Commission Rebate Scheme for Warrant Trading

Once a time the Hong Kong Government was proud of Hong Kong being a key hub for warrant trading. What do they feel when your territory's stock exchange has become a big gambling house? In fact, the active trading of warrants was partly induced by the "commission rebate schemes" offered by warrant houses.

Last week SFC reprimanded Macquarie Equities (Asia) Ltd and fined it $4 million following an investigation into Macquarie's operation of a commission rebate scheme in relation to derivative warrants issued by Macquarie Bank Ltd (MB warrants). SFC found that Macquarie operated the commission rebate scheme in breach of its obligation to act with due skill, care and diligence in the best interests of the integrity of the Hong Kong market. In fact SFC banned commission rebate schemes in March 2006.

Macquarie used the commission rebate scheme to reduce transactions costs for investors and stimulate trading in selected MB warrants. Under the rebate arrangement, Macquarie agreed to reimburse investors, through their participating brokers, either in full or in part, the brokerage costs they were charged by their brokers for trading specified warrants.

In January 2002, SFC warned Macquarie that they should ensure their commission rebate scheme did not facilitate trading of MB warrants that was not for any genuine economic or commercial purpose. SFC was concerned that such scheme could encourage improper trading and lead to a false market for the MB warrants. SFC identified heavy trading activities in MB warrants between two clients from two participating brokerages during the period from January 2004 to January 2005. The two clients repeatedly traded the MB warrants at or near the same prices within short time intervals and created substantial amounts of turnover.

For example, in one particular warrant, on one day, two clients of two participating brokers engaged in about 400 trades between themselves in just over 60 minutes of trading with a transaction around every 10 seconds (being 90% of turnover on that day). The trades were conducted at or near the same prices within short time intervals and with effective brokerage commission costs below the amount of commission rebate paid by Macquarie. It appears the trading turnover of the relevant MB warrants was inflated and may have misled investors into believing that certain MB warrants were more actively traded than was actually the case.

While generating a significant amount of commission rebate from Macquarie, the two brokerages gave the clients discounts on brokerage costs for large volume trading. The two clients were then able to generate risk-free profit from the difference between the commission rebate and the discounted brokerage costs. Macquarie had put in place some controls to deal with the risk to market integrity and monitored the payment of commission rebate, but it failed to check whether the commission rebate scheme was providing clients with more money than was required to rebate actual brokerage costs. The volume and nature of the trading should have alerted Macquarie to make additional inquiries about the operation of the scheme and to check whether it was distorting the market for these MB warrants.

The SFC considers that if Macquarie had realised the true nature of this trading activity, Macquarie would have been obliged to ban those brokers from further participation in the commission rebate scheme. Macquarie eventually did ban some commission rebate scheme participants, but this was too late.

What are the root problems in my opinion? First, too many investors believe that actively traded warrants are "good" warrants. Second, SFC was wrong in releasing the warrant market in 2001. May I ask those frontline staff working for warrant houses a question: don't you feel guilty of teaching the general public to gamble?

Squawk Boxes

Have you heard about this term "squawk box"?

According to Investopedia:

• Squawk box is an intercom speaker often used on brokers' trading desks in investment banks and stock brokerages.
• It allows a firm's analysts and traders to communicate with the firm's brokers.
• Firms usually use squawk boxes to inform their brokers about current analyst recommendations, market events and information about block trades. This line of communication helps to keep brokers updated on important market factors and allows the firm to guide the trading of its brokers.

However, can you imagine squawk box may become a tool for front-running?

SEC recently charged Merrill Lynch, Pierce, Fenner & Smith Inc. with securities laws violations for having inadequate policies and procedures to control access to institutional customer order flow information. Merrill Lynch agreed to settle the SEC charges and pay a US$7 million penalty, among other remedies. In a series of related cases, SEC previously sued brokers from Merrill Lynch and other broker-dealers and employees at the day-trading firms who used the information to illegally trade ahead.

According to the SEC proceedings, Merrill Lynch utilizes institutional equities "squawk boxes", which are internal intercom systems used by broker-dealers to broadcast institutional customer order information to traders and sales traders at the broker-dealer. From 2002 to 2004, several Merrill Lynch retail brokers at three branch offices permitted day traders at other firms to listen to confidential information on large unexecuted block orders of Merrill Lynch institutional customers. The Merrill Lynch brokers put their telephones next to the squawk boxes and let the day traders listen to the squawk box, often for the entire trading day. The day traders used the broadcasts to trade ahead of the orders placed by Merrill Lynch customers.

In fact, Merrill Lynch lacked written policies or procedures to limit which employees within the firm had access to the equity squawk box, to track which employees had access, or to monitor employees for possible misuse of the order information. This created conditions that rogue brokers could exploit, as happened in this case.

Remote Participation of Hong Kong-Based Markets

Some people asked me such a question before: If financial firms located overseas place agency orders to trade securities / futures through SEHK / HKFE, are they required to be licensed by SFC? I would say if the firms place such orders to a local broker (of course licensed by SFC) for execution, then they are exempt from licensing. However, if they want to become direct exchange participants of SEHK / HKFE, they must be licensed.

Recent SFC published a consultation paper to address the issue of remote participation of Hong Kong-based markets (mainly SEHK and HKFE). SFC understands that globalization and advances in technology has made it possible for market players to access a market from a remote location without local presence. The current definitions of "dealing in securities" and "dealing in futures contracts" under SFO are wide enough to catch the dealing activities of all participants (including remote participants) of a Hong Kong-based market. However, SFC is unable to grant licences to participants unless they have a place of business in Hong Kong, which is not feasible.

To facilitate remote access to the local futures market and enlarge its investor base, SFC is proposing to amend the definition of "dealing in futures contracts" such that participants of a Hong Kong-based futures market do not need to be licensed by SFC if the following requirements are met:

• the market is operated by either an exchange company recognized by SFC or an automated trading services provider authorized by SFC;
• the participant must be a remote participant;
• the participant must not establish a place of business in Hong Kong, conduct any dealing activities in Hong Kong, serve Hong Kong clients, nor market their services to Hong Kong public; and
• the remote participant must be regulated, or be a participant of an overseas futures market which is regulated, in their home jurisdiction by a recognized regulator.

However, this time SFC is not introducing corresponding amendments to the definition of "dealing in securities" because SFC proposes to take a gradual approach to introducing remote participation in Hong Kong-based markets.

I think even such remote participants are not licensed by SFC, they would be indirectly regulated by SFC through the exchange rules and SFO provisions, especially for market integrity issues.

Remuneration Policies

One of the factors leading to the financial tsunami was "moral hazard" - investment bankers were motivated to take excessive risks in order to bet for a huge amount of bonuses without bearing the consequential losses. While the banks have been "nationalized", the remuneration policies would be expected to undergo a significant reform.

UK FSA recently published a draft code of practice on remuneration policies relevant to all FSA regulated firms. The aim of the code is to ensure that firms have remuneration policies which are consistent with sound risk management, and which do not expose them to excessive risk. However, It is not concerned with setting levels of remuneration, which are a matter for the boards of companies and their shareholders.

The specific principles of this code are highlighted as follows:

A. Governance

1. Boards and relevant remuneration committees should exercise independent judgement and demonstrate that their decisions are consistent with the firm's financial situation and future prospects. Their members should have the skills and experience to reach an independent judgement on the suitability of the remuneration policies, including the implications for risk and risk management.

2. The procedures for setting compensation within the firm should be clear and documented, and they should include measures to avoid conflicts of interest. Risk and compliance functions (in consultation with the firm's HR function as may be deemed appropriate) should have significant input into setting compensation for business areas.

3. Compensation for staff in the risk and compliance functions should be determined independently of the business areas. They should have different performance metrics, with greater emphasis on the achievement of their own objectives.

B. Measurement of performance for the calculation of bonuses

4. Assessments of financial performance to calculate bonus pools should be principally based on profits. The bonus pool calculation should include an adjustment for current and future risk, and take into account the cost of capital employed and liquidity required.

5. Firms should not assess performance solely on the results of the current financial year.

6. Non-financial performance metrics, including adherence to effective risk management and compliance with regulations, should form a significant part of the performance assessment process

C. Measurement of performance for long-term incentive plans

7. The measurement of performance for long term incentive plans, including those based on the performance of shares, should also be risk-adjusted.

D. Composition of remuneration

8. The fixed component of remuneration should be a sufficiently high proportion of total remuneration to allow the company to operate a fully flexible bonus policy.

9. The major part of any bonus which is a significant proportion of the fixed component should be deferred, with a minimum vesting period.

10. It is highly desirable that the deferred element of variable compensation should be linked to the future performance of the division or business unit as a whole.