Market Making in Hong Kong A New Frontier for Exchange Participants?

Summary

The frontline regulator of the Hong Kong stock market (the Exchange) recognizes the important role played by market makers in facilitating market efficiency and functioning in the securities, listed derivatives and stock options markets. Authorized market makers, many of whom are required to become exchange participants (EPs), contribute to Hong Kong’s market quality by providing improved liquidity and price efficiency, enabling investors to trade in a timely manner and at reduced transaction cost. 

Recent trends

Market liquidity has returned to levels comparable to those before the global financial crisis, although to different degrees across asset classes and jurisdictions. However, there are growing signs of increased illiquidity, with market activity concentrated in more liquid instruments and deteriorating in less liquid instruments. Postcrisis, concerns arose that the big banks often viewed as the traditional market-maker vanguards were a potential source of a liquidity contagion. These perceptions have provided, to some degree, opportunities for other participants to step in as liquidity providers. While the business models of market makers differ depending on the market session and products traded, market makers do not trade on any specific informational advantages with profits being closely correlated to quoted spreads, while the market simultaneously benefits from better liquidity. 

Although several well-known EPs operate globally successful proprietary trading groups that focus on market-making activities, there remains a relatively small number of players in Hong Kong relative to other well-established financial centers. Due to reduced immediacy of liquidity providers, liquidating assets is often more difficult when market sentiment deteriorates and generally implies upward pressure on trading costs. To address this imbalance and lure new entrants, the Exchange has enhanced initiatives for market makers, offering better incentives for existing participants (and new entrants alike) to conduct market-making activities, with many new entrants focusing on activities requiring less stringent capital requirements. 

The Exchange currently offers three types of market-maker permits: (i) Securities Market Makers (SMMs); (ii) Market Makers at the Hong Kong Futures Exchange (HKFE) (or Derivative Market Makers) (DMMs); and (iii) Options Market Makers (OMMs). The product scope and eligibility for each type of permit are summarized below.

Existing EPs will be required to submit application forms and internal reports setting out their risk management policies and internal controls during the approval process. However, existing EPs are not generally required to satisfy increased capital resources requirements or additional licensing requirements to become market makers. This therefore represents a good option for EPs seeking diversification while minimizing capital burdens. At present, there are fewer than 50 EPs holding one or more of the market-maker permits in Hong Kong. Taking into account market turnover, there is ample room, incentives and opportunities for more players.

Key incentives and opportunities

Authorized market makers enjoy a wide range of benefits, including reduced trading fees and transaction levy concessions (and even exemptions for certain products) for market-making trades. SMMs can also apply for a Market Making Orion Central Gateway Session at a discounted rate for exchange-traded products. In addition, market makers are exempt from certain stamp duty, large open positions reporting and short selling requirements.

To further incentivize EPs to become market makers, the Exchange has recently enhanced its market-maker programs to allow affiliates and qualified corporate clients, even unlicensed overseas clients that satisfy certain credit rating/capital requirements, of SMMs and DMMs to participate in market-making arrangements in Hong Kong. This effectively allows SMMs and DMMs to “rent out” their market maker permit(s), enabling them to tap into additional income streams. While OMMs are not currently able to “sponsor” third-party clients to access these opportunities, their qualified offshore affiliates can still participate without triggering any licensing requirements when conducting market-making activities as nonexchange participants. 

Way ahead

It is unclear, at this stage, whether the market trends discussed above are cyclical or structural in nature. At the same time, rising issuances of debt securities, increased holdings by institutional investors and the asset management sector, and the more widespread use of benchmarks have spurred the demand for market-making and liquidity providers. Against this background, the increased incentives offered to market makers in Hong Kong support market liquidity under more stressed conditions. In principle, at least, such factors make market-making activities performed by existing participants (and non-EPs alike) more attractive than in other jurisdictions and improve the robustness of Hong Kong’s financial markets, reducing sensitivity to liquidity shocks during times of stress.

How can Sidley assist?

Sidley is at the cutting edge of legal work for market-making and liquidity providers. Our experience is comprehensive in all core aspects that are relevant to the market-making ecosystem, including advising on structural options and trading platforms to optimize commercial outcomes as well as the regulatory licensing requirements for existing exchange participants, market makers and new entrants. If you would like to discuss the approval requirements or plan to become a market maker and would like to explore how we may be able to assist you, please do not hesitate to contact us.