Reforms threaten smaller brokers

IT WAS a David-and-Goliath contest. On one side, Hong Kong's small brokers. On the other, the territory's powerful market regulator, the Securities and Futures Commission (SFC). David won. At an extraordinary general meeting (EGM) on September 2, the Stock Exchange Council (SEC) rejected the SFC's decision to revise downwards share price spreads. But even as the underdogs celebrate, it appears this is only the start of a prolonged battle. And it is one that the Goliaths of the SFC are almost certain to win. One observer said after the SEC's EGM vote: 'Small brokers should not be too triumphant, because the sweet taste of victory will be short-lived. It may be the beginning of a catastrophe.' The standoff between brokers and the SFC is a product of the Hong Kong market's continuing evolution from family-run business to world-class market. The SFC's effort to narrow share spreads was part of a wider movement to bring Hong Kong's stock trading practices into line with international standards. The tussle over share spreads has exposed the deep divisions between the reformers and those brokers who still hark back to the cosy practices of the pre-1987 era, when most brokerages were run by families and even the stock exchange was controlled by a family-style 'syndicate'. The EGM sent a message of defiance to the reform-minded authorities. Among a further five resolutions passed was one in favour of an extra five minutes' trading for manual execution of orders. Some brokers decried the move, saying manual trading would open the door for 'rat trading' (when a broker who has received an order to buy shares at a certain price obtains them for a lower price and pockets the difference). One broker said: 'These challenges will induce the SFC to suffocate the unco-operative band of small brokers, threatening their very survival.' It was the share-spread issue that sparked the confrontation. On July 1, trading spreads for shares were revised downward to between 0.1 of a cent and $2.50 from a previous range of 0.1 of a cent to $5 under the instructions of the SFC. Many brokers complained that no consultation had taken place beforehand, although they admitted that a narrower spread would make Hong Kong share prices more competitive and reduce volatility. Smaller spreads hurt the profits of small brokers who, unlike their larger counterparts, rely on trading in the cash market for the bulk of their business. Their numbers are already declining. According to the Hong Kong Stockbrokers' Association, membership has dropped from more than 400 before 1987 to a present total of only about 160. 'The reasons for the drop include migration and the closing down of the business because of keen competition,' said association chairman Chu Chung-tin. In order to cope with increasing overheads and fierce competition, many small local brokerages have begun to merge into larger operations. Brokers have also started to complain the authorities' policies discriminate against small brokers in favour of larger institutions. 'One example is that banks can open stockbroking branches anywhere without much restriction,' said a broker. Raymond Lai, a controversial former broker who was criticised in the Tomson Pacific report for certain share placements made during his employment with Standard Chartered Securities, said the market had already reached a new phase in its development. 'The atmosphere of the local industry has changed. Some traditional practices are not only frowned upon but the authorities are also keen to investigate the practices done before the new rules applied,' he said. But he added that the enforcement of the rules would be more important than the rules themselves. 'I think the SFC has been nit-picking so far,' said Mr Lai. However, this was understandable since the standpoint of the authorities was different because they had to implement the law. THE watershed for the Hong Kong market came with the 1987 crash. Wide-ranging reforms proposed by the Hay Davison Report which followed the crash changed it from a family affair to an institution. Since then, the rules and regulatory framework have followed the blueprint of the report, which suggested the establishment of the SFC as the top local regulatory body. However, the golden age of stockbrokers is history now, much to the chagrin of some. 'In the 1960s, the status of a broker was similar to a Justice of Peace,' said a broker with 30 years' experience. Under the family-run style, many practices which allowed brokers to make more money were unofficially permitted. This encouraged many to join the industry. These practices were widely accepted, but would largely be regarded as malpractices by today's standards. They include the old underwriting system, market-making and rat trading. The old underwriting system was known as 'sharing the pie' among the members which made up the market hierarchy, starting from the SEC to the brokerages, owners, brokers and floor traders. Whenever there was a share issue, the council would inform all brokerages to take up certain number of shares at whatever the price set, but usually a certain amount of profit would be guaranteed. But the system broke down after the introduction of the post-crash reforms. Market-making activities have obviously slowed down as the SFC has imposed more restrictions on the local market, such as heavy penalties on false market making. One of the charges directed by the SFC at Standard Chartered Securities involves a type of market making. But market makers may not necessarily be the major shareholders. 'An individual who has taken positions in a stock could be a market maker,' said a broker. After buying a certain amount of shares of a particular stock, he has the power to control the liquidity of the stock. Rat trading has also been commonplace, despite assurances from the authorities that the practice had been virtually eradicated by the introduction of auto-matching late last year. 'It may have disappeared on the floor trading level, but it could still exist among the traders in the office,' an experienced broker said. OTHER practices are even more controversial. 'Window-dressing' is a common practice among fund managers. It can involve any practice which serves to improve artificially the performance of a particular investment or company. As the Hong Kong market continues to develop, it seems inevitable that these traditional, and sometimes dubious, practices will eventually disappear.