LegCo Panel on Financial Affairs
Meeting on 6 January 1997
Rolling Forex and Future Development
of Hong Kongs Foreign Exchange Market
In Hong Kong, foreign exchange trading is mainly handled between authorised institutions (AIs) at the interbank money market. At the retail level, AIs which carry on foreign exchange trading are regulated by the Hong Kong Monetary Authority (HKMA), while other traders, by the Securities and Futures Commission (SFC).
2. Hong Kong is now the fifth largest foreign exchange trading centre in the world, having recorded the fastest growth rate among the three Asian centres (Tokyo, Singapore and Hong Kong) during the period from 1992-1995. The HKMA has proposed a formal authorisation regime for money brokers. This will help to ensure that a high standard of integrity and fair dealing are observed by the brokers, which is crucial for an orderly and efficient interbank foreign exchange and money market. Details are outlined in a paper at Annex A on "Future Development of the Foreign Exchange Market" prepared by the HKMA.
Leveraged foreign exchange trading
3. Following numerous complaints of fraud and abusive trading practices, the Leveraged Foreign Exchange Trading Ordinance was enacted in September 1994 to regulate leveraged foreign exchange trading in Hong Kong. The SFC is the regulator and has conducted a review of the regulatory framework in the light of the experience in operating the system. In August 1996, the SFC issued a consultation paper setting out the results of the review and proposals for a number of changes to the existing regulatory framework. The SFC will be seeking the views of the Securities and Futures Commission Advisory Committee in due course. A paper entitled "The Development of the Rolling Forex Market in Hong Kong" prepared by the SFC is at Annex B.
4. In November 1995, the Hong Kong Futures Exchange (HKFE) launched a currency futures product, viz., Rolling Forex, with a view to providing a more transparent, structured and regulated foreign exchange market. Rolling Forex is the first exchange-traded currency futures product in Hong Kong. There have been a broad spectrum of users, ranging from retail to institutional. Details are set out in a paper at Annex C entitled "Review of the Rolling Forex Market" prepared by the HKFE.
Financial Services Branch
30 December 1996
LegCo Panel on Financial Affairs --Future Development of the Foreign Exchange Market
Market size and growth
· According to a global foreign exchange market survey conducted by the Bank for International Settlements in April 1995, Hong Kong has become the fifth largest foreign exchange trading centre in the world, up from sixth in 1992. The average foreign exchange turnover (including spot, forward, options and futures trading) was US$91 bn per day in April 1995. This represented a 49% increase over 1992.
· In the Asian time zone, Hong Kong ranked after Japan and Singapore in terms of the absolute business volume. Japan has a leading position in the Region because of the sheer size of its economy. Singapore, on the other hand, has always benefited from the active trading in its neighbourhood, such as Brunei and the rest of ASEAN. Hong Kong is maintaining, and in fact improving, its competitive edge, recording the fastest growth rate among the three Asian centres during the period 1992 to 1995 (Hong Kong: 49%; Singapore 43% and Japan 34%)
· The structure of the foreign exchange market appears to be evolving in the following directions :
- the growth of spot foreign exchange transaction has slowed down and the profit margin of this type of business appears to have been squeezed in major financial centres in recent years. This is partly due to the direct access of counterparties to the electronic brokerage system, which reduces the need for different layers of financial intermediaries. On the other hand, an increasing share of the foreign exchange business is related to forward transactions, largely due to the wider use of currency swaps for funding or hedging purposes. In this market segment, Hong Kong recorded an impressive growth rate of 93% during 1992-1995, considerably faster than that in Singapore (69.4%).
- while trading between the US$ and other major international currencies such as Japanese Yen, Deutschmark and pound sterling account for the bulk of foreign exchange transactions, trading involving some regional currencies is on the increase. Hong Kong should be well-positioned to capture a share of these business opportunities; and
- alongside with traditional voice brokers, electronic brokers have established a notable presence in the foreign exchange market. This would over time change the technological platform of conducting foreign exchange business, particularly spot transaction.
· Given the strategic time zone location of Hong Kong and the rapid growth in the regional economies, there are good prospects for a further expansion of Hong Kongs foreign exchange market.
· Hong Kongs unrivalled position as the most convenient gateway to mainland China also offers tremendous potential for future growth of Hong Kongs financial services sector. In the longer term when mainland China relaxes its control on capital movements and renminbi becomes freely convertible, Hong Kong has tremendous potential to develop into a world leading centre for renminbi trading.
On the regulatory front, the HKMA has proposed a formal authorization regime for money brokers. This will help to ensure that a high standard of integrity and fair dealing are observed by the brokers, which is crucial for an orderly and efficient interbank foreign exchange and money market. The main authorization criteria will include fitness and propriety of the management, financial soundness, prudent conduct and adequacy of accounting and control systems.
A Discussion Paper on The Development of The Rolling Forex Market in Hong Kong for The LEGCO Panel
1. Trading of Rolling Forex Contracts on the Hong Kong Futures Exchange Limited ("HKFE")
1.1 Trading System
Rolling Forex contracts were launched in November 1995 by the HKFE after approximately eight months of development. The introduction of Rolling Forex contracts led the HKFE into a new arena by bringing forth a new automated trading system ("ATS") developed by OM International of Sweden.
These contracts are priced and settled in US Dollars. The special feature of these contracts is that they have no expiry day (i.e. continuously rolled forward until such time as they are closed out in the market).
1.3 Trading Hours
The market operates nineteen to twenty hours a day spanning the business hours of Tokyo, London and New York and are designed to simulate the over-the-counter spot currency market save all trades are executed through the ATS. The market comprises Registered Traders who provide continuous two-sided firm quotes to ensure sufficient liquidity.
1.4 Risk Management
On 21 August 1995, the Commission endorsed the HKFEs new Rolling Forex product as being appropriate and represented a significant step in the advancement of Hong Kongs financial markets. The HKFE and HKFE Clearing Corporation ("HKCC") have undertaken, as a condition of authorization, that the HKFE will appoint an experienced independent third party to undertake a technological review of ATS and HKCC will review the risk management systems in respect of this market twelve months after commencement. Both of these reviews are now in progress. Certain risk management measures presently employed by HKCC with respect to Rolling Forex contracts are similar to those applicable to HSI conracts and include intra-day margin calls, recalculations of margin assuming various market rises and declines, capital based position limits, large open position reporting by members as well as the availability of the Reserve Fund.
1.5 Trading Volume
On 3 November 1995, two Rolling Forex contracts (the Japanese Yen and German Deutchemark contracts) commenced trading on the ATS. Since the contracts commenced trading, the turnover has remained relatively low. During the past one year period from November, 1995, an average of 15,649 contracts have been traded each month with average daily volume and average daily open interest at 734 and 559 contracts respectively..
1.6 Investor Education
To enhance the recognition of the product, the HKFE has conducted a series of seminars prior to its launch and continued to organize periodic public seminars during the past year. It also made several modifications to the Rolling Forex Regulations to resolve the operational difficulties experienced by HKFE members and address comments from the public subsequent to the commencement of trading.
1.7 Feature Enhancement
With the introduction of Rolling Forex and the expansion of HKFE products in the coming future, which might lead to an increase in its overall risk exposure, the HKCC reviewed the Reserve Fund calculation methodology whereby it would collect additional Reserve Fund contributions and margin amounts from members based upon their respective risk exposures.
In order to attract retail investors participation, HKFE introduced the British Pound contract on 20 September, 1996, increased the number of Registered Traders in the Rolling Forex market from five to seven and exempted the Exchange levy for the Rolling Forex contracts. With a view to synchronize with the HKFEs efforts and maintain an environment that is conducive to further market development, the Commission upon the request of the HKFE, proposed to the Governor-in-Council that the statutory levy on Rolling Forex be nil subject to 12 months review (i.e. until October 1997).
2. Overseas Competition
2.1 Rolling Forex contracts traded on the HKFE mirror products which are trading in the "interbank" market (i.e. a professional market used by banks and large brokers and dealers to buy and sell foreign currencies, including derivatives, for purposes of hedging, arbitrage and the facilitation of other investment strategies). Similar products trading in other markets include the Rolling Spot Currency Futures Contract available at the Chicago Mercantile Exchange ("CME") and the Deferred Spot Forex Futures Contract (in Japanese Yen and German Deutschemark) available at the Singapore International Monetary Exchange ("SIMEX").
2.2 Although the underlying commodities of the Rolling Forex contracts are currencies which are traded in global markets with trading interests existing internationally. The products have their unique feature (they do not have an expiry day) which is not provided for in other markets including SIMEX. As the product is designed, in accordance with the HKFE, to capture retail interests, the contract sizes of the DM and Yen contracts are only half of those of the Deferred Spot USD/JPY and Deferred Spot USD/DM contracts traded in SIMEX. In addition, the Rolling Forex market operates nineteen to twenty hours a day, three to four hours longer than the SIMEX contracts.
2.3 Although the average monthly turnover in value of the Rolling Forex market is lower than the Deferred Spot contracts in the past one year (approximately USD770 million and USD1,380 million respectively), as a new product, the Rolling Forex which has attracted a steady turnover could be regarded as successful. With the unique feature of the Rolling Forex contracts and HKFEs continuing efforts on the enhancement of the related systems, it appears that the competition from Singapore or other markets would not pose a threat to the Rolling Forex market
3 Future Developments of the Market in Hong Kong
3.1 In the past year, the HKFE has endeavored to promote the Rolling Forex market and to resolve difficulties experienced by market participants. Besides making the modifications described in section 1, the HKFE continues to explore enhancements to the system in view of market demand. The Commission staff will assist and support the HKFE in its development of this market.
3.2 In addition to the development of the Rolling Forex market, HKFE has proposed to establish a linkage to allow HKFE members to trade PHLX currency options during Asian business hours. The Commission staff are discussing with HKFE, the Options Clearing Corporation, the US Securities and Exchange Commission and Commodity Futures Trading Commission as to the details of the proposed linkage program. The Commission is awaiting HKFEs finalization of the proposed arrangements.
4. A Review of the Leveraged Forex Regulations
The consultation paper on the review of the leveraged foreign exchange trading regulatory system was issued for public consultation on 28 August. 18 responses have been received. The reaction of market participants and investors have been mixed. A report on the outcome of the consultation for consideration by the SFC Advisory Committee and the Commission is under preparation.
REVIEW OF THE ROLLING FOREX MARKET
( A discussion paper for the LEGCO PANEL on Financial Affairs)
1.1 For a number of years, the Hong Kong Futures Exchange (HKFE) has been thriving on equity based products, with the Hang Seng Index (HSI) Futures and Options contracts serving as the flagship products for the Exchange. This bias towards equity-related products have changed with the launch of a new Currency Futures product - Rolling Forex, on 3 November 1995.
1.2 Not only has Rolling Forex added a new dimension to HKFEs trading activities, it also led to introduction of the Exchanges brand new Automated Trading System (ATS), through which a variety of new products can be traded in a screen-based environment.
1.3 The HKFE Automatic Trading System, through which Rolling Forex is traded, is a fully integrated electronic dealing system for trading financial products real time. It provides a linkage network between the Central System at the Exchange and the terminals at member firms offices.
1.4 A client can start trading in the futures market after opening an account with his broker who is a member of the HKFE. The brokers ATS operator will place the order in the system through the ATS terminal at the brokers office. The ATS will automatically match the buying and selling orders based on price/time priority mechanism. The broker can immediately confirm the execution of orders to his clients. At the same time, the deal will automatically be transmitted to HKFE Clearing Corporation (HKCC) for registration and clearing.
1.5 Rolling Future is a standardised, legally binding agreement on a spot foreign exchange transaction with a continuously rolling arrangement. It is a Currency Futures Contract denominated in US Dollars and traded in terms of direct and indirect quotations.
1.6 All open Rolling Forex positions at the close of trading on every Forex Business Day will be rolled over automatically to the next Forex Business Day unless closed out by offsetting sales or purchases in the market. It means that all Rolling Forex Contracts have effectively no expiry date.
1.7 The first two contracts - the Deutschemark and Japanese Yen Contracts - were introduced in November 1995, and the British Pound Contract was introduced in September 1996. Four other currencies namely, Swiss Franc, Canadian Dollar, Australian Dollar and ECU are expected to be introduced at a later stage.
1.8 Rolling Forex has a number of unique features which set it apart from other similar trading activities.
All Rolling Forex orders are matched and executed through strict price/time priority matching. The Automated Trading System automatically matches orders with the best bid or best offer on a first-in, first-out basis. Time stamping of all orders and transactions is mandatory, thus establishing an effective audit trail of all market activities and minimizing the potential for market malpractice.
1.8.2 Investor Protection
Rolling Forex is traded in a regulated Exchange environment, with all activities subject to the Rules and Regulations of the HKFE and the HKCC.
1.8.3 Market Transparency
Firm bid/offer prices are continuously quoted, along with the quantity of contracts available at each price and are displayed on the ATS screen. The prevailing best bid and best offer prices are instantly disseminated by all major market information vendors. Prices of the last trade, day high and day low are displayed both on the ATS and by the major market information vendors.
1.8.4 Market Making System
To ensure adequate market liquidity, Market Makers continuously quote firm bid/offer prices (under normal market conditions) through the ATS. Each quotation is valid for at least a minimum number of contracts with the total value equivalent to not less than US$1 million on each side of the quotation.
1.8.5 Maximum Five Basis Point Quote Spread
Market Makers are required to continuously quote a maximum bid/offer spread of 5 basis points (under normal market conditions) to the market through the ATS. Investors can elect to "deal within the market spread" rather than "deal at the quoted spread" of an individual counter-party. Given the potential participation of a wide spectrum of investors, the price discovery process often serves to narrow the spreads even further.
1.8.6 HKCC Guarantee
All Rolling Forex Contracts are registered with and guaranteed by HKCC.
1.8.7 Low Transaction Costs
Transaction costs are kept to a minimum through the presence of narrow bid/offer spreads resulting from competitive market forces as well as the participation of Market Makers and the negotiable commission rate (Maximum HK$150 per contract per side).
All open positions at the close of one Forex Business Day are rolled over automatically to the next, unless closed out by offsetting sales or purchases. Hence Rolliing Forex has effectively no delivery months or expiry dates.
1.8.9 Expanded Trading Hours
The Rolling Forex market is operated daily during Asian, European and North American trading hours (19 to 20 hours each Forex Business Day), which enables investors to accurately assess global foreign exchange market conditions.
1.9 Not only can Rolling Forex be used as an investment tool, it can also be used for hedging currency risks by establishing a long currency position to hedge a rising currency market, or establishing a short currency position to hedge a falling currency market. Meanwhile, investors can use Rolling Forex to capture market movements by establishing a long currency position to profit from an anticipated rise in the currency market, or by establishing a short currency position to profit from an anticipated fall.
As there are a variety of applications and strategies, there will be a spectrum of users, including retail and institutional investors, banks and financial institutions, treasury operations of multi-national companies, hedgers, arbitrageurs and fund managers.
2. DECLINE OF THE LOCAL FOREIGN EXCHANGE ACTIVITIES
2.1 In line with the contraction of global cash markets, the trading volume of foreign exchange in Hong Kong has also dropped significantly during the past two years.
2.2 Frequent joint intervention by the Central Banks is the main reason for creating low volatility. Hence, the market has only fluctuated within a narrow trading range.
2.3 The most recent austerity program implemented by the Chinese Government was accompanied by slow-down in the local economy. Investors inclination to participate in foreign exchange trading has dwindled significantly.
3. PERFORMANCE OF THE ROLLING FOREX MARKET
3.1 Rolling Forex has become the "Benchmark Rate" of the local market. Retail investors are able to utilize the benefits of real-time price dissemination, through information vendors and the free telephone enquiry service provided by the HKFE, as a standard to measure price quotations which they obtained from banks and Leveraged Foreign Exchange Trading (LFET) licensed traders.
3.2 Despite a downturn of trading volume in the cash and LFET markets, the Rolling Forex market has experienced a slow but steady growth during the past 12 months. The daily average turnover and open interest of Rolling Forex for the period between November 1995 and November 1996 can be found in Appendix 1.
3.3 The main reasons for sustained steady growth are:
3.3.1 Liquidity Creation
The diligent performance of Market Makers, in terms of providing running price-quotations to the market, have generated the initial liquidity to attract additional liquidity. Investors can benefit from the aggressive pricing approach of an outstanding Market Maker occasionally providing the market with a narrow spread of 2 to 3 basis points at intervals, and even at 1 point on some occasions, during certain times of the day.
3.3.2 Aggressive Promotion Campaign
HKFE organized over 180 free seminars between September 1995 and October 1996 at 18 different locations. More than 6,500 participants attended these seminars. HKFE specialists have also participated in Members in-house seminars as guest speakers. Retail investors are more familiar with the unique features of Rolling Forex. The objective of these seminars is to enhance retail investors awareness of their own protection and benefits.
3. 3.3.1 System enhancement was made in mid December 1995 to enhance, Market Makers efficiency in providing continuous price quotations in the Rolling Forex market.
184.108.40.206 Risk management procedures were enhanced to streamline trading operations on 12 January 1996.
220.127.116.11 Two additional Market Makers were appointed in February 1996 and November 1996 respectively to enhance market liquidity.
18.104.22.168 Communication between HKFE and all Market Makers was enhanced with the installation of private telephone lines.
22.214.171.124 In order that retail investors could have accessibility to the real-time price quotations, a free-of-charge price enquiry hotline service was implemented in June 1996. A detailed analysis on such utilization can be found in Appendices 2 and 3. Complimentary display screens were also installed at a number of HKFE Members offices.
3.4 The surge in trading volume between April and July 1996 could have been attributed to the volatility of the market during that period of time. However, the popularity of Rolling Forex among retail investors was consistently on the increase. It is evident that the number of contracts per non-Market Makers transaction has also increased significantly. Comparison on market share between Market Makers and non-Market Makers can be found in Appendices 4 and 5. Clients trading orders in excess of 20 contracts, and at times 40 to 100 contracts, per trade, appeared more often in the order book of the market. Recently, HKFE recorded a single transaction for 300 contracts between client and Market Makers Accounts.
4.1 Although some of the LFET licensed traders currently are, or previously were, registered as ATS Members of the Exchange, clients trading activities of these Members in Rolling Forex are extremely low. HKFE has received complaints from investors that account executives of these Members had deliberately discouraged investors from participating in the trading of Rolling Forex. At the same time, they took the opportunity to induce investors to participate in LFET. The reasons behind such actions may include higher commission rebates for account executives and the ability to collect higher cost of carry on clients interest rate charges. LFET licensed traders may also wish to retain their priviliges on price quotations due to the clients inability in closing out open positions with an alternative counter-party and advantageous information on clients position.
4.2 Rolling Forex contracts are very similar to products of the over-the-counter (OTC) market, namely, margin trading accounts offered by banks and leveraged foreign exchange trading accounts operated by LFET licensed traders. HKFE Members, who are subsidiaries of banks or LFET licensed traders, are unlikely to encourage their clients to trade in Rolling Forex due to conflict of interests.
4.3 Similar products exist in other markets including the Rolling Spot of the Chicago Mercantile Exchange (CME) and the Deferred Spot of the Singapore International Monetary Exchange (SIMEX). Most contracts in these markets are traded in an open outcry environment instead of the electronic trading environment. On the contrary, Rolling Forex is able to offer investors an open, fair and transparent market with much longer period of time for continuous trading. The contract size of Rolling Forex is also designed to capture the enormous underlying interests of retail investors in Hong Kong.
5. CURRENT POSITION
During 1996 the HKFE Rolling Forex market grew to a point where critical mass is capable of sustaining a moderately successful market. However, the potential of the Rolling Forex market is much larger than current order flows indicate.
Recent increases in retail interest and sustained support by Market Markers combine to provide much encouragement that Rolling Rorex can follow in the footsteps of Hang Seng Index Futures and Options in bringing business from surrounding jurisdictions and customers. The first ingredient, a dependable pool of liquidity, has already been achieved. However, significant growth from the current plateau will require implementation of several enhancements. These enhancements are aimed at narrowing the "playing field" gap between the less regulated over-the-counter market and the listed HKFE Rolling Forex market. HKFE has begun to pursue a series of technical changes with the Securities and Futures Commission in order to accomplish this goal.
6. FUTURE DEVELOPMENTS OF THE ROLLING FOREX MARKET
6.1 Several proposals which will be submitted to the Securities and Futures Commission will be aimed at attracting dealers in the LFET market to the more transparent, structured, and regulated Rolling Forex market. In most cases, they will provide a bridge between the markets which will remove artificial incentives for such dealers to divert client interest way from Rolling Forex.
These proposals will include: a more precise margining system which will recognize the systemic implications of the difference between overnight and intraday risk, provision for immediate facilitation of customer orders by dealers with a resultant electronic display, addition of a "stop-loss" mechanism, a new quote system for less-frequently traded currencies, relaxed "bad weather condition" trading restrictions, and a supplementary HKFE Membership program.
6.2 HKFE will initiate contacts with major LFET licensed traders to encourage their clients participation in the Rolling Forex market.
6.3 HKFE will launch additional currency contracts on a "Quote Request" basis at the first possible opportunity.
6.4 HKFE will improve the accessibility and visibility of the Rolling Forex market for retail investors.
6.5 HKFE will continue to pursue the linkage with Philadelphia Stock Exchange. The launch of PHLX currency options traded during Asian business hours on the ATS will certainly enhance the trading activities of Rolling Forex.
6.6 HKFE will continue to improve the order routing between investors and Members.
Last Updated on 18 August 1998