In yet another example of the global trend toward dematerialization, the Hong Kong Stock Exchange (HKEx ) will introduce a scripless model for share ownership based partly on proposals first put forward by the Securities and Futures Commission (SFC) in September 2003.
Details of the final operational plan are due for release by the HKEx this month, but in broad terms the HKEx and the SFC are committed to implementing a gradual approach using a split registry model similar to those adopted by the U.K. and Australian central depositories.
"We will go scripless. The government will support a change to regulations for a gradual approach based on our industry conclusions and compromises with concerned parties," Stewart Shing, head of clearing business at the HKEx and CEO of the Hong Kong Securities and Clearing Corp. (HKSCC), announced at a recent global market update hosted by Standard Chartered Bank. "After reviewing submissions, we have come up with model that can satisfy everyone."
Legislation to enable a scripless market will be in place by fourth-quarter 2004 or first-quarter 2005, added George Tam, senior manager for the supervision of markets at the SFC. HKEx expects the transition to a fully scripless market to take one to two years after that, but that would depend on the model's commercial viability.
Under the SFC's original proposal, the model would allow Hong Kong's central depository, CCASS, to run a new registry operation managed by its nominee business, HKSCC Nominees, and offer registry services for scripless holdings of individual shareholders via their CCASS Investor Participant Accounts or HKSCC Nominee Investor Accounts. Registry participation would effectively be split between existing issuer registries, who would hold stock in both certificated and uncertificated forms, and the new CCASS registry, who would only hold stock in paperless form. Reconciliation of total registry holdings and stock movements would be completed on a daily basis via batch runs between the two registry types and recorded in a central registry for public inspection at the registrar.
The model would also introduce a new CCASS Sponsored Participant Account, whereby, in a model similar to Australia and the U.K., investors are sponsored in CCASS by a broker-dealer or custody bank and allocated a Shareholder Register Number (SRN) for a fully disclosed investor account held in CCASS.
However, dematerialization won't be mandated by the HKEx or regulators, allowing paperless and certificated models to run concurrently on the assumption that if the new model delivers on expected efficiency, transparency and lower costs, these benefits would drive scripless take-up by investors. But many observers believe the actual benefits of a scripless model are difficult to quantify in the HKEx context. Infrastructure costs and ongoing fees have yet to be announced. These and related operational issues were canvassed by the SFC and HKEx in a third round of consultations conducted by an industry working group, IWG, in October 2003 and finalized this month for announcement by HKEx.
However, concerns remain. "No one was able to discuss costs, so how can I say if I want to agree or not?" said James Wong, head of custody and clearing at HSBC.
YF Cheung, head of securities services for Hong Kong and China at Standard Chartered Bank, agrees. "We've been asking CCASS to review the fee schedule and there has been quite a lot of pressure from the market requesting fee reduction," he said. A number of key operational issues appear unresolved and reflect the idiosyncrasies of the Hong Kong processing model and local market needs. Issues include doubtful efficiency gains in settlement, CCASS expanding its role to operate a commercial registry, connectivity between issuer and CCASS registries, and the SRN account structure.
Immobilization drives certificated settlement depository models, and Hong Kong is no exception. CCASS physically holds about 30 percent of scrip by market capitalization and 60 percent of the 25 to 30 million share certificates for Hong Kong's two million shareholders. CCASS participants deposit their own or clients' shares in CCASS, which are then registered in the name of the HKSCC (HKSCC Nominees) and HKSCC, in turn, credits the accounts of depository participants. Acting as nominee, HKSCC allow trades to be settled electronically on a continuous basis providing CCASS with high rates of settlement efficiency. "Our settlement efficiency is already high at 99.9 percent," HKEx's Shing observes, "but no paper is still better than paper and that's why we put up the scripless proposal."
Given the high percentage of market capitalization immobilised in CCASS, Citbank's James Wong believes transition to the scripless model shouldn't be a problem, but he agrees paperless settlement won't have a huge impact on settlement efficiency until it results in a higher number of shares being dematerialised in CCASS and that depends on market take up.
According to Cheung, transparency is nevertheless a key driver for the SFC scripless proposal because a fully disclosed model would allow regulators to more effectively monitor market players in real time; for example, whether or not investors have exceeded their 5 percent maximum shareholding in any given stock that requires disclosure of interest.
CCASS proposed role as a registry participant is also a concern. According to Cheung, an earlier model proposed that CCASS directly provide registry services but that was ruled out as CCASS (holding all immobilised stock) would have an unfair advantage over issuer appointed registries. This resulted in the SFC's 2003 split model where CCASS would operate a registry alongside issuer appointed registries but that model is also now under review according to Cheung. "They will keep the status quo at the present stage whereby CCASS will appear as a shareholder of the new registry participant," he said, "but this is pending a final announcement." This revised model would be more in step with the ASX-Perpetual registry business in Australia and the CrestCo in the UK, which have broader shareowner structures.
Also at issue is daily batch processing between the proposed new registry and issuer registries. Respondents initially favoured real time processing, but according to Cheung the benefits may not justify costs. "Batch processing won't affect settlement and I think market sentiment is to let the model run first and consider further investment subsequently," he said.
Cheung also believes the complexity of new investor CCASS account types offered in the current model may deter investors. "There are six types of shareholder status in the proposed model and at the end of the day investors may not understand what's going on and simply prefer scrip," he observed.
Unlike depository models in Australia and the UK, CCASS acts as the central clearer for the Hong Kong market as well as being the central counterparty effecting settlement. It also operates a rudimentary custody business offering investors an Investor IP account. Unlike investors who currently participate in CCASS via a sponsoring broker or custodian, these CCASS IP accounts are fully disclosed. This provides investors with better safe custody as shares are held in their own names rather than being co-mingled with the broker's stock in broker's sponsored CCASS accounts.
Investors are thus already faced with four participant options: Issuer sponsored (certificated), Broker/ Custodian sponsored (undisclosed), CCASS IP account sponsored (fully disclosed) and HKSCC Nominee sponsored as beneficial owners. New uncertificated sponsorship through the proposed CCASS registry and new CCASS sponsored dematerialised investor accounts (fully disclosed) comprise the complex basket of proposed investor options Cheung refers to if HKEx proceeds with the proposed concurrent paperless and certificated model.
The structure of the new investor SRN account model also raises issues of security, credit risk and unnecessary proliferation of SRN numbers. Under the proposed model, investors choosing to hold stock in scripless form through their broker via the new CCASS sponsored investor accounts would be issued with an SRN account whereby holdings are disclosed in CCASS in sub-register accounts. However critics say this new account and SRN number (which the investor must reveal to his broker) doesn't offer investors any additional protection from unauthorised sell down of their portfolios or misappropriation by the broker.
According to the SFC, the new SRN and CCASS investor account isn't designed to eliminate credit risk but they argue investors are better placed because their shares are no longer co-mingled with their sponsoring broker and they can view holdings via monthly CCASS statements.
According to Cheung, under the proposed model a new SRN would be issued to investors with each buy trade. Respondents to the SFC and HKEx consultation recommend the adoption of a single SRN identifier for each investor, but the adoption of this single ID would depend on the ability of share registries to align their systems. "There has been a lot of discussion about how to protect the investor and streamline the SRN process and right now they are still exploring the possibilities but don't have a solution," Cheung said.
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