|
HKEx Discusses Derivative Warrants and Invites Feedback
Hong Kong Exchanges and Clearing Limited (HKEx) today (Monday, 10 October) publishes an article on derivative warrants (DW) that includes the Stock Exchange's rules on DW, a summary of the recent discussion and debate on DW and the views of HKEx management on key issues raised recently in respect of DW.
HKEx invites interested parties to provide their views on the DW market and the matters discussed in the article. Comments received will be shared with the Securities and Futures Commission (SFC).
Comments should be sent to the address below:
Hong Kong Exchanges and Clearing Limited
11th Floor, One International Finance Centre
1 Harbour View Street
Central
Hong Kong
Re: Understanding Derivative Warrants / Request for Comments
Comments may also be sent by fax to (852) 2868 5223 or by email to feedback@hkex.com.hk.
The names of persons who submit comments on the article together with the whole or part of their submissions may be disclosed to members of the public.
HKEx Discusses Derivative Warrants and Invites Feedback
Introduction
- Since their introduction in Hong Kong in 1989 and as revised and re-launched in 2002, derivative warrants (DW) have proven to be a very popular product among a broad cross-section of investors, particularly retail investors. Despite this popularity and the significant growth in the DW market, this investment instrument has at times also generated its share of discussion and debate. In Part I of this article the requirements governing DW contained in the Stock Exchange's Listing and Trading Rules are discussed. Part II provides a summary of the recent discussion and debate and HKEx management's response. Finally, HKEx invites interested parties to provide their views on the DW market and the matters discussed in this article.
HKEx has worked closely with the Securities and Futures Commission (SFC) concerning the DW market since its inception. Recent discussions with the SFC include the issues raised in this article. HKEx will continue to assist the SFC in its consideration of the DW market and the feedback received on this article will be shared with the SFC. HKEx understands that the SFC will be publishing its views on the DW market by approximately the end of November 2005.
Part I - Listing and Trading Rules for DW
Issuer Eligibility
- DW holders are unsecured creditors of an issuer. They have no preferential claim to any securities an issuer may hold to hedge the exposure arising from a DW issue. As such, investors are exposed to the credit risk of the issuer; HKEx has sought to reduce that risk by imposing stringent entry criteria for issuers. There is, however, no guarantee against an issuer's default and as discussed below such default represents only one of the various risks to which investors are exposed when trading DW.
- An issuer is required to have net assets of $2 billion or more. This level is seen as a measure of the issuer's commitment to the business of issuing derivative warrants. Issuers are also required to have either a credit rating (which must be at least an "A" grade) or to be regulated by the Hong Kong Monetary Authority (HKMA) or the SFC. The minimum credit rating is currently equivalent to the sovereign rating ceiling assigned to the Hong Kong SAR Government. Requiring issuers who do not meet the minimum rating requirement to be regulated by either the HKMA or the SFC helps to ensure that the issuer will be subject to an appropriate regulatory regime which will protect the interests of parties dealing with an issuer.
- The issuer eligibility requirements are intended to provide a high degree of assurance, but not a guarantee, that issuers will be able to fulfil their obligations arising from DW issuance. Since 1989, there has been only one case of an issuer default on its obligations as a DW issuer. DW are complex leveraged products and pose numerous risks that investors should be aware of. For this reason DW may not be suitable for many retail investors and investors should make sure they understand warrants and the related risks before trading in them.
DW Liquidity
- Issuers are required to provide liquidity for DW issues. To comply with this requirement issuers are required to appoint a Liquidity Provider (LP), who must be a Stock Exchange Participant and who may be either a member of the issuer's group or an independent party who acts as the issuer's agent. Liquidity may be provided by means of market-making in which either two-sided quotes are made on a continuous basis or are made in response to a quote request. Issuers should specify the applicable spread interval between their bid and ask prices in the listing document. Liquidity should be provided commencing no later than five minutes after the market opens and should be for a minimum of 10 board lots. There are exemptions for fast markets and for when an issuer has no DW available to sell. All dealings by an issuer in one of its DW must be conducted through the applicable LP. The LP for each DW has a broker number starting with "95" or "96" thus providing transparency of the LP's trading activity.
- The requirement to provide liquidity was introduced in 2002 after the market-wide consultation conducted in 2001[1]. The requirements are intended to help ensure that investors are able to purchase and sell DW throughout an issue's life in what are considered to be retail-sized amounts. These requirements were set at alight level to enable market forces and competition to drive issuers to provide service levels beyond those noted above. Other exchanges also address the issue of post-listing liquidity in DW by likewise requiring issuers to provide a market-making capability for their DW. Market-making is also a normal feature of the exchange-traded options markets internationally.
Further Issues of DW
- As noted above issuers are required to ensure a certain level of liquidity for their DW. One of the exceptions to this requirement is where the issuer has sold the entire approved supply of the relevant DW in which case it is no longer required to quote offer prices for that issue. When over 80 per cent of a DW issue has been sold an issuer may, but is not required to, create an additional supply of that issue by way of a Further Issue.
- Further Issues are permitted on the basis that they help to eliminate pricing anomalies when DW issues have been fully sold. Creating a timely additional supply of a DW helps ensure that the price of the DW is determined by fundamental market factors (eg strike price relative to underlying asset price, expected volatility of the underlying asset(s), time to maturity and interest rate) rather than by supply and demand for the DW. Further Issues are discussed again below.
Eligible Stocks
- To be eligible for DW issuance a stock must be either a constituent of the Hang Seng Index or be on a list published by HKEx approximately every quarter. To be included on the list a stock must have maintained a public float capitalisation of $4 billion or more for approximately three months. Newly listed stocks may be exempted from the three-month requirement if their public float capitalisation is at least $10 billion. Currently, about 90 listed stocks are eligible for DW issuance.
- These requirements are intended to limit issuance to liquid stocks in order to minimise the potential impact of DW on the price of the underlying shares. To guard against any such impact at DW expiry, cash settlement at expiry is calculated using the average closing price for the five days preceding the expiry date. In practice, DW expiry has not proven to be a problem as the number of DW outstanding usually shrinks substantially prior to expiry. HKEx also notes that the vast majority of DW are issued on the Hang Seng Index and on 10 to 15 stocks which are among the highest in terms of liquidity and market capitalisation.
- The Exchange previously operated a quota system which limited DW issuance over a company's shares to the lower of 20 per cent of its issued share capital or 30 per cent of its public float. In reviewing the Listing Rules in 2001 HKEx noted that other exchanges did not adopt a quota as a means of limiting DW issuance. The interests of issuers, HKEx and market participants are aligned in this area. Although each issuer will have a different risk appetite, in general issuers limit issuance or use alternative hedging mechanisms to minimise any impact their DW issuance and hedging activity may have on the prices of an underlying shares. If a quota system were to be imposed it would in certain instances restrict the ability of issuers to launch Further Issues, potentially resulting in pricing anomalies in the DW. In light of these factors the quota system was repealed in 2002 after market-wide consultation.
Transparency
- All DW launches and upcoming expirations are published on the HKEx website. Issuers' listing documents including the particulars of each DW are also published on that website. Each day issuers publish a daily trading report showing their aggregate sales and purchases of each DW and related average prices, and the total amount of that issue in the market. As mentioned, trading by the DW's LP can be seen by the market due to the LP's unique broker number which is displayed on AMS/3. As discussed below, extensive technical details about each DW are available from most DW issuers' websites, newspapers and other financial publications, as well as various information vendors.
Trading Rules
- The LP for each DW is allowed to short sell the DW and receives an exemption from the "tick rule" in this regard; other market participants are not allowed to short sell DW.[2] There is also a provision for DW Hedging Participants (DWHP) who are appointed by the issuer to conduct hedging activities and who receive an exemption from the tick rule for hedging in the underlying stock. However, only two out of approximately 20 DW issuers have appointed a DWHP. HKEx provides an AMS/3 terminal or a standard "throttle" to each LP for every five DW for which they provide liquidity. (Throttle refers to the standard order input capacity within which orders can be submitted to the trading host system through the Open Gateway within a specific period of time.)
Part II - SomeConcerns regarding the DW Market and HKEx Management's Response
-
Some market participants argue that the DW market unduly influences the prices of the underlying stocks and increases market volatility.
Response
The DW market adds liquidity to trading in the underlying stocks via DW issuers' hedging transactions and as such provides benefits to all market participants. It must be noted, however, that this liquidity is just one of many forces that interact in a free price discovery market to establish a market price. Moreover, many DW are hedged with options and other instruments rather than the underlying stock.
DW are leveraged and have lower transaction costs (eg no stamp duty for cash-settled DW) than the underlying stocks. For these reasons, market forces may first appear in the DW market or other derivative markets rather than the market in the underlying shares; this is similar to and also observable in futures and options markets in Hong Kong and overseas.
Overall, market volatility in Hong Kong has been low whilst DW activities have been growing as reflected in Appendix 1. Some academic studies indicate that the presence of derivatives trading does not affect or may decrease market volatility, whilst other studies provide a contrary view. On these points there is no consensus among academics.
In any event, if derivatives such as DW are not traded on the Exchange or the Exchange environment is not conducive to their trading then these instruments are very likely to trade in the over-the-counter markets or in overseas markets. Derivatives on Hong Kong stocks are already traded in Singapore, Germany, and the United States, among other markets. In the past, trading in Japanese NIKKEI index futures moved from Japan to Singapore and German Bund futures moved from Germany to London when local conditions were not conducive or competitive in relation to the derivatives. Further, given that the most actively traded DW in Hong Kong relate to "blue chip" stocks that are also available for trading in other major international markets, it is possible that various DW hedging activity using the underlying stock may also migrate to these other markets.
-
Other market participants say DW prices and trading activity may be manipulated by issuers, liquidity providers or others.
Response
As derivatives, the prices of DW can be compared to similar derivatives on the underlying stock such as other DW and Exchange-traded stock options. One such comparative measure is known as "implied volatility". In its educational programmes for DW, HKEx encourages investors to learn more about the various factors that affect DW prices and to compare products against one another to assess the price and whether one product may be out of line with the others. Various DW issuers' websites also include much information in this regard. HKEx is considering ways to improve the disclosure and dissemination of technical information about DW and will discuss these ideas with DW issuers and the SFC.
Sometimes a popular and active DW may trade at a premium to similar DW and Exchange-traded stock options. Market feedback indicates that this may occur due to buying demand that results when a DW has sold out or before a Further Issue can be completed. In these situations, arbitrage activity may not operate freely, for example because supply is fixed and the DW is not eligible for short selling, except by the issuer's LP. Although the issuer may launch a Further Issue (in effect increasing the available supply of the issue) after 80 per cent of an issue has been sold out, some issuers report that there may be insufficient time to complete the Further Issue to keep up with the demand thus potentially leading to a higher price (and higher implied volatility) than similar products. However, when the issuer does launch the Further Issue, the additional supply may satisfy the demand and lead to a correction of the DW price. This may be seen by some as manipulation. Issuers comment that the rules should be changed to enable Further Issues to be completed more quickly which would help to prevent these potential overvaluations. In other derivatives markets such as those for futures and options, supply is not fixed and new short positions are allowed thus making pricing anomalies less likely. In other words, natural market forces serve to ensure that price discovery is allowed to operate freely.
Recently there have been suggestions that issuers create "wash sales" in DW to create the appearance of trading activity to attract additional investor interest in the DW. Some observers say that issuers may pay incentives to those who generate such trading activity (discussed further below). In this regard, issuers' trading in their DW may be conducted only through the designated LP whose trading is transparent to the market. The HKEx surveillance team monitors for wash sales and other suspicious activity and refers cases where appropriate to the SFC. See also paragraph 18 below concerning rebates and other incentives.
-
One concern is that DW issuers are permitted to reissue additional DW which can have the effect of driving down DW prices.
Response
This is most likely because of the factors mentioned in the second paragraph above. HKEx believes a less restricted issuance system would be more efficient and less likely to produce pricing anomalies, for example no specific limit on each issue or by enabling faster completion of Further Issues.
-
Some people complain that DW do not always reflect movements in the underlying share price.
Response
This phenomenon may be explained by a failure to understand the various factors that affect a DW price. The HKEx educational programme for DW covers a variety of factors including implied volatility, premium, gearing, time to expiry, and the "delta" (or hedge ratio) of DW. Information on these factors is often also provided on issuers' websites.
Some examples of how market forces may affect DW include -
- DW prices may fall even though the underlying asset price has not changed. This can result from a decrease in the implied volatility determined by market forces. Similarly, DW prices may fall over time as they approach expiry, which is why options are often referred to as a "decaying asset."
- The delta of a DW will determine how sensitive the DW is to changes in the underlying asset price. DW with strike prices far "out of the money" may not respond at all to some changes in the underlying asset price whereas those far "in the money" may move nearly one-to-one with the underlying asset.
-
Another concern is that DW issuers pay incentives or rebates to selected brokers or other investors who trade in their warrants. Observers argue these practices are not fair or are designed to create an appearance of active trading in the DW.
Response
Discounted commissions and other sales incentives may be part of normal competition and consistent with market rules. However, market feedback indicates that some trading in DW may be generated solely to receive sales incentives. HKEx management questions whether it is appropriate for DW issuer incentives or commission rebates to be the only reason DW trades are conducted and intends to discuss this further with the SFC.
-
Some people suggest that insufficient effort is made in providing education about DW.
Response
HKEx agrees that education is very important. HKEx has a continuing educational effort to explain to market participants including the investing public the features and risks of DW. A main message is that DW carry a high degree of risk and may not be suitable for all investors, particularly small retail investors whose market knowledge or financial resources may be inadequate to enable them to understand the risks and bear losses. The HKEx educational programme also covers the technical aspects of DW.
HKEx market education activities with EPs on DW include the following.
| - |
Publication and distribution of flyers on DW through the following channels: |
|
|
|
HKEx's sales counter |
|
|
|
Investor seminars organised by HKEx
|
|
|
|
Expositions with HKEx's participation in public exhibitions
|
|
|
|
Visits to EPs
|
|
|
|
Requests from EPs
|
|
|
|
Visitors to HKEx; etc.
|
|
|
|
|
| - |
HKEx's Product webpage on DW publishes information relating to DW under the following headings: |
|
|
|
DW Leaflet.
|
|
|
|
Listing Documents.
|
|
|
|
Daily Trading Summary.
|
|
|
|
Pre-Listing Trading Summary.
|
|
|
|
Trading Arrangement Announcements (Including New Listing, Last Day of Dealings and Others).
|
|
|
|
Derivative Warrants Manual Transactions for the Day.
|
|
|
|
Derivative Warrants with Liquidity Provider Information.
|
|
|
|
Basket Warrants Information.
|
|
|
|
Obligations of Liquidity Providers for Derivative Warrants.
|
|
|
|
| - |
Newspaper articles relating to DW |
|
|
HKEx publishes articles relating to products in the newspapers, including articles about DW. |
|
|
|
|
| - |
Continuous Professional Training (CPT) course relating to DW |
|
|
From July 2004 to date, HKEx organised 10 CPT courses for EP staff on various topics relating to DW, such as on DW in theory and in practice, relationships with otherlisted derivative products, trading strategies and market analysis. Leading issuers were invited as speakers. |
|
|
|
|
|
|
HKEx also organises periodic investor education events. So far in 2005, HKEx has organised three public seminars specifically on DW and another for the Institute of Financial Planners of Hong Kong. |
Conclusion
- HKEx has striven to create an evolving framework for the issuance and trading of DW and other structured products that is transparent and tailored to meet market needs, consistent with international standards, and which recognises that there is substantial retail interest in dealing in DW. HKEx management believes this helps to maintain Hong Kong's position as a leading international financial centre.
- Some concerns about the DW market appear to result from misunderstandings of the technical aspects of DW. In this regard, HKEx has an educational programme for DW and will increase its efforts in this area whilst also encouraging issuers and EPs to participate and it will coordinate with the SFC. Other concerns about the DW market suggest changes should be made to improve the market and HKEx has in this article indicated that it will consider a number of possible changes. These will be discussed further with market participants and the SFC. Finally, there are concerns that there is misconduct in the DW market. In this regard, HKEx will continue its surveillance programme in cooperation with the SFC to detect and punish any misconduct.
- DW are geared instruments and investing in them carries many risks. In certain cases investors may sustain a total loss of their investment. Investors should ensure that they fully understand all the risks involved before they invest in DW.
- HKEx invites all interested persons to provide comments on this article and the DW market. Comments received will be shared with the SFC.
Comments should be sent to the address below:
Hong Kong Exchanges and Clearing Limited
11thFloor, One International Finance Centre
1 Harbour View Street
Central
Hong Kong
Re: Understanding Derivative Warrants / Request for Comments
Comments may also be sent by fax to (852)2868-5223 or by email to feedback@hkex.com.hk.
The names of persons who submit comments on this paper together with the whole or part of their submissions may be disclosed to members of the public.
[1]Consultation Paper: The Listing Rules of the Stock Exchange of Hong Kong Relating to Derivative Warrants published May 2001 by HKEx
[2]The "tick rule" stipulates that a short sale of a Designated Security shall not be made on the Exchange below the best current ask price except where the Designated Security is an Exchange Traded Fund traded under the Pilot Programme or is an Exchange Traded Fund approved by the SFC to be excluded from the application of this Regulation.
Appendix
Appendix 1 - Volatility Chart
|