Asset Transactions Integrated Thoroughfare:An Integrated Transactions Operating System

to Support Hong Kong’s Financial Development

Prof. Jerome YenCenter for Advancement of E-Commerce Technologies (CÆCT)

Department of Systems Eng. and Eng. ManagementThe Chinese University of Hong Kong

Prof. David YeungDepartment of Finance and Decision Sciences

Hong Kong Baptist University

1. Preamble

In the rapidly developing environment of the global financial system, an individual country is in the position of Alice in Through the Looking Glass -- just to remain standing still, it would have to run faster and faster. This observation is especially pertinent in the case of Hong Kong, for other (South East Asian) countries have actively been vying to challenge the SAR’s position as one of the world’s five leading financial centres. Though average stock market turnover has been steadily increasing, if Hong Kong is to preserve the status quo and more importantly to move forward, we have no alternative but to continuously innovate and enhance the degree of financial intermediation which the SAR’s markets and institutions are able to offer, to international as well as domestic investors (particularly in the Mainland). With this end in view, the present paper submits to the Securities and Futures Commission a case for a pilot study of the Asset Transactions Integrated Thoroughfare -- ATIT -- which has been specifically designed to support the further development of financial intermediation in Hong Kong’s asset markets.

2. Financial Sophistication and Economic Development

A close relationship exists between a country’s financial sophistication and economic development (Tobin 1998). The tangible wealth of the country consists of its natural resources, stocks of goods, and net claims against the rest of the world. The country also possesses intangible wealth, in particular the skills and knowledge of its people, and the framework of law and conventions which support social interaction, co-operation, decentralised decision making, markets and exchange. Many elements of the nation’s wealth are appropriable, so that these assets can be owned and exchanged, publicly by the government or privately by individuals and other legal entities. Appropriable assets are often intangible, for example patents and copyrights, as well as tangible, for example plant and equipment . In a modern capitalist society, capital markets allow the nation’s wealth to be transferred from individual to individual.

An individual in such an economy may be wealthy without directly owning any of the assets which fall under national wealth. Typically, a personal balance sheet would include money of different kinds (coins and notes and bank deposits), bonds, stocks, shares in mutual funds, and the present values of insurance policies and pension rights. Adding up the net worth of all the individual economic entities, paper claims and paper obligations cancel out, leaving the value of

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national wealth. If the government is excluded, private net worth then consists of two parts: privately owed items (tangible and intangible) of national wealth, and government obligations to the private sector. Generally, these “outside” assets are not directly owed by private individuals, but indirectly, through the intermediation of “paper” or financial debts and claims known as “inside” assets and liabilities, and their corresponding markets. Financial intermediation therefore transforms real items of privately owned outside wealth into a range of inside or financial assets, in which its ultimate owners hold wealth in a money-using economy.

Though inside assets net out in aggregate accounting, the inside financial network is essential for the efficient functioning of the money-using market economy. Financial markets deal in paper contracts and claims, which allow inside assets and debts to be created and exchanged for each other and for outside assets, thereby enabling individuals to hold their savings and arrange inter-temporal allocation of consumption in a variety of forms in a money-using market economy. Financial markets complement the market for real properties, by allowing trading in assets which are promises to pay at specific dates specific amounts of money (often conditional upon future events and environments), therefore facilitating the intertemporal transfer of general purchasing power over goods. In particular, it would be possible for private individuals to buy a real property and pledge it as security against instalment payments in terms of a paper contract, for businesses to acquire capital goods in exchange for paper loans, and for households to purchase homes on the strength of paper mortgages. Because of the elimination of barter requirements and the substitution of money-denominated financial assets, transactions cost is significantly reduced in each case, leading in particular to the creation of new financial products and additional markets to support the intertemporal allocation of consumption and production.

It is seen, therefore, that financial intermediation contributes to efficiency and growth by transforming items of outside wealth into inside or financial forms. By supporting the creation and exchange of inside assets, financial markets begin this process of intermediation. Financial intermediaries continue the process, by adding products, services and markets, and co-operating with individuals in other markets to support intertemporal optimisation in consumption, saving and investment. The typical financial intermediary buys and sells and creates financial assets, holding a balance sheet almost entirely composed of financial assets and paper liabilities with few real assets beyond buildings and equipment of the trade, and displaying small owners’ equity in comparison to financial obligations. As major participants in modern financial markets (often as market makers and innovators), financial intermediaries are distinct from middlemen like brokers and dealers, whose function is to execute transactions on behalf of other individuals. In particular, banks and non-bank financial institutions stand between financial assets such as commercial loans, mortgages, consumer credit and derivatives based on such assets, and financial liabilities such as demand deposits, savings deposits, and certificates of deposit. Insurance companies and pension funds purchase financial assets such as government and corporate bonds and mortgages, to hold against financial liabilities in the form of contracts with policy-holders and obligations to pay retirement income. Investment companies intermediate by collecting and pooling the savings of individuals, investing them in a wide variety of financial assets, and professionally managing the portfolios on behalf of (fund) shareholders.

Economic theory distinguishes a number of means by which financial intermediation can be achieved and enhanced:

(i) Convenience of denomination and reduction of transactions cost, (ii) The pooling, reduction, and allocation of risk, (iii) Maturity shifting, and (iv) Transformation of illiquid assets into liquid liabilities through financial innovation.

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It is then possible for financial intermediation to reduce (output held constant) the society’s requirements for outside money, net worth and tangible capital. Modern economic activity therefore demand asset markets in which financial intermediaries are major participants, to provide a wide (and increasing) range of heterogeneous assets, risk pooling and transfer. According to the classic study by Goldsmith (1985), the degree of financial intermediation in any economy is indicated by the (gross) value of financial assets, with maturity in this sense occuring when the ratio between financial and tangible assets reaches unity. (This has been the case in the United States, for example, since the end of the 19th century.) With the current trend towards global deregulation, new opportunities are increasingly circumventing traditional barriers between the different financial intermediaries, bringing outside businesses into areas which have hitherto been preserves of certain firms and enlarging the scope of financial intermediation through the creation of new products. In particular, banks are expanding into institutional investor businesses like insurance and mutual funds, while many investment companies are beginning to offer accounts from which money can be withdrawn on demand or transferred to third parties by cheque or electronic means. Financial conglomerates and financial supermarkets are emerging, which frequently offer a full financial menu of consumer credit, mutual funds, instalment lending, life and non-life insurance.

Two observations follow in particular:

(I) The ability of a country’s markets and institutions to offer financial intermediation determines in large part its relative attractiveness as a financial centre.

(II) The extent and efficiency by which markets and institutions are able to financially intermediate depend crucially on transactions cost, in the broad sense of the resources which must be expended in the buying and selling of financial assets and to execute optimal investment strategies at a point of time and over time (Cheung 1998). In addition to direct trading costs, the costs of information and portfolio risk management are therefore understood to fall under the rubric of “transactions cost”.

Economic theory suggests that transactions cost in turn depends on the markets’ micro-structure, and on public policy (Cheung op. cit.). In the latter case, it is clear that regulations such as taxes can substantially affect the costs of buying and selling in the asset markets. The present paper concentrates on financial market micro-structure and suggests that in the context of Hong Kong, it is possible to engineer a significant reduction in transactions cost through the introduction of an integrated environment for the SAR’s financial markets, and the implementation of “ATIT” -- an Asset Transactions Integrated Thoroughfare -- to support such a development.

3. The Micro-Structure of Hong Kong’s Financial Markets

It is convenient to briefly consider current trading procedures in Hong Kong’s financial markets, from the perspective of transaction cost in the broad sense.

3.1. Current Equity Trading Procedures

According to current practice, individuals trading equities place instructions through brokers, which manually transfer the orders to the trading room for transmission to the Stock Exchange of Hong Kong (SEHK)’s Automatic Order Matching and Execution System (AMS) for queuing. After order matching, buying or selling are completed, brokers and clients then settle

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accounts (the latter with the SEHK within two days), with the necessary transaction(s) processed through the Hong Kong Securities Clearing Co. (HKSCC).

3.2. Current Futures Trading Procedures

Two avenues are currently available for equity derivatives trading, the Open Outcry System and the Automated Trading System.

3.2.1. Open Outcry System

Open outcry is employed in the market for Hang Seng Index Futures and Hang Seng Index Options. With instructions on hand, floor representatives of brokers which are members of the Hong Kong Futures Exchange (HKFE) congregate at the trading pit, where orders are transmitted through the crying out of buying and selling prices. Upon the matching of bids and offers floor representatives would withdraw to finalise the transaction, which would then be reported to the clients concerned. Simultaneously, the deal would be referred to the HKFE Clearing Corporation (HKCC) for registration and settlement.

3.1.2. Automated Trading System (ATS)

ATS is an electronic screen-based system, trading all derivative products apart from Hang Seng Index Futures and Hang Seng Index Options. The central marketplace is operated by the HKFE, and instead of crying out in the trading pit, brokers buy and sell on behalf of clients through their ATS terminals. The ATS is designed to automatically match orders in terms of price and time priorities, with transactions being transmitted to the HKCC for registration and settlement after confirmation.

3.2. Actual and Potential Problems

During testing in July 1999, the ATS was unable to pass a loading test. More generally, because orders are executed through brokers instead of being directly transmitted to the AMS, a number of problems are seen to arise:

(i) Relatively high direct transactions cost to investors;(ii) Relatively low informational transparency in securities trading;(iii) Possibilities for illegal short selling;(iv) Absence of power of disposal or protection for stocks stored with brokers.

4. An Integrated Financial Trading Environment and ATIT.

It is seen that opportunities exist, by which transactions cost can be reduced in Hong Kong’s financial markets. As noted in Section 2 above, the cost of acquiring and processing information contribute importantly to transactions cost in financial activities. During the past decade, the SEHK has invested heavily in technology to facilitate the transfer of information from brokers to other elements of Hong Kong’s financial markets, in particular the SEHK itself, the HKFE, and the HKSCC. Further efforts in this direction seem warranted. According to the Association of Chartered and Certified Accountants, disclosure of major shareholders in listed companies is insufficient, and it is difficult for the public to obtain reliable information regarding the status of listed companies. Individuals who experience problems in accessing and collecting financial

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information are often forced to rely unduly on the advice and decisions of brokers, thereby creating opportunities for market manipulation and (illegal) short selling.

The SFC has long recognised the importance of informational transparency and transactions cost to the efficiency and development of Hong Kong’s financial markets. The forthcoming merger of the SEHK and HKFE represents an important institutional reform directed towards this desideratum. The separation between stock exchange and futures exchange and the existence of two clearing houses suggest the possibility of a reduction in transactions cost through economies of scale, issuing from the merger of the exchanges and clearing houses and ultimately the combination of the resulting institutions. In addition, a comprehensive and accessible central database would be more easily established and maintained under the auspices of the new body, while the change from T + 2 to T + 0 and its effective monitoring are likely to remove opportunities for illegal short selling. The introduction of Internet trading under the control of the merged bodies would constitute another important step towards enhanced accessibility to Hong Kong’s financial markets, thus reducing direct transactions cost for both foreign and domestic (including Mainland) investors.

Following the logic of the above developments, an integrated financial environment to enhance Hong Kong’s financial development can be constructed schematically as follows:

In the first place, a major change will issue from the replacement of the existing Stock Exchange and Futures Exchange by a new trading centre, and the replacement of the two existing Clearing Houses by one such facility. The responsibilities for stock and futures trading will be assumed by the new centre, while the new clearing house will settle all transactions conducted in this centre.

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The Asset Transactions Integrated Thoroughfare -- ATIT -- is designed to support an integrated environment as depicted above. Leaving the discussion of its architecture to the following section, we point out that, apart from general effects on financial sophistication and competitiveness as a financial centre, several market-specific benefits can be expected from ATIT’s implementation as the operating system supporting Hong Kong’s integrated financial environment:

(i) Reduction in transactions cost;(ii) Increase in trading volume at lower average cost;(iii) Increase in financial intermediation, competitiveness in the supply of financial services, and

efficiency in intertemporal resource allocation;(iv) Increase in informational transparency in financial activities;(v) More effective policing of illegal activities such as market manipulation and short selling;(vi) More effective monitoring and control;(vii) Possibility of 7 - 24 trading at low cost.

In addition, an ATIT-supported integrated trading environment is expected to facilitate new developments and financial engineering innovations. In particular, we note:

(i) Virtual stocks and other securities;(ii) Online trading;(iii) Personal accounts and direct trading;(iv) Real-time transactions and settlement;(v) Monitoring and (indirect) control.

Given the recent financial crisis, item (e) is worthy of special mention. According to Soros (1998), a high degree of instability is inherent in the global financial markets, due in large part to “reflexive” (feedback) behavior under uncertainty. Under the ATIT systems architecture proposed in Section 5 an early warning sub-system would be in place, to monitor Hong Kong’s financial activities for signs of Greenspanian “irrational exuberance” and market disorder. Given early warning, it would be possible to devise stabilising counter-measures, in particular to introduce a reduction or temporary suspension of trading if unduly large fluctuations are detected in the markets, or if the monitoring sub-system should indicate the presence of manipulative activities such as insider trading.

5. ATIT Systems Architecture

It is proposed that, to support the integrated trading environment discussed in the previous section, the following ATIT system be designed and introduced.

1. Processing power will based on the 10 percent of the peak trading volume during the past five years with a safety factor of 5

2. For database design, database should be able to store information of 300,000 personal accounts.3. Processing and response time should not be longer than the current system use in SEHK.

5.1 System Users

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5.2 System ModulesOrder Matching System

- brokerage interface- automatic order matching

Order Execution System- transaction verification- trading rules enforcement- automatic deposit calculation- account balance checking

Transaction Monitoring System- automatic breaking mechanism- transaction irregularity tracing,

logging, warning and reporting- statistics generation

Account Management System- account management- stocks settlement- account enqiry- margin calculation and margin

offset equationMonetary Settlement System

- connection to banks/CMU/RTGS

User Authentication System- user account

management- secure authentication

serviceRemote Administration System

- system control- backup/restore- maintenance- security policies

enforcementDisaster Recovery System

- automatic detection and activation

- alarming service- intelligent watchdog

Event Announcement System- multi-channel automatic

announcement/alert service- event announcement

pushing mechanismUser Interface System

- user interaction interface- feedback solicitation- email communication

channel

5.3 Network Layout

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6. ATIT Software and Technology

6.1 DevelopmentJava ServletsJava Servlets will be used to address the problems currently associated with server-side programming, including inextensible scripting solutions, platform-specific APIs, and incomplete interfaces. Using Java Servlets, the server-side functionality can be packaged as a DLL file, which can efficiently sold out server attention to multiple clients using the same executable file. They are used for the communication between the trading system and clients, such as, brokers.

CORBACORBA is an important tool for effortlessly writing cross-platform, cross-language, and distributed object-oriented component. It provides a clean object-oriented interface to low level network access. The distributed objects can locate on client side to make requests of objects on server side without any prior knowledge. Reusable CORBA components will be used in building the modules to support the transactions of client-to-trading system and the trading-to-clearinghouse system.

Agent TechnologyAs the system will process huge amount information with great variety, which are primarily stored in an enterprise relational database management system (RDBMS), that would generate an immense need to manage the information overflow problem. A set of software agents will be developed to transfer information to and from different system modules, monitor the performance of the system, and increase the overall efficiency of the system.

PHPPHP can enable server-side scripting with HTML. It can bring tremendous dynamic elements to web page authoring. Furthermore, its capability to interact with different databases adds to its advantage as a scripting engine.

PL/SQL & Pro*CSQL stored procedures will be used to enhance the efficiency of the system when doing complicated querying and updates. Together with Pro*C, systems development will be smoother and the whole development cycle will be shortened because SQL statements can be directly embedded in the C or C++ source code without much modification.

6.2 BackendOracle and Oracle Application ServerOracle8i has been designed to be a Java and Internet enabled relational database. It has advanced features, such as, large-database partitioning, flexible security, parallelism, and excellent multi-versioning concurrency control. In addition, our system will be built with High Reliability and High Availability in mind, in which a High Availability database such as Oracle can definitely increase the uptime of the system. To bridge the clients and the database, Oracle Application Server will be deployed in the 2nd tier to serve as a database gateway. It enhances the network I/O of the overall system and hence increases system scalability.

Sun ClusterDowntime in the system is absolutely not tolerable as this is a mission critical trading system. Therefore, we need clusters of computers or two high-end servers with multiple CPUs and sufficient shared memory to support searching and processing of information of individual accounts. Fail-over and load balancing are also important to provide higher quality-of-service

(QoS) to the users. A clustering software will be used to provide High Availability service, such as, fault tolerance, automatic fault recovery, dynamic load balancing, easy manageability, and single system image (SSI).

6.3 Client PresentationXMLFor HTML, the tag semantics and tag set are fixed, therefore, it cannot tell you about data, only display the contents in a browser. XML is not static tags, it lets you grab data from any SQL database. This makes building dynamic XML easily and quickly. Simply by returning your query, without re-creating the HTML, it can bind and display the new data to Web clients. An XML interface enables Internet Account User and Broker to query market information and support transactions among different components of the centralized trading system.

JavaJava is an Object Oriented programming language. Especially, it is a platform independent language. It can run client application identically on most operation systems (Win98/WinNT/Unix … etc.) or electronic appliances, such as, Jini. Java supports the development of a complete infrastructure for Internet-base E-Commerce and E-Trading. It will be the core of user interface development of the trading system.

JavaScriptJavaScript is a scripting language to add interactive features to Web documents. With JavaScript you can perform calculations, customize graphics selection, capture events, as well as include other special effects. JavaScript can be a client-side scripting for creating content for Web pages and providing preliminary validation for user input of User Interface in Web.

7. Concluding Remarks

The present paper submits to the Securities and Futures Commission a case for a pilot study of the Asset Transactions Integrated Thoroughfare -- ATIT -- to support an integrated trading environment for Hong Kong’s financial markets. It is expected that the design and installation of the ATIT system in question can be completed within nine months. The successful implementation of the proposed pilot study will enhance confidence in the development and benefits of an integrated trading environment for Hong Kong’s financial activities, and will create a cost-effective opportunity to simulate the operation of such a framework, and to test the introduction of new institutions and complex financial engineering innovations and their effects on the SAR’s future position and competitiveness as a financial centre.

In particular, it is expected that the new ATIT system will significantly reduce transactions cost, in the broad sense of the resources which must be expended in the buying and selling of financial assets, to execute optimal investment strategies at a point of time and over time, and to pursue risk management and control. The potential degree of financial intermediation the SAR’s institutions and markets can offer will in turn increase, leading to an increase in competitiveness and a strengthening of Hong Kong’s relative position as one of the world’s leading financial centres.

References

Cheung, S.N.S., The Transaction Costs Paradigm, Economic Inquiry, 1998.Goldsmith, R., Comparative National Balance Sheets. Chicago: University of Chicago Press, 1985.Soros, G., The Crisis of Global Capitalism. New York: Public Affairs, 1998.Tobin, J., Money, Credit, and Capital. New York: McGraw Hill, 1998.