Friday, September 16, 2005

Hong Kong Debates Volatility

Critics Fret About Plans
For 'Bull-Bear' Contracts;
'Domino Impact' on Stocks?

September 16, 2005

HONG KONG -- Hong Kong's stock exchange regulator plans to introduce an equities derivative that its detractors believe could undermine the city's thriving warrants market, and bring unwanted volatility to leading blue-chip stocks.

The move to introduce callable bull-bear contracts as an alternative to warrants came as regulators ruled out this week calls from some market quarters for stricter regulations governing the issuance of warrants.

The contracts may be introduced within months of getting the green light from the Securities and Futures Commission, said Paul Chow, chief executive of Hong Kong Exchanges & Clearing Ltd., which operates the stock and derivatives markets. That may be as soon as January, according to local newspaper reports.

Warrants, which give the holder the right to buy or sell an underlying equity at a set price, have become popular among investors in Hong Kong. But they have recently drawn criticism on concerns over market manipulation, with calls to regulators for stronger regulations governing their issuance and trading.

While callable bull-bear contracts share some characteristics of warrants, they are structured to have lower volatility than a warrant and greater pricing transparency, removing the possibility for issuers to generate the sort of profit margins that warrants can chalk up. But some are concerned a so-called knockout feature of these contracts designed to limit investors' losses by a stop-loss mechanism could add to volatility in the market when issues are forced to sell their corresponding hedging position of the underlying stock.

SG Securities' senior vice president of equity derivatives, Edmond Lee, said a stock's downward movement could trigger a series of knockout levels of CBBCs and accelerate the fall of the underlying stock as issuing banks are forced to liquidate hedging positions.

"It could have a domino impact on the market," Mr. Lee said.

A trader with an investment bank said CBBCs could certainly drain liquidity from the warrants market as investors perceive them to be a slightly safer bet.

This would be bad news for a number of banks in Hong Kong, including HSBC Holdings PLC and UBS AG, which last week formally made their forays into the warrants market, which typically accounts for at least 20% of the daily volume on the stock exchange.

The Hong Kong exchange has been mulling the introduction of CBBCs for more than a year. Some in the market believe the exchange has dragged its feet over opposition from warrant-issuing banks, which oppose the introduction of a rival instrument. And some believe the exchange is now keen to introduce CBBCs as a way of defusing some of the criticism leveled at the warrants market.

Last week it was disclosed that the Securities and Futures Commission was investigating instances of alleged market manipulation and may review warrant regulations. But at a meeting Wednesday the exchange's board decided not to impose stricter regulations on the trading of warrants.

The exchange concluded that "supply and demand should determine the volume of warrant issues," said Mr. Chow, the exchange's CEO.


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