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Tuesday, October 09, 2018 07.09AM / HKSFC
Being text of keynote
speech at the 2018 Refinitiv Pan Asian Regulatory Summit by Ms Julia Leung
Deputy Chief Executive Officer And Executive Director, Intermediaries, Hong
Kong's Securities And Futures Commission, on October 09, 2018.
Good morning. It’s an honour to be
invited to the 2018 Refinitiv Pan Asian Regulatory Summit to deliver this
keynote speech.
We live in a time of great promise
and great peril. New technologies are having a profound impact on the sciences
as well as businesses and economies. The rapid development of artificial
intelligence and machine learning has changed the way financial firms provide
customer advice, how trading orders are executed and how regulators conduct
surveillance. This is not a gradual evolution — it’s a revolution.
In the midst of rapid technological
and financial innovation, it’s easy to forget that economic development is
predicated on fair and efficient capital markets. So I thought this would be an
opportune time to reflect on the basic yet essential role that market
regulators play in tackling misconduct in capital markets and how that ties in
with our current regulatory approach at the Securities and Futures Commission
(SFC).
Importance of regulating capital
markets
A decade on from the Global
Financial Crisis (GFC), it is worthwhile to reflect on how a combination of
misconduct and excessive risk taking can destroy trust and prevent markets from
functioning properly.
The sub-prime mortgage crisis in the
US had its roots in lax underwriting standards and risky lending which fuelled
a housing bubble. Banks repackaged poor quality loans via the securitisation process.
Flawed credit ratings were assigned to complex products and they were mis-sold
to investors as high-credit-quality securities.
When the US housing bubble finally
burst, global financial institutions suffered crippling losses on their balance
sheets. Confidence deteriorated and interbank lending seized up. The
evaporation of public trust led to bank collapses and rescues in the UK and the
US.
More recently, failures of
peer-to-peer lending platforms in mainland China were triggered by a series of
high-profile scams coupled with tightening credit, liquidity and regulatory
conditions as authorities reined in excessive lending after years of explosive
growth.
These are stark reminders of the
need for regulators to tackle fraud, excessive risk-taking and misconduct in
capital markets.
As a regulator in an international
financial centre, the SFC is charged with maintaining and promoting the
fairness, efficiency, competitiveness, transparency and orderliness of the
securities and futures markets. But as both a conduct regulator and a
prudential regulator, our objectives are not limited to safeguarding the
interests of investors and minimising fraud and market misconduct. Our role
also extends to maintaining Hong Kong’s financial stability and mitigating
systemic risk. I’ll now talk about the characteristics of capital markets that
give rise to misconduct and how the SFC addresses it.
Characteristics of capital markets
that give rise to misconduct
Recently, the FICC1 Markets
Standards Board (FMSB) published a fascinating study of “Misconduct Patterns in
Financial Markets.” The study examined 390 cases from 26 jurisdictions,
spanning 225 years, to identify the causes of misconduct. It found that
misconduct has been similar across time, asset classes and jurisdictions. In
other words, there is a core set of underlying behaviours which recur over
time. These patterns also have a tendency to adapt to both new technologies and
market structures.
Twenty-five specific patterns of
misconduct were identified and these can be classified into seven broad
behavioural categories: price manipulation, wash trading, improper handling of
client orders, misleading customers, manipulating reference prices (such as
benchmarks), trading on inside information and collusion.
The FMSB report cited a case in US
in 1929 when the president of a listed company used dummy accounts he and his
associates controlled to conduct wash trades. What is the modern day version
like? In Hong Kong, China AU Group Holdings Limited issued convertible bonds in
2009 to finance an acquisition of Mainland property. Its then-CEO and her two
associates opened 14 securities trading accounts in various names. The SFC
alleged that the former CEO funded these accounts to trade China AU shares to
create a false and misleading impression of active trading so that the
fundraising exercise would appear more attractive to potential investors. In
August, the Market Misconduct Tribunal found the former CEO and her two
associates culpable of false trading.
Understanding misconduct and the
behavioural patterns behind it helps us design a more robust and effective
control framework. It also reinforces the industry’s collective memory. New
joiners who have no experience of prior failings are made aware of them.
So what are the characteristics of
capital markets that enable misconduct to occur in the first place? Well, we’ve
actually touched on some of them already.
First is the age-old problem of
conflicts of interest.
When discussing the GFC, I alluded to credit rating agencies which were incentivised to assign higher credit ratings to debt instruments to win more business. In capital markets, there are inherent conflicts of interest in the way firms operate. Whether as market makers or as sole proprietary traders, they may be trading as an agent for clients or as principal. Their interests in price movements may conflict with those of their clients, opening the way for possible misconduct.
For example, when transacting for
clients as agents in opaque markets, they may hide and retain any price
differences behind obscure fees and charges. The SFC reprimanded Societe
Generale in July 2012 for failing to disclose that it retained the difference
between the actual transacted price and what it charged clients for over 3,000
secondary market transactions in over-the-counter (OTC) bonds, options and
structured notes. As part of the resolution of this case2, Societe Generale,
without admitting liability, agreed to reimburse affected customers with
interest. It has since taken steps to overhaul its systems and procedures to be
fully compliant.
The opacity of OTC trading makes it
relatively easy to charge mark-ups or spreads to unsuspecting clients. This
opacity and the complexity of some of the financial products traded over the
counter impede effective market surveillance by regulators and make it more
difficult to detect misconduct such as manipulation, mis-use of information,
front running and collusion.
Next, let’s mull over the lack of
senior management accountability. No doubt we’ve all seen the prominent news
coverage of firms being taken to task and fined for misconduct.
But even when charges were brought
against individuals, senior management deflected attention from their own
failings during the GFC and laid the blame on rogue traders. Very few senior
executives were prosecuted. It’s not difficult to see why the public and even
the individuals concerned have the false impression that senior management or
star employees are not personally liable for misconduct.
Finally, as I alluded to earlier,
financial innovation, particularly automation and algorithmic trading,
heightens misconduct risk by magnifying existing concerns and introducing new
ones. By enabling more transactions to be conducted even more quickly,
automation makes it even more challenging for regulators to monitor and analyse
the huge volume of trading data as well as to ensure that market integrity is
maintained.
Questions have been raised over the
role of automation and algorithms in flash crashes such as the one in August
2015 when the S&P 500 fell 5% within minutes of opening. Some commentators
argued that market volatility was exacerbated by high-frequency trading and
market makers holding back liquidity because their computer models malfunctioned
or shut down.
The SFC’s regulatory approach
But are we doomed to repeat the
mistakes of the past? Are market misconduct, excessive risk taking and the
cycles of boom and bust going to stay with us? Is the notion of stopping
misconduct in capital markets a lost cause?
Of course not. Alice in
Wonderland has to keep running just to stay in the same spot in the race with
the Red Queen. We regulators have to do better — to keep running a step ahead
of the bad actors. We need to adapt to the times and arm ourselves with the
appropriate technologies, data and methods to combat misconduct more
effectively with the resources at our disposal.
Throughout history bad actors have
exhibited the same behaviours and recycled the same old tricks. So the SFC aims
to drive and mould good conduct to achieve the desired regulatory outcomes.
Rather than letting potential issues fester and morph into more serious
problems later on and then using our enforcement and disciplinary powers to
deal with the fallout, our tactic is to pre-empt them. This means adopting a
front-loaded regulatory approach whereby we intervene at an earlier stage with
targeted actions designed to achieve a quicker, more impactful outcome.
Before I go into more detail, I want
to clarify that enforcement still has an essential role as a regulatory tool
for deterring bad behaviour. My colleague Tom Atkinson will speak here tomorrow
on the role of enforcement. However, disciplinary action is not the panacea,
and it takes time. The point is, no single regulatory function can address
today’s complex misconduct risks.
We need to pool our regulatory
expertise and industry knowledge to home in on nascent issues and tackle
misconduct in a coordinated, holistic manner. That’s why we’ve adopted the “One
SFC approach”, so that we can put our heads together to unmask the masterminds,
unravel ulterior motives and hidden agendas and expose linkages among the
connected parties behind misconduct.
Misconduct in the listed market
Two years ago, we formed a
multi-disciplinary project team called ICE after the first letters of our
Intermediaries, Corporate Finance and Enforcement divisions. The team’s
objective was to identify patterns of misconduct that aims to manipulate stock
prices, rig shareholders’ votes or scam minority shareholders. Even though the
so-called “con stock” activities involve a small number of listed companies,
the reputation risk for Hong Kong is not small.
The ICE team’s strategy has had
tangible results. An early success was against price manipulation of GEM
shares. There was a pattern: high concentrations of GEM shares were placed with
a few shareholders, with 10% or less suspected to be distributed among a number
of nominees. On the first day of listing, prices soared multiple times3 only to
fall flat later, suggesting a pump-and-dump scheme.
In response, the SFC and Hong Kong
Exchanges and Clearing Limited issued a joint statement4 in January 2017 which
detailed our regulatory concerns5. The SFC concurrently issued a guideline6 to
sponsors, underwriters and placing agents involved in the listing and placing
of GEM stocks. Following our intervention, the average first day price change
of newly-listed GEM stocks immediately dropped to a more normal level of 20%,
where it has since remained.
ICE
also took on the dubious market activities associated with shell companies. Our
response was clear – better gatekeeping at both the front gate and the back
gate. In cases where we suspected that listing applicants reported seriously
inflated sales figures, the SFC exercised its power7 to query the listing
applications, which were subsequently withdrawn. In cases where vote rigging
was suspected, we invoked our power to order suspension of trading in the
shares8. In 2017, around 40 cases involved the actual or potential use of these
powers, compared to only two or three such cases in prior years.
We also put sponsors in the
spotlight. We identify sponsors with a history of having their sponsored
listings rejected because of substandard work. These sponsors have a higher
chance of being inspected by us. If our supervisory inspection identifies poor
quality sponsor work9, we open an enforcement investigation.
Our recent inspections uncovered a
worrying trend of intermediaries concocting convoluted arrangements to either
conceal the identities of the beneficial owners of securities or cloak their
true intentions, such as to engage in margin lending. Firms should not
facilitate market misconduct by making “nominee” or “warehousing” arrangements
for their clients. To protect investors and maintain the integrity of the
markets, the SFC will not hesitate to take stiff enforcement action against the
perpetrators as well as the firms and individuals who participate in such
arrangements.
Our intervention tools also include
requiring immediate rectification of bad behaviour, imposing licensing
conditions or issuing a restriction notice on the intermediary to limit or, in
extreme cases, to prohibit some or all of their regulated activities to
mitigate and control the risk. We’ve adopted similar approaches to manage the
risks posed by persistently loss-making but thinly-capitalised brokers who
struggle to meet their minimum liquid capital requirements.
Misconduct in the wholesale market
Let me now shift to the
decentralised wholesale market. As discussed earlier, inherent conflicts of
interest coupled with a lack of transparency is a recipe for misconduct. That’s
why globally, this issue is most taxing to conduct regulators. The SFC Code of
Conduct10 requires intermediaries to disclose material interests or conflicts
to the client. The client’s best interest is the overarching principle.
While this seems like a simple rule
to follow, firms sometimes conflate their principal roles and their agency
roles. We have made this the theme of a joint inspection we conducted with the
Hong Kong Monetary Authority (HKMA). The HKMA examined the wealth management
unit of a bank that sourced in-house products as agent, and the SFC inspected
the books of the securities unit in the same banking group that sold the
products as principal. We are able to identify conflicts of interest by
examining both ends of the same transaction.
Thematic reviews allow us to
deploy our limited regulatory resources to increase our touch points with
intermediaries on specific risks identified from our intelligence gathering and
monitoring activities. This helps focus our risk-based supervision on imminent,
high-impact issues. In the past two years, we completed five thematic reviews
on conduct issues in capital markets11.
Innovation and technology can help the industry
improve performance but it can also amplify the risks in capital markets. Quant
funds have long employed algorithms to execute large orders to achieve
particular statistical benchmarks, such as Value Weighted Average Price.
Algorithmic programmes now use a vast number of hidden layers to process large,
unstructured data sets to drive investment decisions. These programmes may be
too complex and hard for humans to comprehend.
I was once asked this question at a forum — as
machines replace humans, what handle do we have over machines to control the
risks? The answer is simple. If a computer algorithm goes awry and runs
rampant, the SFC can’t exactly arrest the computer or bring it in for
questioning, as fun as that may sound. Our regulatory handle is over the
operator, and to hold senior management responsible for implementing a robust
governance structure and appropriate policies and procedures with effective
controls to ensure reliability, data protection and security.
This brings us to the final issue of senior
management responsibility, which is our response to one of the causes of
misconduct discussed earlier. We introduced the Manager-In-Charge regime in
2016 to reinforce the message that senior management are responsible and
accountable for fostering good conduct and behaviour. Let there be no doubt —
we will vigorously pursue individuals culpable for misconduct.
Before I conclude, I want to go back to what I
said about the SFC leveraging technology to enrich our market surveillance and
intelligence. To improve the effectiveness of our gatekeeping function, the SFC
has embarked on a strategic effort to more closely track bad apples involved in
misconduct and to keep bad actors out of the market altogether. New initiatives
help us collect and analyse data as well as to more easily identify and
visualise the relationships between firms, listed companies and individuals. To
enhance our market surveillance, we also use big data processing techniques to
analyse trading information. Those who exploit technology should be aware that
the SFC is also leveraging technology to make sure that they have no place to
hide.
Conclusion
Ladies and gentlemen, 10 years on, it’s more
important than ever to remember the lessons from the GFC. While misconduct
appears throughout the ages in various forms and guises, the behavioural
patterns always remain the same. In this rapidly changing world, on the cusp of
revolutionary breakthroughs in financial technology, it seems the adage “the
more things change the more they stay the same”, still rings true today.
But one thing that has not changed is the SFC's
steadfast determination to keep our capital markets clean. The bad actors are
on our radar and we will do whatever it takes to prevent them from harming our
markets. Hong Kong is open for business, but not at any cost. That’s why the
SFC has shifted to a front-loaded regulatory approach. The examples I cited
today demonstrate the positive impact that this new approach has had, as well
as the SFC’s resolve to tackle misconduct.
Thank you.
Footnotes
· 1 Fixed income, currencies and commodities.
· 2 Under section 201 of the Securities and Futures Ordinance.
· 3 The average first day price change of GEM listings was over seven times in 2015 and five times in 2016.
· 4 Joint statement regarding the price volatility of GEM stocks, 20 January 2017.
· 5 We were concerned that these market practices undermined the GEM Listing Rules and prevented an orderly, informed, fair and efficient market in GEM stocks to develop.
· 6 Guideline to sponsors, underwriters and placing agents involved in the listing and placing of GEM stocks, 20 January 2017.
· 7 Under Section 6 of the Securities and Futures (Stock Market Listing) Rules.
· 8 Section 8 of the SMLR gives the SFC the power to order suspension of trading in the shares of listed companies.
· 9 For example, not following up on obvious due diligence red flags or a lack of professional scepticism.
· 10 Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission.
· 11 These reviews covered algorithmic trading, alternative liquidity pools, best execution, client facilitation, distribution of fixed-income and structured products. Reviews on prime broking and book building are continuing.
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