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Putting the pieces together for an ideal market

Updated: 02 Mar 2016
Charles Li Direct Page

We are hard at work on our new Strategic Plan, but have come across some questions about two of our suggested initiatives: the Third Board and Primary Equity Connect.  Both are important components of our roadmap to build Hong Kong into an ideal market, and they can only be achieved with regulatory guidance.  Speaking purely in my personal capacity, I want to examine these initiatives in more detail, explain some of the logic behind my thinking and provide some perspective to stimulate a constructive debate on whether these initiatives are sound, necessary and realistic.

Why are we talking about a Third Board?

The Hong Kong IPO market has been a great success story over the last 20 years and our listing regime is considered to be world class with its unique track record of bringing Chinese companies into the international norms of sound corporate governance and investor protection.  Despite the success, we are still very sensitive to periodic calls for greater efforts to attract promising, emerging companies to list; to complaints that some companies become "bad apples" shortly after listing; and to occasional frustration that some "zombie" shell companies are allowed to stay on the market for far too long.

I think we all agree that these issues should be tackled in our effort to create an ideal market, which is one that efficiently allocates capital by allowing good companies to list and raise funds and poor companies to be quickly removed from the market.  The question is what is the best way to achieve it.

Some argue we should make the initial listing criteria even more stringent and build a higher wall to keep bad companies out.  However, a side effect of this higher wall is it may keep companies with great potential out, too.  If a higher wall could guarantee that bad companies are kept out, maybe this would be a worthwhile trade off – but it's not the case.  China has arguably the highest wall possible with hundreds of companies waiting for years to be listed, and even it can't eliminate the many failing companies that cause substantial investor losses each year.  The reason is simple: a few companies that meet those higher standards at listing might still become poor quality companies later.

In my view, instead of focusing on the entrance criteria, we should be focusing on the exit instead.  That's why I think we should be looking at a much more robust post-listing regulatory regime and a more efficient delisting process, a system which wouldn’t allow zombie companies or "shell" companies to stay for too long.

So why hasn't this happened yet?  In fact the market considered reforms to the post-listing regulatory regime many years ago, but the plans never came to fruition.  Hong Kong rightly values its tradition of rule of law and due process, particularly when it comes to material regulatory changes that might have far reaching impacts on stakeholders, especially existing issuers and investors.  There are also a lot of entrenched interests (especially those "shell" companies), which means any potential regulatory change would likely require a very lengthy consultation period.  Even after that process, the market may still be unable to reach a consensus, as we found out previously.

It is not clear to me whether the markets, including the regulators, the exchange, our participants and investors, are prepared to take another hard look at this thorny issue again today.  So if we are not able or don't want to touch the existing regime but still want to do something, what are the alternatives?  It is in this context that we begin to explore the idea of a Third Board as an option to consider.

A Third Board would require no changes to our existing regulatory regime and could contain three important features that would differentiate it from the GEM board: (i) a lower entry threshold which will allow more emerging companies to list in Hong Kong; (ii) more aggressive and robust continuous listing obligations for issuers to ensure investor protection; and (iii) a much more effective and efficient delisting procedure, which will allow the market to "flush out" bad companies quickly to protect the reputation of our markets.  If lower entrance hurdles and a faster exit process give rise to concerns about investor protection, particularly regarding retail investors, regulators could consider limiting participation to professionals.  A Third Board, if successfully launched and smoothly operated over time, may eventually create market pressure on our other boards, leading to further improvements in those markets as well.

I am not suggesting that a Third Board is a preferred option over changes to GEM.  This decision is ultimately for the regulator and market to make.  If market participants agree a Third Board is an option worth exploring, we can then take guidance from our regulators and work together to design details of the new market such as the admission criteria, post-listing regulatory regime, investor eligibility and other rules.  Of course if the market has other solutions, we’re open to hearing those, too.

As a market operator and the frontline regulator of issuers, it is our duty to continue looking at ways to facilitate economic development by helping issuers raise capital and strengthening investor protection through enhancing market quality.  We continue to think about how we can fulfill this mission, and I believe we need to have the courage to take action now.

Primary Equity Connect

Now to the Primary Equity Connect.  This is our plan to expand Stock Connect, which has connected the secondary markets in Shanghai and Hong Kong, to the primary market.  In other words, it would allow Mainland investors to participate in Hong Kong IPOs and vice versa.

There are very good reasons for both the Mainland and Hong Kong to embrace a Primary Equity Connect.  The Shanghai and Shenzhen exchanges both have their sights set on building international boards to welcome foreign listings and investors, however we expect this to take considerable time, if it happens at all.  The urgent need for the Mainland is to diversify its investor base, including attracting more institutional participation, and to allow Mainland investors to have greater access to high-quality international investment assets so they can diversify their holdings.  Both of these key objectives can be met by opening up the primary markets on both sides of the boundary to investors from the other side.

For Hong Kong, it would strengthen our attractiveness as a global listing destination to enable international companies to access China's vast domestic savings.  It would also reinforce our role as the primary access point to welcome international investors to directly participate in new issuances from China.

So how difficult would it be to get this done?  There has been some skepticism about the feasibility of introducing a Primary Connect, with some people believing it would take substantial regulatory changes and is therefore unlikely in the short term.  While it's true regulators would need to cooperate and some changes would be required, it's not as far-fetched as it might seem.

For Southbound, which means Chinese domestic investors buying primary shares offered by companies already listed or newly listed in Hong Kong, there should be no regulatory changes needed in Hong Kong as our city is already open to international (including Mainland China) investors who wish to participate in IPOs in the city.  However, approval from the Mainland regulator would be required.  While it is far from certain that such approval would be forthcoming, there are good reasons to believe that Mainland regulators could eventually look at this as an effective, efficient and low risk way to help China direct its massive domestic savings into more diversified global allocation through the Connect programme.

For the Northbound channel, which means international investors participating in offerings of primary shares in Mainland China, I do not believe that there should be any material Hong Kong regulatory issues or concerns if shares are offered to professional investors only.  Chinese issuers in these instances are primarily interested in attracting international institutional investors to their domestic offering and see no need to tap Hong Kong's retail investors.  However, I recognise that different regulatory considerations would arise should Hong Kong retail investors be permitted to participate.

The Primary Equity Connect is an example of the best kind of initiative, because it brings real value to the Mainland's development and liberalisation while also bringing value to Hong Kong as the connector and platform that can make it happen.  Still, this is ultimately a decision for regulators; while there would be some regulatory hurdles, we believe it's in Hong Kong and the Mainland’s best interest for us to overcome them.

The Third Board, too, is an idea to help us build an ideal market, and ensure we are ready for future opportunities.  Both of these initiatives are in the early stages and we are always open to a vibrant debate and feedback from the market, including alternatives that make us better. Only by working together can continue building Hong Kong and ensuring its position for another generation of success.


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