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?
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