Hong Kong moves into a new era

This blog post originally appeared on AsiaEtrading.

Trading in Hong Kong remains a challenging endeavor for global investors. As authorities work to eradicate insider trading, Hong Kong has served as an informal test case for exploring how far the free market ethos can go before it begins to scare off investors.

Hong Kong embodies an irony about capital markets—they have to be free to attract investors but rampant abuse of that freedom will drive investors away. In this case, unrestricted insider trading was threatening the integrity of Hong Kong’s markets.

The negative publicity about a culture of insider trading, that only recently was made illegal, led to a crisis of confidence. Things were so bad that insider trading was seen as almost a privilege. Market participants and the regulators knew they had to do something. Thus the regulators had to serve as the catalysts for a fundamental shift in the trading culture. And, so far, it appears to be working.

Over the past four years, Hong Kong’s market regulator the Securities and Futures Commission (SFC) has cracked down on insider trading and put the markets on notice that it is serious about lawbreakers. This has resulted in convictions of local violators, and surprising attempts to stop foreign firms under suspicion from trading in Hong Kong. The crackdown continued throughout 2011, and even included the conviction of a man who was providing unlicensed securities trading advice via a Facebook group. In another example of its vigilance, the SFC also runs online photos and information about securities industry participants that it is trying to track down.

While the authorities stepped up their enforcement, the issues of better due diligence and corporate governance have come to the fore. Last year, Hong Kong Exchanges & Clearing Ltd. (HKEx) requested that Chinese companies submit to commissioned due diligence reviews in order to do a better job of meeting regulatory requirements for listing. In addition, some local and global investors in Chinese firms that list via HKEx have embarked upon their own due diligence efforts.

Reinforced due diligence is a prescient move because anti-money laundering (AML) efforts and counter terrorist financing (CTF) preparations will intensify as mainland China and Hong Kong slowly explore currency liberalization between the yuan and the Hong Kong dollar. In addition, Charles Li, the CEO for HKEx, said in January that mainland Chinese investors may one day be able to take part in yuan-denominated IPOs via HKEx, according to media reports.

In addition, over the long term, there is likely to be more demand for yuan-denominated services, including IPOs in Hong Kong, which has had the largest IPO market for the past three years. At the same time, the Hong Kong Monetary Authority (HKMA) is reminding institutions to prepare for the money laundering and CFT issues that could come with yuan-denominated offerings.

Overall, IPO sponsors will have to do some heavy lifting for modern-day due diligence. The SFC has found some IPO sponsors failed to properly list an IPO applicant’s business and documentation, poorly disclosed information to HKeX, and were in need of better IT systems and controls to govern their clients’ IPOs. The SFC also wanted investors to get a better grip on their rights and obligations via such tools as key facts statements (KFS) before funding a new listing.

Investors need to develop a clearer and updated understanding of the differences in the ownership structure and governance among firms listed in what is still one of the world’s most dynamic markets. For sure, investors will need as much disclosure as possible on how a firm handles insider trading and other abuses especially if the firm never monitored these problems before. This is all made possible because of the stronger enforcement and regulatory reforms underway in Hong Kong.