1. This Consultation Paper seeks views and comments from all interested parties regarding the proposed introduction of a Volatility Control Mechanism (VCM) in the securities and derivatives markets and a Closing Auction Session (CAS) in the securities market in Hong Kong.
2. The two proposals to enhance the market microstructure are aimed at improving the global competitiveness of the Hong Kong market. The VCM is needed to contain systemic risk caused by extreme price volatility in both the securities and derivatives markets, in line with international regulatory guidance and trading practice, while the CAS is needed to meet the diverse needs of investors for the securities market by allowing execution at the closing price.
Volatility Control Mechanism
3. In view of the impact of technological change on market integrity and efficiency, the International Organisation of Securities Commissions (IOSCO) has issued guidance on implementing volatility control mechanisms in trading venues, with the objective of preventing major trading incidents such as the Flash Crash seen in the US market. Many international exchanges have also implemented some forms of volatility control mechanism to contain systemic risk caused by extreme price movement. As a market operator, it is HKEx's statutory duty to safeguard market integrity in the context of changing market conditions.
4. Based on the IOSCO guidance, the VCM should address systemic risks arising from the inter-connectedness of securities and derivatives markets, particularly with respect to index products. Furthermore, a VCM model with a temporary cooling-off period would be effective by allowing market participants to reassess their strategies and reset their algorithm parameters, as well as the re-establishment of an orderly market during volatile market situations. As such, the VCM model considered here should be distinguished from other models such as circuit breakers which halt market trading or static daily price limits which set a fixed price range for trading, as seen in some other markets.
5. Consideration has also been given to the type of VCM model would be suitable for Hong Kong. Based on some preliminary discussions with the market, a light-touch and simple model would be preferable for Hong Kong as the first step, since VCM would be new to the market, and participants and investors may not be familiar with such mechanisms.
6. Accordingly, HKEx has developed a dynamic price limit VCM model for the securities and derivatives markets, which would trigger a cooling-off period in case of abrupt price volatility detected at the instrument level. This model is preferred because it is relatively simple and minimises market interruption.
7. In accordance with IOSCO's guidance, HKEx would focus on instruments that pose systemic risks arising from the inter-connectedness of securities and derivatives markets, particularly with respect to index products. Therefore, the VCM model is proposed to be applied to Hang Seng Index (HSI) and Hang Seng China Enterprise Index (HSCEI) constituent stocks in the securities market, and Hang Seng Index (HSI), Mini-Hang Seng Index (MHI), H-shares Index (HHI) and Mini H-shares Index (MCH) (spot month and the next calendar month) futures in the derivatives market.
8. The proposed VCM is summarised as follows:
- During the Continuous Trading Session (CTS), order execution of each instrument subject to VCM (VCM Instrument) would be monitored against a dynamic price limit of ±10% (±5%) from the last trade 5 minutes ago1 in the securities (derivatives) market.
- If the potential execution price falls outside of the price limit, the order would be rejected, and a 5-minute cooling-off period would start immediately. The instrument would only be allowed to trade within a fixed price limit (the same price limit right before the VCM trigger) during this cooling-off period. High bid and low ask orders (otherwise known as aggressive orders) violating the upper and lower price limits would also be rejected immediately during the cooling-off period.
- The same dynamic price limit monitoring mechanism (i.e. ±10% (±5%) from the last trade 5 minutes ago in the securities (derivatives) market) will resume after the cooling-off period. If there is no trading in the cooling-off period, the first trade can be executed without any price limit applied.
- For each VCM Instrument, there would be a maximum of two VCM triggers in a single trading session (Morning Session and Afternoon Session are counted as two separate trading sessions), with the VCM monitoring completely relaxed in that trading session upon expiry of the second cooling-off period.
- The VCM would not be in effect in the last 15 minutes of the CTS2 to allow for efficient price discovery at market close and to avoid potentially preventing investors from closing out their positions and being forced to take overnight risks. After Hours Futures Trading in the derivatives markets would also be excluded from the VCM, as it already has a static price limit of ±5% from the last traded price in the day session.
- When there is a VCM triggered, the trading of linked instruments or other instruments with the same underlying would not be affected.
9. The details of the VCM model are set out in Chapter 2.
Closing Auction Session
10. Hong Kong is an international market with participants and investors from all over the world. Over 500 Exchange Participants (EPs) from origins spanning the globe come to trade in Hong Kong, and they bring both international and local investors to us.
Some 60% of trading value is from institutional investors, 23% is from retail investors, and the remainder is from EPs' principal trading3. Some institutional investors and index trackers in particular are mandated to execute at the closing price, and a significant amount of securities market order flow comes from these market participants every day and especially on index rebalancing days.
11. Market feedback indicates that Hong Kong's current trading methodology does not support execution at closing price. The issue has led to index tracking errors, which in turn undermines the performance of investment funds and is ultimately be borne by their investors such as pension funds and retail investors. Internationally, almost all securities markets have already adopted closing auction as an effective way to facilitate execution at market close. As such, many market participants have been requesting the introduction of a CAS in Hong Kong for some years.
12. A CAS was introduced in the Hong Kong securities market in 2008. However, large price movements during the CAS were observed on certain days and in certain securities. Accordingly, the previous CAS was suspended in March 2009 in order to restore investor confidence.
13. Nonetheless, market participants have continued to request a CAS in order to execute Market-on-Close (MOC) Orders4. A new and improved CAS model has therefore been developed which would address the issues that were experienced with the previous CAS.
14. As an initial phase, the proposed new CAS model would only be applied to securities which require execution at market close, namely the major index constituent stocks (which for this purpose would be taken as the constituent stocks of the Hang Seng Composite LargeCap Index and Hang Seng Composite MidCap Index as well as other Stock Connect Securities for southbound trading) and ETFs with Hong Kong stocks as underlying (collectively known as CAS Securities). The closing mechanism of other securities would remain unchanged. Subject to market feedback after its implementation, the CAS model may be further expanded in the second phase to cover all equity securities and funds but still excluding structured products, equity warrants and debt securities.
15. The new CAS model would consist of four periods:
- In the first period (Blocking Period), a reference price, which sets the allowable price limit of the CAS (±5% from the reference price), would be calculated for each CAS Security.
- In the second period (Order Input Period), at-auction orders and at-auction limit orders within the ±5% price limit could be input, amended or cancelled.
- Starting from the third period (No-Cancellation Period), prices of the new at-auction limit orders would only be permitted within the lowest ask and highest bid of the order book, and no orders could be amended or cancelled.
- In the last period (Random Closing Period), while the order rules would follow the preceding period, the market would randomly close within 2 minutes followed by order matching of all CAS Securities.
16. The proposed new CAS model aims to facilitate a smooth price discovery process while at the same time addressing the price instability issue observed in the last CAS.
17. The details of the new CAS model are set out in Chapter 7.
Timeline and responses to the Consultation Paper
18. The proposed introduction of the VCM and the CAS constitute the major market reforms of the Hong Kong market microstructure planned for the near to medium term. These proposals, if adopted and subject to market feedback, may be implemented in conjunction with the enhancement of the Trading Halts mechanism in the securities market which was the subject of a separate consultation with conclusions published in March 2013. The implementation of the VCM in the derivatives market would be independent from the securities market as derivatives products are traded on a different platform. The proposed implementation approach for the VCM, CAS and Trading Halts in the securities market is set out in Chapter 10.
19. If these proposals were to be implemented, market participants would be given adequate preparation time (e.g. one year from the publication of the consultation conclusions) to prepare for the necessary system changes. Market education programmes would also be provided to help the market understand the new trading mechanisms. HKEx will work with the Securities and Futures Commission (SFC) to cater for any new market monitoring and surveillance functions required.
20. We invite market participants and the investing public to express their views and comments on the two proposals. Respondents should reply to this Consultation Paper by completing and returning the questionnaire on or before 10 April 2015 (a softcopy of the questionnaire is available at http://www.hkex.com.hk/eng/newsconsul/mktconsul/Documents/cp201501q.doc
21. A Consultation Conclusions Paper would be issued in the first half of 2015 summarising the main points made by the respondents and indicating the way forward.
1 This refers to the last trade of the instrument five minutes prior to the current potential trade.
2 The VCM monitoring would stop 20 minutes before the end of CTS as the duration of a cooling-off period is 5 minutes.
3 Source: Cash Market Transaction Survey 2012/13 ( http://www.hkex.com.hk/eng/stat/research/Documents/cmts2013.pdf)
4 Market-on-Close Order is an order with the objective to trade at the closing price.
To continue reading this article click here
Visit us at www.mayerbrownjsm.com
Mayer Brown is a global legal services organization comprising legal practices that are separate entities (the Mayer Brown Practices). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; Mayer Brown JSM, a Hong Kong partnership, and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.
© Copyright 2015. The Mayer Brown Practices. All rights reserved.
This article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein. Please also read the JSM legal publications Disclaimer.