, takes five days, during which time keen demand for the remaining 20 per cent can send a warrant's price soaring. 'There may be insufficient time ... [for an issuer] to keep up with the demand, thus potentially leading to a higher price,' the exchange said. 'When the issuer does launch [more warrants], the additional supply may satisfy the demand and lead to a correction. This may be seen by some as manipulation.' The exchange said there had been a demand from market players for the trigger point for new sales to be set at 60 per cent instead of 80 per cent to avoid the price-boosting squeeze. While HKEx did not endorse this suggestion explicitly, it did note that 'a less restricted issuance system would be more efficient and less likely to produce pricing anomalies'. Sources close to the exchange also said it could support shortening the reissue approval process from five days to two, so liquidity could be restored more quickly.