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Technology and financial globalization

Introduction

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 ofscale will eventually drive down costs and increase competitiveness. The rise of the Internetand 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 reducedtransaction costs. Being a portal in this global trading network has become a critical factor forsuccess.

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

Technology-driven competition

Technology is driving the transformation of the global financial marketplace. There aredifferent facets of technology that have contributed to the emergence of an increasinglyinterrelated global marketplace with strong linkages between cash and derivative markets.

First, advances in telecommunications and information processing offer financial institutionsthe 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 ofmarkets. 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 aneffort to reduce high development costs in technology and to increase market share.

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

Third, methodological breakthroughs in the pricing of sophisticated derivatives products have

led to the invention and marketing of new financial instruments and trading strategies inrepackaging risk and return profile. The process of unbundling and redistribution of risk andreturn has strengthened cross-market linkages and has blurred the traditional demarcation of"cash" and "futures" markets.

Internet trading

As the world's stock and futures exchanges grapple with the issue of electronic trading andalliances, a quiet revolution has already been taking place on the Web: Internet trading of

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securities, particularly in the US. Before 1995, Internet trading did not exist. Today, investorscan 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 onlineinvesting accounts would grow to 14 million by the year 2002 with assets managed online

reaching US$688 billion1.

In the US, the success of online trading specialists like E*Trade, and the traditional discountbrokerage firm Charles Schwab, which has made perhaps thesmoothest transition to onlinetrading, has been dramatic. For example, Charles Schwab opened 1.4m new accounts during1998 and ending the year with 5.6 million active accounts. The number of online transactionshas averaged 93,000 a day during the fourth quarter of 1988, which accounted for 61% of thetotal transactions during the same period.

Online trading is becoming increasingly popular in the US, but the rest of the world still hasquite a way to catch up. For example, in Hong Kong, there are only a handful of brokersoffering online trading services on domestic stocks. Some 50% of inhabitants in the US havePCs and. 23% of inhabitants have Internet access, compared with 23% and 11 % in HongKong. Forward-looking US online brokerage firms will continue to charge ahead with

ambitious geographic expansion. For example, E*Trade is already offering online services inCanada, Australia and New Zealand and plans to start operating in the UK in 1999.

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

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

Basic transactional and information services will become commoditised and competeincreasingly on price alone. By offering no-frills execution and on-line research andanalytics, online brokers will continue to attract sophisticated or self-directed investors withcompetitive pricing. This will diminish the role of local brokers in trade execution aloneservice.

In an effort to stay ahead of the pack amid growing competition, established online brokerswill 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*Tradeannounced it planned to take a stake in an online investment bank called E*Offering, which isexpected to begin underwriting public offerings for sale to E*Trade subscribers. This willallow retail investors to get into the primary as well as the secondary market, furthernarrowing the gap between institutional investors and their retail counterparts.

Technological speaking, the combination of the Internet technologies is able to create newvirtual exchanges, thereby undermining the role of traditional exchanges. The core functions

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of an exchange are to bring together buyers and sellers, provide a mechanism for pricediscovery 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 andenabling price discovery via browsing or search engines.

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.

y How safe is trading of securities on the Internet? The key is to ensure that the datacarrying the order across the Internet is adequately encrypted so that it cannot beemulated and sent to competitors. The system should be made secure from hackerstrying to break in and damage orders or generate orders that were bogus. The solutionto this problem is public key cryptography, where each trade placed online wouldhave its own unique digital fingerprint so that interested parties could be absolutelycertain who was the author and where it came from.

y Temporary service breakdowns that have hit leading online brokerages have raisedconcerns about protection of online investors. When online brokers suffer outages,

their customers stand to lose much more than just access to the markets, but losttrading opportunities and even financial losses. Perhaps regulation may be requiredfor third party certification that online trading system capacities can handle spikes indemand.

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

Online trading will inevitably involve cross-border transactions. This highlights theneed, to adegree, to globalise supervision in order to avoid the risk of inconsistent regulation. Thealternative would be the use of firewalls and barriers to insulate certain markets and playersfrom the global marketplace.

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

Alliances and mergers of exchanges

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

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Alliance of exchanges is not confined to continental Europe. CME, MATIF and SIMEXannounced 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 electronicplatform 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 SINEXadopting the French trading system, the MATIF adopting the CME's clearing system and the

CME implementing the French trading technology. This arrangement allows SIMEX andCME the access to a transatlantic platform without incurring high initial development costs innew electronic trading systems. In return, by offering direct access to traders based in the USand Asia, MATIF would be able to draw business away from its competitor, Liffe, in Euriborfutures, the benchmark product for interest rates in the core EMU zone.

The rapid pace of consolidation of exchanges coupled with high initial development costs ofelectronic trading systems exerts enormous pressure on small exchanges whose incomesdepend on a narrow product range. The cost base of small exchanges may not allow them toremain independent for much longer.

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 diversegeographical locations, unification and consolidation ofexchanges' functions provide animportant means for cost reduction.

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

Regional portals of a global trading network

Electronic trading and remote access will attract investors to do business in any exchangeswith the largest pool of liquidity. Exchanges are battling over price, efficiency and liquidityin 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 inEurope is a clear example.

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 byMSCI Taiwan stock index futures and option in 1997 and the Dow Jones Thailand stockindex futures in November 1998. The domestic Singapore equity market remained essentiallyout 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 indexfutures contract in November 1998 in direct competition with the HKI7E's flagship HangSeng products. SIMEX's contracts are based on the MSCI Hong Kong+ Index (HiMSCI+),which has a 99.995% correlation with the Hang Seng Index.

In price-efficient securities markets, no net benefit can be expected from spending extraresources on active management strategies in trying to beat the market "index". Thus,

portfolio indexing can be the optimal investment strategy. In particular, the use ofbenchmarks tailored to individual pension funds' liabilities has increased. For example, the

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use of individual benchmarks for UK pension funds has grown from less than 5% in 1990 tomore 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 furtherendorsement of using indexing as a strategy in gaining an edge in the global marketplace.

Conclusion

Thus a number of important issues affect our securities market. These include the impact ofthe advancement of information technology and the market globalization on the securitiesmarket. As a regulator, these changes affect the way we conduct business. We have to keepthese issues in mind and monitor their development.