A TUG-OF-WAR appears to be looming between the Securities and Futures Commission and the stock exchange over the embarrassment of riches generated by the transaction levy from sharper higher market turnover. SFC chairman Robert Nottle said a recommendation had been made to Financial Secretary Hamish Macleod to slash the transaction levy by 40 per cent from 0.02 per cent to 0.012 per cent on stock transactions in the 1994-95 budget. The SFC's decision came after stock exchange chairman Charles Lee Yeh-kwong said on Tuesday he had reservations about lowering the levy because the exchange needed money to fuel its expansion plans. This need was highlighted by the launch of short-selling and equity options next year. Mr Nottle said it became clear in discussions yesterday that Mr Lee was concerned about the size of the reduction. However, Mr Nottle said the commission believed the cut was viable and left a sufficient source of revenue for the SFC and stock exchange. Mr Lee said the exchange wanted to establish a reserve fund of $600 million - 50 per cent higher than an estimate compiled last month - to cover its expansion over the next two years. But Mr Nottle said it was important for Hong Kong to have a competitive cost structure, or trade would leave for other markets. This scenario has already been borne out in London, where turnover of Hong Kong stocks passed $10 billion for the first time in October, more than double the previous high for the year of $4.9 billion in June. Total turnover in London for the first 11 months was $57.3 billion, costing Hong Kong's financial community more than $400 million in lost commissions and stamp duty. Mr Nottle said the SFC had also recommended that it not receive a government grant for a second consecutive year, and it would not accept any transaction levy income for six months after the reduction was imposed. ''Given the increase in turnover that has taken place, there must be scope for reducing the levy,'' Mr Nottle said. ''The commission's overall policy is we must do everything we can to keep dealing costs to a minimum.'' The recommendations were necessary because the Securities and Futures Commission Ordinance limited the SFC's reserves to twice the level of its annual operating expenses, he said. In fiscal 1993, the SFC generated excess income of $164.6 million, bringing total reserves up to $251.9 million. Operating expenses, which fell slightly from the previous year, were $162.2 million. While the stock exchange has had a record number of new listings this year, Mr Nottle said he was still concerned about the high level of over-subscription that accompanied many initial public offerings. He said it was clear the pricing of many issues was not right, raising the question of whether the SFC should re-examine the framework in which offer prices were set. ''We want to look at what's happening in the market to see if there is sand in the gears . . . and see if there is anything causing the pricing mechanism to not work properly,'' he said. Mr Nottle, who first lashed out against over-subscription in August in a speech to the Australian Chamber of Commerce, said it would be necessary to look at pricing methods or the role of advisers, underwriters and directors. He said the exchange's listing rules had a catch-all clause that allowed any type of pricing method to be used. This included book building, which enables an issuer to test the market and discover the price, or the tender method, where potential investors were approached and asked to bid. Mr Nottle said a conflict of interest between advisers and underwriters could be a problem because advisers sought to price an issue as high as possible, while underwriters had a vested interest in their ability to place it. The pricing debate has intensified recently with the initial public offers of Esprit Asia and Kunming Machine Tool. Esprit jumped 100 per cent during its first day of trading to $3.90, while Kunming soared 192 per cent to $5.80.