Information Technology, Financial Flows and Globalization

(An overview of the issues, problems and opportunities involved in using
information technology in the financial sector)

Informal Panel Discussion

55th session of the Commission
Bangkok, 27 April 1999

Stephen Cheung
Research Consultant
Securities and Futures Commission
Hong Kong

Introduction

1 . Technology is fundamentally changing the landscape of the global financial marketplace by lowering transaction costs and reducing asymmetric information, thus levelling the playing field for investors and issuers. Despite high initial investments for technology, economies of scale will eventually drive down costs and increase competitiveness. The rise of the Internet and the explosive pace of consolidation of exchanges are creating an increasingly round-the-clock, borderless global trading network. This has greatly increased the number of investment products accessible to international investors, improved market efficiency and reduced transaction costs. Being a portal in this global trading network has become a critical factor for success.

2. Institutionalisation of funds has tremendously increased the financial clout of institutional investors. As intermediaries of large pool of funds, institutional investors exert strong influence on transaction costs, financial products, trading strategies, cross-border capital flows and regulatory and tax issues. The ability to meet the needs of institutional investors in a cost-efficient manner is another critical element for a securities market to be successful in the global trading network.

Technology-driven competition

3. Technology is driving the transformation of the global financial marketplace. There are different facets of technology that have contributed to the emergence of an increasingly interrelated global marketplace with strong linkages between cash and derivative markets.

4. First, advances in telecommunications and information processing offer financial institutions the capability in handling vast amount of data at very high speed and at relatively low costs. Technology has shrunk the world and reduced the importance of geographical location of markets. This serves as a catalyst for exchanges to abandon open outcry and adopt screen-based trading technology. Exchanges are fostering alliances with overseas counterparts in an effort to reduce high development costs in technology and to increase market share.

5. Second, the emergence of the Internet is reducing information asymmetry, giving individual investors unprecedented access to the global marketplace. Smaller investors are gaining access to real-time market information and low-cost trading and risk management systems which have until recent years been largely accessible by financial institutions. Technology has levelled the playing field for all investors around the world.

6. Third, methodological breakthroughs in the pricing of sophisticated derivatives products have led to the invention and marketing of new financial instruments and trading strategies in repackaging risk and return profile. The process of unbundling and redistribution of risk and return has strengthened cross-market linkages and has blurred the traditional demarcation of "cash" and "futures" markets.

Internet trading

7. As the world's stock and futures exchanges grapple with the issue of electronic trading and alliances, a quiet revolution has already been taking place on the Web: Internet trading of securities, particularly in the US. Before 1995, Internet trading did not exist. Today, investors can choose from 100 online brokers in the US alone. This trend is expected to pick up further over the next few years, certainly in the US. One study forecasted that the number of online investing accounts would grow to 14 million by the year 2002 with assets managed online reaching US$688 billion¹.

8. In the US, the success of online trading specialists like E*Trade, and the traditional discount brokerage firm Charles Schwab, which has made perhaps the smoothest transition to online trading, has been dramatic. For example, Charles Schwab opened 1.4m new accounts during 1998 and ending the year with 5.6 million active accounts. The number of online transactions has averaged 93,000 a day during the fourth quarter of 1988, which accounted for 61% of the total transactions during the same period.

9. Online trading is becoming increasingly popular in the US, but the rest of the world still has quite a way to catch up. For example, in Hong Kong, there are only a handful of brokers offering online trading services on domestic stocks. Some 50% of inhabitants in the US have PCs and. 23% of inhabitants have Internet access, compared with 23% and 11 % in Hong Kong. Forward-looking US online brokerage firms will continue to charge ahead with ambitious geographic expansion. For example, E*Trade is already offering online services in Canada, Australia and New Zealand and plans to start operating in the UK in 1999.

10. New technology brings unique challenges and opportunities. The Internet trading phenomenon is still very much at its infancy crowded with technical difficulties such as online reliability, performance and security. It is hard to predict with high accuracy the development of online market in a five- to ten-year horizon. However, it is believed that the Internet technologies will have significant impacts on a number of areas:

• The traditional role of brokers on trade execution will diminish.
• Technology creates a level playing field for investors, issuers and broker/deals.
• The role of traditional exchanges will be undermined.
• New challenges for investor protection.
• Regulatory issues become global issues.

11. Basic transactional and information services will become commoditised and compete increasingly on price alone. By offering no-frills execution and on-line research and analytics, online brokers will continue to attract sophisticated or self-directed investors with competitive pricing. This will diminish the role of local brokers in trade execution alone service.

12. In an effort to stay ahead of the pack amid growing competition, established online brokers will continue to add more services to their web sites such as research, real-time share price quotes and portfolio management in order to extend their product portfolios. For example, Charles Schwab has started selling new shares direct to its online customers. E*Trade announced it planned to take a stake in an online investment bank called E*Offering, which is expected to begin underwriting public offerings for sale to E*Trade subscribers. This will allow retail investors to get into the primary as well as the secondary market, further narrowing the gap between institutional investors and their retail counterparts.

13. Technological speaking, the combination of the Internet technologies is able to create new virtual exchanges, thereby undermining the role of traditional exchanges. The core functions of an exchange are to bring together buyers and sellers, provide a mechanism for price discovery and central clearing, and provide a regulatory environment in which trading can take place. The Internet can already substitute the first two, linking buyers and sellers and enabling price discovery via browsing or search engines.

14. Online trading is not without problems. The Internet can present new threats to investors in areas such as security, performance and dissemination of false information.

• How safe is trading of securities on the Internet? The key is to ensure that the data carrying the order across the Internet is adequately encrypted so that it cannot be emulated and sent to competitors. The system should be made secure from hackers trying to break in and damage orders or generate orders that were bogus. The solution to this problem is public key cryptography, where each trade placed online would have its own unique digital fingerprint so that interested parties could be absolutely certain who was the author and where it came from.

• Temporary service breakdowns that have hit leading online brokerages have raised concerns about protection of online investors. When online brokers suffer outages, their customers stand to lose much more than just access to the markets, but lost trading opportunities and even financial losses. Perhaps regulation may be required for third party certification that online trading system capacities can handle spikes in demand.

• The Internet allows individuals to easily disseminate information to the investing public. It may enable irresponsible individuals to spread false information or hype to the investing public for their own benefits. This highlights the importance of investor education as well as the need for appropriate regulations and regulatory vigilance.

15. Online trading will inevitably involve cross-border transactions. This highlights the need, to a degree, to globalise supervision in order to avoid the risk of inconsistent regulation. The alternative would be the use of firewalls and barriers to insulate certain markets and players from the global marketplace.

16. Whatever Hong Kong does, forward-looking online brokers from the US will continue their ambitious expansion into other geographic locations including Hong Kong. Online services will stimulate interest from local investors to invest in overseas securities in search of higher returns and for portfolio diversification. Local markets will suffer as a result of losing volume to foreign markets through the Internet. Small brokers are especially vulnerable because of their lack of resources to develop their own Internet capability. A concerted effort by the government, brokers and exchanges is required to hammer out a solution.

Alliances and mergers of exchanges

17. Alliances between exchanges make perfect sense in capturing market share, improving liquidity and cutting costs. For example, the alliance formed by Eurex and the French derivatives exchanges MATIF and MONEP is to build electronic links between the exchanges on a common trading platform so that members of any of the exchanges can deal simultaneously in all three markets from a single computer screen.

18. Alliance of exchanges is not confined to continental Europe. CME, MATIF and SIMEX announced that they would form an alliance spanning three time zones, offering round-the-clock trading in some of the most actively traded financial products on a single electronic platform by June 1999. The common trading platform will link some 2000 trading screens in Europe, the US and Asia. The alliance also agreed to exchange technologies, with SINEX adopting the French trading system, the MATIF adopting the CME's clearing system and the CME implementing the French trading technology. This arrangement allows SIMEX and CME the access to a transatlantic platform without incurring high initial development costs in new electronic trading systems. In return, by offering direct access to traders based in the US and Asia, MATIF would be able to draw business away from its competitor, Liffe, in Euribor futures, the benchmark product for interest rates in the core EMU zone.

19. The rapid pace of consolidation of exchanges coupled with high initial development costs of electronic trading systems exerts enormous pressure on small exchanges whose incomes depend on a narrow product range. The cost base of small exchanges may not allow them to remain independent for much longer.

20. The issue of costs is equally crucial for exchange members and it adds credence to the rationale of consolidation. For those who are members of multiple exchanges in diverse geographical locations, unification and consolidation of exchanges' functions provide an important means for cost reduction.

21. The global marketplace of the 21st century is one in which investors and issuers will be linked over a worldwide network. This will provide true value for international institutional investors in terms of lower transaction costs and availability of a broad range of products for investment and risk management purposes spanning different time zones.

Regional portals of a global trading network

22. Electronic trading and remote access will attract investors to do business in any exchanges with the largest pool of liquidity. Exchanges are battling over price, efficiency and liquidity in an effort to become the portal in their own time zones of the global trading network. The battle between the DTB and the LIFFE for the position as the premier futures exchange in Europe is a clear example.

23. In Asia, SIMEX has been aggressively launching a series of regional equity index contracts, in a bid to maintain its position as the leading centre for trading offshore Asian derivatives products. SIMEX first launched a NIKKEI 225 futures contract back in 1986 and followed by MSCI Taiwan stock index futures and option in 1997 and the Dow Jones Thailand stock index futures in November 1998. The domestic Singapore equity market remained essentially out of reach for foreign investors until SIMEX launched the MSCI Singapore stock index futures in September 1998. More significantly, SIMEX re-launched a Hong Kong stock index futures contract in November 1998 in direct competition with the HKI7E's flagship Hang Seng products. SIMEX's contracts are based on the MSCI Hong Kong+ Index (HiMSCI+), which has a 99.995% correlation with the Hang Seng Index.

24. In price-efficient securities markets, no net benefit can be expected from spending extra resources on active management strategies in trying to beat the market "index". Thus, portfolio indexing can be the optimal investment strategy. In particular, the use of benchmarks tailored to individual pension funds' liabilities has increased. For example, the use of individual benchmarks for UK pension funds has grown from less than 5% in 1990 to more than 30% of the total in 1996. The recent announcement by the Sydney Futures Exchange (SFE) and Dow Jones Indexes to create a new set of investable indices is a further endorsement of using indexing as a strategy in gaining an edge in the global marketplace.

Conclusion

25.I have touched on a number of important issues facing our securities market. These include the impacts of the advancement of information technology and the market globalization on the securities market. As a regulator, these changes affect the way we conduct business. We have to keep these issues in mind and monitor their development.

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Note 1 "Net Investing blasts off", Money & Technology Strategies, volume 2, Number 12, The Forrester Report, August 1997.