Main Features

The securities market in Hong Kong is operated by the SEHK and futures market, the Hong Kong Futures Exchange Limited (HKFE), both being wholly owned subsidiaries of the Hong Kong Exchanges and Clearing Limited (HKEx). At year-end, there were 469 exchange participants on the SEHK and 135 exchange participants on the HKFE.

By the end of 2006, there were 1 173 companies listed on the main board and the Growth Enterprises Market (GEM) of the SEHK with a total market capitalisation of about $13,338 billion, raising an aggregate of $524.5 billion within the year.

New products continued to be launched during the year. The first open-ended equity fund that directly invests in China A-shares via the fund manager's own Qualified Foreign Institutional Investors (QFII) quota was authorised in June 2006. An index fund which tracks the Indian market was listed on the SEHK in November, increasing the total number of Exchange Traded Funds (ETFs) traded on the SEHK to 11. It is envisaged that more ETFs will be listed in the coming year to further enrich the product base of the ETF market in Hong Kong. Callable Bull/Bear Contracts (CBBCs) began trading in June. At the initial launch, seven CBBCs were introduced by four issuers. In November, the number of Hong Kong stocks eligible for CBBC issuance was expanded from the initial five to 28. Three additional classes of stock options and futures based on individual stocks were also launched and starting from March, three additional long-dated options on Hang Seng Index and three additional long-dated options on H-share Index were available for trading.

The SEHK operates the Third Generation Automatic Order Matching and Execution System (AMS/3) for securities trading. AMS/3 provides an electronic platform for trading equities, debt securities, exchange-traded funds, unit trusts/mutual funds, derivative warrants and equity linked instruments. It also provides facilities and investor access channels that make securities trading more accessible.

The Hong Kong Securities Clearing Company Limited (HKSCC), a wholly owned subsidiary of the HKEx, operates the third generation of the Central Clearing and Settlement System (CCASS/3) for clearing and settlement of securities transactions concluded at the SEHK. The CCASS/3 is an automated book-entry system that operates on an open architecture. In addition to brokers and custodians, certain CCASS services are also available to retail investors. For example, investors may open Investor Participant Accounts with the clearing company to keep their securities in CCASS.

The HKFE operates the Hong Kong Futures Automated Trading System for the trading of futures and options contracts and the Derivatives Clearing and Settlement System (DCASS) for the clearing and settlement of such contracts. DCASS shares the same common database and system infrastructure as the trading system.

HKEx is migrating the three networks above and the Market Data Feed System onto a single new network, SDNet, utilising latest technologies. SDNet enables brokers and participants to use a more reliable network at lower network costs. The first three phases of migration were completed in December 2006 and the last phase of the migration is scheduled for completion by the second quarter of 2007.

At year-end, there were 12 automated trading services providers, comprising mainly foreign exchanges and regulated entities, authorised by the SFC under section 95 of the Securities and Futures Ordinance (SFO) to provide automated trading services in Hong Kong. Automated trading services are services provided by means of electronic facilities, not being facilities provided by a recognised exchange company or a recognised clearing house, to transact or settle transactions in securities or futures contracts.

Securities and Futures Commission

The SFC was established in May 1989 following the enactment of the Securities and Futures Commission Ordinance (SFCO). The regulatory objectives of the SFC, as set out in the SFO that came into effect on April 1, 2003, are:

Established as an autonomous statutory body, the SFC is responsible for regulating the securities and futures markets in Hong Kong. At year-end, the SFC had a governing body of 14 directors (the chairman, six executive directors and seven non-executive directors) appointed by the Chief Executive. The Government is not involved in the day-to-day regulation of the securities and futures industry.

The SFC is funded by the market. No government funding has been sought since 1993. The revised estimate of its operating expenditure budget for 2006-07 (including depreciation) was $562 million.

The SFC seeks advice on policy matters from its advisory committee, which comprises the chairman of the SFC, three executive directors of the SFC and 12 independent members. The independent members are appointed by the Chief Executive and are broad-based and representative of market users.

The exercise of powers by the SFC is subject to a range of checks and balances. For instance, a wide range of SFC decisions are subject to appeal and appeals are made to the independent Securities and Futures Appeals Tribunal chaired by a High Court judge. In November 2000, the Process Review Panel for the SFC (PRP) was established by the Chief Executive to review and advise the SFC on the adequacy of the internal procedures and operational guidelines governing the actions and operational decisions it takes in the performance of its regulatory functions. Members of the PRP are appointed by the Chief Executive. In July 2006, the Government published the PRP's fifth annual report, which concluded that the SFC had generally followed its internal procedures in handling cases under review.

Broadly speaking, the SFC's work involves licensing, supervision and monitoring of intermediaries; regulation of the public marketing of unit trusts, mutual funds and other collective investment products; regulation of takeovers, mergers and other corporate activities; listing regulation under the dual filing system for IPO applicants and issuers; supervision of markets including the exchanges and clearing houses; enforcement of securities laws and rules and investor education.

As at year-end, there were 28 051 licensed persons, including securities brokerage firms, futures dealers, and securities margin financiers, as well as their representatives, and 88 registered institutions, such as banks, engaging in regulated activities like dealing and advising on securities and futures.

Investor education continues to be a priority of the SFC's work. The SFC's investor education theme in 2006 was 'Before you invest, ask the right questions', which aimed at encouraging investors to ask the right questions about products and services to make informed choices.

The SFC designated January 2006 as the Investor Education Month and renamed its investor portal to InvestEd (www.InvestEd.hk). Lively flash animation videos were introduced to complement text information on InvestEd. The SFC also ran new TV and radio commercials highlighting the importance of asking the right questions in buying warrants, opening a margin account and seeking investment advice.

The SFC and Radio Television Hong Kong jointly produced a 10-episode TV drama series, Investment Challenge, to enhance public understanding of complex and structured products. Besides, the SFC and MetroFinance launched a 20-episode radio programme, Learn More About Investing. To highlight risks associated with securities margin accounts, the SFC launched an educational video, Know the Pooling Risk.

In light of several cases of broker failures in mid-2006, the SFC reiterated to investors through different channels the importance of safeguarding themselves against misappropriation and unauthorised trading.

The SFC continued to organise outreach activities targeting different audiences. It held workshops for vocational teachers and secondary school teachers of economics, commerce and related subjects as well as talks for secondary school students. The SFC also expanded its investor education efforts to all local universities through credit-based courses, guest lectures and workshops. The response to these activities was positive — 8 750 people attended the 77 sessions.

In terms of international activities, the SFC signed a memorandum of understanding (MOU) with the Israel Securities Authority (ISA) in 2006. The MOU established a framework to facilitate cooperation in the enforcement of securities law as well as the exchange of information between the SFC and the ISA.

The SFC continued to actively participate in the work of the International Organisation of Securities Commissions (IOSCO). In June 2006, it hosted the 31st Annual Conference of the IOSCO in Hong Kong, attracting over 650 regulators and market practitioners from 135 jurisdictions. During the conference, IOSCO adopted a new resolution that encouraged members to examine the legal framework under which they operated and to enable the freezing of assets derived from cross-boundary securities and derivatives violations.

Insider Dealing Tribunal and the Market Misconduct Tribunal

The Insider Dealing Tribunal was an important feature of the regulatory framework for the securities market in Hong Kong. Established under the repealed Securities (Insider Dealing) Ordinance, the tribunal looked into cases involving suspected insider dealing referred to it by the Financial Secretary. By year-end, it had concluded a total of 24 cases since it commenced operation in 1994.

When the SFO came into force on April 1, 2003, the Insider Dealing Tribunal was replaced by the Market Misconduct Tribunal (MMT), which covers five other types of market misconduct (false trading; price rigging; disclosure of information about prohibited transactions; disclosure of false or misleading information inducing transactions and stock market manipulation) in addition to insider dealing. The MMT decides cases on the civil standard of proof and can impose a range of civil sanctions, such as ordering the disgorgement of profits, banning a person from trading in SFC regulated financial products and disqualifying a person from directorship or management of a company.

The MMT inquires into market misconduct that occurred on or after April 1, 2003. The Insider Dealing Tribunal continues in existence to inquire into cases of insider dealing that occurred before April 1, 2003.

As an alternative to civil proceedings, market misconduct is subject to criminal prosecution, which, if successful, may result in more severe penalties on conviction, including up to 10 years' imprisonment or a fine of up to $10 million.

Recent Developments

Apart from reinforcing Hong Kong's status as the premier capital formation centre for Mainland enterprises, the listing of more quality overseas companies in Hong Kong will be encouraged to further consolidate its position as an international financial centre. Currently, listing applications submitted by companies that are not incorporated in the pre-approved jurisdictions⁵ are assessed on a case-by-case basis with the burden of proof primarily resting on the listing applicants to demonstrate the adequacy of shareholder protection of the jurisdiction in question. In practice, this makes it relatively onerous for companies incorporated outside the pre-approved jurisdictions to list in Hong Kong. To facilitate the listing of more quality overseas companies in Hong Kong, HKEx would publish a policy statement setting out its expectations as a schedule of shareholder protection measures that overseas applicants should address in seeking a listing in Hong Kong.

With effect from February 16, 2006, all SFC-authorised REITs adopted the relevant disclosure provisions substantially equivalent to those in Part XV of the SFO in their trust deeds. As a result, holders of REIT units are required to submit to the REIT manager and HKEx notification of interests upon the attainment of the 5 per cent disclosure threshold.

To further enhance the understanding of fund managers and practitioners on SFC's authorisation requirements of UCITS III funds (funds domiciled in the EU states which are governed by the Undertakings for Collective Investment in Transferable Securities III issued by the European Commission), the SFC issued in August 2006 a guide to the information relating to the risk management and control process that should be provided in support of applications for UCITS III funds using financial derivative instruments for investment purposes. By year-end, the SFC had authorised 1 347 UCITS III funds, representing over 93 per cent of the UCITS III funds applications received.

The SFC approved HKEx's proposal to increase the position limits on stock options contracts in October 2005. The increased limit took effect on February 10, 2006 after completion of legislative amendments.

In July, the SFC approved HKEx's rule amendments on the reduction of minimum spreads for shares trading between $2 and $20. This was the second phase of HKEx's reduction of minimum spreads, which sought to enhance the competitiveness, efficiency and liquidity of the market. The new trading spreads came into effect on July 24.

Pursuant to a review report of the derivative warrants market released by the SFC in November 2005, which identified certain areas of regulation that could be strengthened, a six-point plan to improve market operations was proposed. In March 2006, the SFC announced the paper 'Hong Kong's Derivative Warrants Market — the Way Forward, Results of the Consultation on the SFC's Six-Point Plan' setting out how it would take forward the six-point plan. Most of the proposals, which included facilitating further and identical issues, banning commission rebates and other incentive schemes offered by issuers, and enhancing investor education and information dissemination, have largely been implemented. The new marketing guidelines, whose overriding principle was that marketing materials should not be false, biased, misleading or deceptive and should include appropriate risk warnings, also came into effect in October. The SFC is working with HKEx and the market to make progress with the remaining two proposals to tighten liquidity provisions and to require the use of plain language and summaries for listing documents.

In September, the SFC published the consultation conclusions on the consultation paper on possible reforms to the prospectus regime in the Companies Ordinance (CO). The consultation conclusions laid down SFC's responses to the submissions received on the 21 reform initiatives put forward in the consultation paper published in August 2005, which marked the final phase of a three-phase exercise to review the existing regulatory framework for offers of shares and debentures. Implementation of the initiatives proposed to be taken forward in the consultation conclusions would more closely align Hong Kong's public offering regime with that of other leading jurisdictions and would also support Hong Kong's continuing role as an international financial centre. The SFC would discuss with relevant stakeholders to refine details of specific initiatives proposed to be taken forward, with a view to consulting the public on the proposed legislative amendments.

In April 2006, the SFC released the consultation conclusions on the regulation of sponsors and compliance advisers. This completed the second part of a two-stage initiative adopted by the SFC and HKEx to raise overall sponsor standards. The consultation conclusions introduced the Guidelines on Sponsors and Compliance Advisers, which set out the eligibility criteria and ongoing obligations for sponsors. The new sponsor regime and the Guidelines on Sponsors and Compliance Advisers would become effective on January 1, 2007. Only those intermediaries that had met the stringent eligibility requirements were allowed to continue their sponsor/compliance adviser work. As at year-end, 183 of the 267 intermediaries licensed or registered for Type 6 regulated activity had been imposed with licensing conditions restricting them from acting as sponsors/compliance advisers from January 1, 2007.

In April 2006, the SFC released the consultation conclusions on Proposed Measures to Address Risks Arising from Securities Margin Financing. The proposed measures aimed to offer greater protection for investors through reducing the risks arising from the provision of securities margin financing, controlling the amount of margin clients' securities that can be re-pledged by securities margin finance providers and improving the transparency of securities margin finance providers' operations. The proposed measures became effective on October 1, 2006.

In 2006, the SFC continued its rigorous supervision of licensed intermediaries and identified three cases of misappropriation of client assets by brokers. In each of those cases, the SFC took swift and decisive action to protect the interests of investors, such as imposing appropriate prohibition on the broker and applying to the Court for appointment of an independent administrator to take over the control of the broker's operations. The SFC also worked closely with the administrator of one of these brokers and a white knight to facilitate reaching an agreement between the administrator and the white knight to take over the broker. The agreement facilitated the return of all client assets to the clients.

In addition, the SFC continued to focus its enforcement resources on fighting market misconduct and intermediaries who are dishonest or put clients at risk. By year-end, there were 22 outstanding investigations of listed companies. During the year, the SFC successfully prosecuted 10 entities for market manipulation and false or misleading disclosure and summonses were issued to an additional two entities but those cases were not concluded by year-end. In the previous year, there were five successful prosecutions and six outstanding cases. There were 16 referrals to the Police and the Independent Commission Against Corruption (ICAC).