How to boost liquidity in the Hong Kong stock market: Lower stamp duty? Widely introduce market makers?

Source: Zhao Ran, Analyst at CITIC Securities

On August 27th, Carrie Lam, the Chief Executive of the Hong Kong Special Administrative Region, announced that the government will establish a working group to study how to increase the liquidity of the stock market, which may bring more favorable policies to the Hong Kong stock market.

Currently, the liquidity of the Hong Kong stock market is relatively poor compared to the mainland China and US markets. Specifically, the liquidity differentiation is more pronounced, with trading showing a concentration towards large-cap companies. The liquidity of large-cap companies is significantly better than that of small-cap companies and the overall market, while the liquidity of small-cap companies is relatively lacking, which is an important reason for the difference in liquidity between the Hong Kong stock market and other markets.

Overall, CITIC Securities believes that the main reasons for the poor liquidity of the Hong Kong stock market are the relatively low proportion of individual investors, high transaction costs, and the lack of a market maker system.

Looking ahead, if measures such as accelerating the GEM reform, reducing market transaction costs, introducing a market maker system, continuously expanding mutual market access, and attracting more international capital participation can be implemented, the liquidity of the Hong Kong stock market is expected to continuously improve.

The overall liquidity of the Hong Kong stock market is relatively poor, and turnover has been under pressure since 2023

As the financial center of Asia, Hong Kong, China brings together global investors and high-quality companies, mainly from mainland China. It is the only offshore market among the top ten exchanges in the world. However, the liquidity of the Hong Kong stock market is relatively poor. According to statistics from the World Federation of Exchanges (WFE), the average daily turnover (ADT) of the Hong Kong Stock Exchange in 2022 was 11.759 billion US dollars, with an annual turnover rate of 62%. It is relatively low among major exchanges in the world, significantly lower than mainland China and the United States, but higher than India, the United Kingdom, France, and similar to Germany.

In the first half of 2023, affected by overall market pressure and relatively tight liquidity, the average daily trading volume of Hong Kong stocks decreased by 16% to HKD 115.5 billion; the average turnover rate was only 0.19%, a year-on-year decrease of 0.03 percentage points.

Liquidity differentiation in the Hong Kong stock market is more pronounced, with trading showing a significant concentration towards the top.

Overall, large-cap stocks in Hong Kong have shown significantly better liquidity in the long term, and trading in the Hong Kong stock market has exhibited a notable concentration towards the top. If we classify stocks of listed companies with a market capitalization of HKD 30 billion or above as large-cap stocks, and those with a market capitalization below HKD 30 billion as small-cap stocks, from the beginning of 2023 to August 25th, the average daily turnover rate of large-cap stocks in the Hong Kong stock market reached 0.36%, significantly higher than the overall turnover rate of 0.19% and the turnover rate of small-cap stocks at 0.17%.

In contrast to the Hong Kong stock market, small-cap stocks on the NASDAQ and the Tokyo Stock Exchange are actively traded and have relatively better liquidity. If we examine the average daily turnover rates of different market segments on the NASDAQ and the Tokyo Stock Exchange, the NASDAQ Capital Market and the Tokyo Stock Exchange Growth Market, which are mainly composed of small-cap, high-growth companies, have average daily turnover rates of 4.42% and 2.31% respectively since the beginning of 2023, significantly higher than the overall turnover rates of 2.23% and 0.80% on the NASDAQ and the Tokyo Stock Exchange, as well as other market segments, reflecting the better market liquidity of small-cap stocks.

Due to the concentration of liquidity in large-cap stocks in the Hong Kong stock market, and the relatively better liquidity of small-cap stocks on the NASDAQ and the Tokyo Stock Exchange, overall, the liquidity of large-cap stocks in the Hong Kong stock market is not poor when compared. The difference in liquidity levels between the Hang Seng Index and the Nikkei 225 Index, the NASDAQ 100 Index, and other blue-chip stock indices is much smaller than the overall market. The relatively lower liquidity level of the Hong Kong stock market compared to the NASDAQ and the Tokyo Stock Exchange is mainly due to the relatively lack of liquidity in small-cap stocks.

Brief analysis of the reasons for the poor liquidity in the Hong Kong stock market

In summary, the bank believes that the reasons for the poor liquidity in the Hong Kong stock market can be attributed to: 1) a lower proportion of individual investors; 2) higher transaction costs; 3) a lack of market-making system in the stock market.

1) Firstly, from the perspective of investor structure, the high level of institutionalization in the Hong Kong stock market and the small proportion of individual investors have led to a lower level of market liquidity.

Generally speaking, institutional investors, due to their focus on long-term and value investing, tend to have more rational trading behavior and lower turnover rates compared to individual investors. Therefore, markets with a higher proportion of individual investors usually have more active trading, while markets with a higher proportion of institutional investors may face liquidity issues.

Overall, the proportion of institutional investors in the Hong Kong stock market is relatively high, with a lower level of institutionalization compared to the US stock market but higher than the A-share and Korean stock markets. According to the latest "Spot Market Trading Research Survey 2020" released by the Hong Kong Stock Exchange in April 2022, the investor structure in the Hong Kong stock market exhibits characteristics of institutionalization and internationalization.

In terms of institutionalization, institutional investors contributed 56.5% of the total trading volume in the Hong Kong stock market in 2020, with a year-on-year increase of 3.1 percentage points. This proportion has remained above 50% since the availability of survey data in 2008, indicating a high level of institutionalization in the Hong Kong stock market. According to statistics from the Federal Reserve, the market value of stocks held by institutional investors at the end of 2020 accounted for 60.0% (remaining unchanged at the end of 2021), and it has consistently remained above 60% since 2002.

2) Secondly, in terms of transaction costs, the Hong Kong stock market has relatively high trading costs primarily due to stamp duty, which makes it difficult to attract a wider range of investors and more trading activities.

In general, lower transaction costs can attract more high-frequency traders and other investors to participate in market trading, thereby contributing to a continuous flow of liquidity to the market. On the other hand, lower transaction costs can also objectively promote existing investors to expand their trading volume, thereby improving the level of market liquidity.

Overall, the difference in trading costs between the Hong Kong Stock Exchange and other major exchanges is not significant. However, due to the higher stamp duty imposed by the Hong Kong Special Administrative Region government, as well as other fees such as trading levies and share delivery fees in the Hong Kong stock market, the overall transaction costs are significantly higher than those in the A-share and US stock markets. Currently, the stock stamp duty collected by the Hong Kong Special Administrative Region government is 0.13%, and it is collected from both the buyer and the seller, resulting in a total stamp duty of 0.26% of the total transaction amount, which is 5.2 times higher than the reduced rate in mainland China.

In terms of average transaction fees, the Hong Kong stock market has a range of 0.17% (internet brokers) to 0.39% (traditional brokers), with stamp duty accounting for a higher proportion. Its comprehensive transaction fee rate is significantly higher than the 0.08241% (Shanghai and Shenzhen Stock Exchanges) to 0.0915% (Beijing Stock Exchange) in the A-share market and around 0.0016% in the US stock market, making it difficult for high-frequency and quantitative traders to conduct transactions in the Hong Kong stock market, which hinders the trading activity of investors. According to data from the Hong Kong Monetary Authority, in 2020, market makers, high-frequency traders, quantitative funds, hedge funds, and other large traders accounted for 67.9% of the total market trading volume in the United States, while in Hong Kong, this proportion was only 28.1%.

3) Finally, in terms of market mechanisms, the Hong Kong stock market does not have a competitive market maker system to ensure a good level of market liquidity.

In the United States, Nasdaq has adopted a competitive market maker system to improve market liquidity and increase its market share in trading business. Nasdaq requires that every stock listed and traded on its platform must have at least two market makers providing market-making services. Market makers acquire inventory stocks through IPO allocations or purchases from the open market and provide competitive continuous bilateral quotes. Investors can choose market makers for trading.

Currently, there are over 500 market makers providing market-making services for stocks listed on Nasdaq, with an average of 14 market makers for each stock. Due to intense market competition and Nasdaq's high liquidity rebates, market makers need to continuously optimize their quotes to increase trading volume. Investors can quickly find the best prices for trading. Therefore, the bid-ask spread and trading efficiency in the Nasdaq market are at a relatively high level. Faster trading speed and better bid-ask spread also attract more investors to trade on Nasdaq, thereby promoting the liquidity of the Nasdaq market.

Currently, the Hong Kong Stock Exchange has established market maker mechanisms in the Exchange Traded Fund (ETF) market and the Hong Kong Dollar - Renminbi dual counter mechanism, and has implemented measures such as trading fee and stamp duty exemptions. Market makers continuously quote bid and ask prices for relevant securities and accept investors' buying and selling requests at those prices to provide liquidity to the market. According to the Hong Kong Stock Exchange's instructions regarding market maker responsibilities, the bid-ask spread entered by market makers into the system should be controlled within a certain range, and the minimum value of the market maker's quote should also meet the relevant requirements. Therefore, in general, investors can expect to quickly complete transactions at reasonable prices in the corresponding market, thus ensuring sufficient liquidity for the relevant securities.

Currently, the ETF market maker and dual counter market maker mechanisms are operating well. The average daily turnover (ADT) of Hong Kong Stock Exchange ETFs has increased from HKD 5 billion in 2019 to the current HKD 13.9 billion, with a compound annual growth rate of 29%. Under the continuous market-making of dual counter market makers, the total ADT of all 24 Renminbi counter securities reached HKD 1.5 billion as of August 25, accounting for 0.53% of the total ADT of dual counter securities, and the bid-ask spread for all 24 securities in Renminbi and Hong Kong Dollar counters remained within 1%. However, the market maker mechanism has not been implemented in the spot market, so the overall Hong Kong stock market cannot benefit from the continuous market-making of market makers to achieve an abundant level of liquidity, making it difficult to improve the level of liquidity.

Looking ahead, the improvement of liquidity in the Hong Kong stock market is promising.

1. The reform of the Growth Enterprise Market (GEM) is expected to accelerate, improving the liquidity and attractiveness of small and medium-sized companies' stocks.

As mentioned earlier, the liquidity of the Hong Kong stock market is relatively concentrated at the top, while stocks of small and medium-sized companies have poor trading volume due to lack of investor attention. The low turnover rate of stocks of small and medium-sized companies is also one of the important reasons why the overall liquidity level of the Hong Kong stock market lags behind other markets.

Therefore, to improve the overall liquidity level of the Hong Kong stock market, it is necessary to enhance the liquidity and attractiveness of stocks of small and medium-sized companies. To improve the secondary market trading conditions of stocks of small and medium-sized companies, strict screening and quality control on the asset side are essential. Currently, the overall fundamentals of companies listed on the Growth Enterprise Market (GEM) of the Hong Kong Stock Exchange are not favorable. As of the end of 2022, there were a total of 340 listed companies on the GEM, with an average market value of only HKD 250 million. Among them, only 98 companies achieved profitability in 2022, accounting for 28.82% of the overall GEM market. Therefore, the relatively poor quality of listed companies makes it difficult for the GEM to attract investors, especially institutional investors.

On the other hand, to enhance the liquidity and visibility of small and medium-sized companies' stocks, the participation of more institutional investors is essential. With their substantial capital advantage, if institutional investors participate more in the trading of small and medium-sized companies' stocks, it will significantly improve their market turnover and liquidity. In addition, due to the mature investment systems and strong research resources possessed by institutional investors, their participation will significantly enhance the market transparency and visibility of small and medium-sized companies' stocks, thereby further promoting the improvement of their liquidity.

Previously, Paul Chan Mo-po, the Financial Secretary of the Hong Kong Special Administrative Region, pointed out in the government's Financial Budget for the 2023-2024 fiscal year that the Hong Kong Stock Exchange will propose specific reform suggestions for the GEM within this year and initiate formal consultations. According to Christopher Hui, the Secretary for Financial Services and the Treasury of the Hong Kong Special Administrative Region, the Hong Kong Stock Exchange has been requested to "take a comprehensive approach when reviewing relevant matters, including reviewing the listing regime and the second market trading mechanism." It is expected that under the promotion of these measures, the attractiveness of the GEM to issuers and investors will significantly increase, and there will be more high-quality issuers listing on the GEM with the participation of more institutional investors.

2. Market trading costs are expected to decrease, attracting more investors and encouraging more trading

The impact mechanism of market trading costs on market activity is relatively clear and significant. As mentioned earlier, the current trading costs in the Hong Kong stock market, including stamp duty, are relatively high. The stock transaction stamp duty rate collected by the Hong Kong Special Administrative Region government is 0.13%, and it is collected on both the buy and sell sides. This rate is significantly higher than the trading costs after the cancellation of stamp duty in the US stock market, and it is also significantly higher than the pre-adjustment rate of 0.1% and the post-adjustment rate of 0.05% in mainland China. This situation is not conducive to the participation of large-scale traders such as quantitative investors and high-frequency traders in the Hong Kong stock market, nor is it conducive to improving the trading activity of existing investors.

Previously, the Hong Kong Securities and Futures Professionals Association publicly called for the revocation of the stock transaction stamp duty by the Hong Kong government. On August 27, Hong Kong Chief Executive Carrie Lam responded to a reporter's inquiry about whether the stock transaction stamp duty would be reduced, stating that "different possibilities will be studied." If the stock transaction stamp duty in Hong Kong is reduced in the future, it is expected to attract more types of investors, including quantitative investors and high-frequency traders, to participate in Hong Kong stock trading. At the same time, it is also expected to encourage existing participants to engage in more trading, thereby assisting in the long-term competitiveness and liquidity improvement of the Hong Kong stock market.

3. If the market maker system is widely introduced, it is expected to provide more liquidity to the market

Objective analysis shows that compared to stocks of large star companies, stocks of small and medium-sized companies have relatively low market attention. Due to the lack of investor participation, there may be situations where orders cannot be executed in a timely manner and there is a large spread between buying and selling prices. This, in turn, may further suppress the enthusiasm of investors to participate in trading small and medium-sized company stocks, which is detrimental to the improvement of market liquidity. On the other hand, active market makers can act as liquidity providers by continuously providing bid and ask prices to the market and accepting investors' trading requests, thereby improving the speed and certainty of transactions and narrowing the bid-ask spread, thus injecting sufficient liquidity into the market.

Looking at the successful experience of NASDAQ, its high trading rebates and effective competitive market maker system have ensured good liquidity for stocks traded on NASDAQ, especially for stocks of small and medium-sized companies, gradually increasing its market share in trading business.

In the Hong Kong stock market, the market maker mechanism introduced by the Hong Kong Exchanges and Clearing Limited (HKEX) in ETF products and the dual counter model has made significant contributions to the improvement of market liquidity. The continuous and healthy operation of the market maker mechanism has also accumulated rich experience for market infrastructure providers such as exchanges, market participants like market makers, and regulatory agencies, providing conditions for the smooth operation of possible market maker mechanisms in the future. If HKEX can introduce an effective market maker mechanism in the spot market in the future, it is expected to significantly improve the current situation of insufficient liquidity and low trading volume in some Hong Kong stocks, thereby enhancing the overall liquidity of the Hong Kong stock market.

4. Continuously expanding mutual market access and actively attracting more international capital

As a typical offshore market, attracting more international capital is necessary to further enhance the trading volume and liquidity of the Hong Kong stock market. Currently, the proportion of holdings by non-local investors in the Hong Kong stock market is relatively high. In 2020, 41.2% of the total trading volume in the Hong Kong stock market came from non-local investors (including mainland China), a decrease of 2.1 percentage points compared to the previous year, but it has remained around 40% since 2008. The trading volume from local investors in Hong Kong accounted for only 30.8%.

In addition, 28.1% of the trading volume comes from exchange participants, namely directional proprietary trading and derivative hedging transactions by securities firms themselves. In terms of investor sources, in 2020, 47.7% of the total trading volume generated by non-local investors in the Hong Kong stock market came from Asian investors (including mainland China), an increase of 5.4 percentage points compared to the previous year. In recent years, with the continuous expansion of mutual market access between mainland China and Hong Kong and the rapid development of the Asian economy, the trading volume from Asian investors has been increasing, from 25.6% in 2008 to 47.7% in 2020. In addition, in 2020, the proportion of investors from Europe, the United States, and other regions in the total trading volume of non-local investors was 24.4%, 23.2%, and 4.7%, respectively.

In the future, on the one hand, HKEX can continue to expand and deepen its mutual market access mechanism with mainland China. For example, it can accelerate the promotion of RMB-denominated Hong Kong stocks, promote the introduction of block trading mechanisms, REITs, and other products into the scope of trading, and continuously attract more RMB funds to participate in Hong Kong stock trading. On the other hand, in the future, the Hong Kong Stock Exchange can actively attract incremental funds from countries and regions including the Middle East.

Charles Li, CEO of the Hong Kong Stock Exchange, has stated that the current size of large sovereign wealth funds in the Middle East is about $4 trillion, with only 1% to 2% of their total assets invested in mainland China through Hong Kong. With the continuous improvement of the Hong Kong Stock Exchange's market ecosystem and the increasing demand for Chinese asset investments, it is expected that its investment position in China will have significant room for growth.

Currently, the Hong Kong Stock Exchange is actively expanding its international influence. It has established offices in New York, USA, London, UK, and other places. The first FII PRIORITY Asia Summit, co-hosted by the Hong Kong Stock Exchange, the Hong Kong SAR Government, and FII (Future Investment Initiative), will be held in Hong Kong, China from December 7th to 8th, 2023. If there is more participation from countries and regions such as the Middle East in the trading of Hong Kong stocks in the future, it will bring abundant incremental funds to the Hong Kong stock market, significantly enhancing its international competitiveness and market liquidity.