Source: CITIC Construction Investment Securities Research

On August 27, the Chief Executive of the Hong Kong Special Administrative Region, Li Ka-chao, announced that the government would set up a working group headed by Financial Secretary Chan Mao-po to study how to increase liquidity in the stock market. Relevant details are expected to be announced soon.

A Brief Study on the Liquidity of the Hong Kong Stock Market

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

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

In the first half of 2023, due to multiple factors such as overall market pressure and relatively tight liquidity, the average daily transaction amount of Hong Kong stocks fell 16% to HK$115.5 billion; the average daily turnover rate was only 0.19%, -0.03 pct over the previous year.

Liquidity differentiation in the Hong Kong stock market is quite obvious, and trading shows significant concentration towards the top

Overall, the stock liquidity of large capitalization companies in Hong Kong has been clearly good over a long period of time, and Hong Kong stock trading has shown significant concentration at the top. If stocks of Hong Kong listed companies with a market capitalization of HK$30 billion and above are called shares of large capitalization companies and those with a market value of HK$30 billion or less are called shares of companies with a small market capitalization, then from the beginning of 2023 to August 25, the average daily turnover rate of Hong Kong stocks with a large market capitalization company reached 0.36%, which is significantly higher than 0.19% of Hong Kong stocks as a whole and 0.17% of small capitalization company stocks.

Contrary to Hong Kong stocks, NASDAQ and the Japan Exchange are actively trading stocks of small-cap companies, and their liquidity is relatively good. If you examine the average daily turnover rate levels of the NASDAQ and Japan Stock Exchange in the different market segments, the Nasdaq Capital Market (Capital Market) and the Eastern Stock Exchange Growth Market, which are mainly dominated by small capitalization and high growth companies, have had average daily turnover rates of 4.42% and 2.31% since the beginning of 2023, which is significantly higher than the overall 2.23% and 0.80% of NASDAQ and the Japanese Stock Exchange and other market segments, showing that their small-capitalization companies' stocks have a better level of market liquidity.

Since the liquidity of the Hong Kong stock market is mainly concentrated on the stocks of leading large capitalization companies, while the stock liquidity levels of NASDAQ and Japanese stock companies with small market capitalization companies are good, overall, the liquidity of Hong Kong stocks with large market capitalization companies is not poor in comparison. The difference in liquidity levels between the Hang Seng Index and blue chip indices such as the Nikkei 225 Index and the Nasdaq 100 Index is far less than the overall market; the reason why the overall liquidity level of Hong Kong stocks is poor compared to the NASDAQ and the Japanese Stock Exchange may be mainly due to the fact that stocks of small capitalization companies are relatively less liquid.

A brief analysis of the reasons for poor liquidity in Hong Kong stocks

In summary, we think the reasons for the poor liquidity in the Hong Kong stock market can be attributed to: 1) the low share of individual investors; 2) high transaction costs; and 3) the lack of a market maker system in the stock market.

1) First, judging from the investor structure, the Hong Kong stock market has a high level of institutionalization, and the small share of individual investors has led to a low level of market liquidity.

Generally speaking, since institutional investors place more emphasis on long-term investment and value investment styles, their trading behavior is more rational, and the turnover rate level is far lower than that of individual investors. Therefore, under normal circumstances, market transactions with a relatively high share of individual investors tend to be more active, while markets with a relatively high share of institutional investors are relatively likely to face the problem of poor liquidity.

Overall, Hong Kong stocks account for a relatively high share of institutional investors. Their level of institutionalization is lower than that of US stocks but higher than A-shares and South Korean stocks. According to the “Spot Market Trading Research Survey 2020” recently released by the Hong Kong Stock Exchange in April 2022, the Hong Kong stock market investor structure shows characteristics such as institutionalization and internationalization. In terms of the degree of institutionalization, 56.5% of the total transaction amount of Hong Kong stocks in 2020 was contributed by institutional investors, with a year-on-year increase of 3.1 pct. Since survey data were available in 2008, it has remained above 50%, indicating a high degree of institutionalization of the Hong Kong stock market. According to statistics from the Federal Reserve, institutional investors held 60.0% of the market value at the end of 2020 (the same as at the end of 2021), and has remained stable at over 60% since 2002.

In contrast, individual investors in A-shares and Korean stocks occupy the mainstream. According to estimates, as of the end of 2020, A-share institutional investors accounted for only 33.68% (36.91% at the end of 2021). A large number of shares of listed companies were concentrated in the hands of individual investors and general legal entities, accounting for 34.5% and 24.7% respectively at the end of 2020 (26.2% and 26.6% at the end of 2021). Meanwhile, in 2020 and 2021, individual investors in the Korea Exchange contributed 76.44% and 73.02% of the total transaction amount, respectively, and occupied the absolute mainstream of the market.

Therefore, as described above, due to the higher share of individual investors, A-shares and Korean stocks are relatively more active. The Shenzhen Stock Exchange, Shanghai Stock Exchange, and Korea Stock Exchange have long ranked in the top three turnover rates among major exchanges in the world. In particular, South Korea's stamp duty is also at a high level in the world, but it has not significantly affected its liquidity, showing that individual investors are relatively sensitive to stamp duty.

Unlike the Hong Kong stock market, the liquidity of US stocks also remains at a high level of institutionalization. We believe that on the one hand, it is due to the low transaction costs of the US market, which makes quantitative and high-frequency trading popular, and on the other hand, it has a complete market maker system. We will analyze the reason 3) described below.

2) Second, in terms of transaction costs, the Hong Kong stock market, which is mainly based on stamp duty, has relatively high transaction costs, making it difficult to attract more types of investors and more transactions

Overall, on the one hand, lower transaction fees can attract more high-frequency traders and other investors to participate in market transactions, thereby contributing a steady stream of liquidity to the market; on the other hand, lower transaction costs can also objectively encourage existing investors to expand their transaction scale, thereby promoting the improvement of market liquidity levels.

Overall, the gap between transaction fees on the Hong Kong Stock Exchange and other major exchanges is not obvious, but since the stamp duty rate levied by the Hong Kong SAR government is high, and in addition to stamp duty, there are also other fees such as transaction levies and share settlement fees in the Hong Kong stock market, so its overall transaction cost is significantly higher than that of A-shares and US stocks.

Currently, the stock stamp duty collected by the Hong Kong Special Administrative Region Government is 0.13%, and is collected bilaterally from buyers and sellers. The total stamp duty collected amounts to 0.26% of the total transaction amount, 5.2 times after the reduction in mainland China; overall, the average transaction fee rate for Hong Kong stocks is 0.17% (Internet brokerage) to 0.39% (traditional brokerage firms), of which stamp duty accounts for relatively high levels; its comprehensive transaction rate is significantly higher than 0.08241% of A-shares (Shanghai and Shenzhen Exchange) to 0.0915% (Beijing Stock Exchange) and US stocks, resulting in high trading volume and 0.0016% Chemical transactions It is difficult for such types of investors to trade in the Hong Kong stock market, which has dampened investors' trading activity.

According to data from the Hong Kong Financial Development Council, large traders such as market makers, high-frequency traders, quantitative funds, and hedge funds in the US accounted for 67.9% of total market transactions in 2020, compared to only 28.1% in Hong Kong, China.

3) Finally, from the perspective of the market mechanism, the Hong Kong stock market does not have a competitive market maker system to ensure a good level of market liquidity

In the US, in order to improve market liquidity and increase the market share of trading business, NASDAQ has adopted a bidding+competitive market maker system. NASDAQ stipulates that every stock listed and traded on the NASDAQ must be provided by two or more market makers to provide market-making services. Market makers obtain treasury stocks and provide competitive continuous bilateral offers through IPO placements or stock purchases from the open market, and investors can choose market makers on merit to trade.

Currently, there are more than 500 market makers that provide market-making services for the shares of companies listed on the NASDAQ. On average, there are 14 market makers for each stock. However, due to sufficient market competition and NASDAQ's high liquidity cashback compensation, market makers need to continuously optimize prices to obtain an increase in transaction amounts, and investors can also quickly find the best price to trade.

Therefore, the NASDAQ market's bid-ask spread and transaction efficiency are at a good level. However, the faster transaction speed and better bid-ask spread have also attracted more investors to trade on the NASDAQ, thus promoting the increase in liquidity in the NASDAQ market.

At present, the Hong Kong Stock Exchange has set up a market maker (market maker) mechanism under mechanisms such as the Exchange-Traded Product (ETF) Market and the Hong Kong Dollar-RMB Dual Counter Model, and has adopted exemptions from transaction fees and stamp duty; market makers continuously report bilateral offers for relevant securities to investors, and accept investors' trading requirements at this price level to provide liquidity to the market. According to the Hong Kong Stock Exchange's instructions on the bookmaker's responsibility, the bookmaker input system should be kept within a certain range, and the minimum price quoted by the dealer must also meet the relevant requirements; therefore, generally speaking, the minimum price quoted by the dealer must also meet the relevant requirements; therefore, generally speaking, Investors are expected to quickly complete transactions at reasonable prices in the corresponding markets, thus ensuring sufficient liquidity of related securities.

Currently, the ETF bookmaker and dual counter bookmaker mechanism are working well. The ADT of the Hong Kong Stock Exchange ETF has increased from HK$5 billion in 2019 to HK$13.9 billion at present, with an average compound annual growth rate of 29%. However, as of August 25, all 24 RMB counter securities have a total ADT of 1.5 billion yuan, accounting for 0.53% of the total ADT of their dual counter, and the price difference between all 24 securities in RMB and Hong Kong dollars remains within 1%.

However, at present, the bookmaker mechanism has not been implemented in the spot market, so Hong Kong stocks as a whole cannot benefit from the abundant liquidity brought to them by the continuous market trading of market makers, making it difficult to achieve an increase in liquidity levels.

Looking forward to the future, the liquidity of the Hong Kong stock market can be expected to improve

1. The GEM (GEM) reform is expected to accelerate, increasing the liquidity and attractiveness of small to medium capitalization companies' stocks

As mentioned earlier, liquidity differentiation in the Hong Kong stock market is quite obvious, and transactions are clearly concentrated at the top; while stocks of small to medium capitalization companies have poor transactions due to lack of investor attention; the low turnover rate level of stocks of small to medium capitalization companies is also one of the important reasons why the overall liquidity level of Hong Kong stocks lags behind other markets.

Therefore, improving the overall liquidity level of the Hong Kong stock market is inseparable from increasing the liquidity and attractiveness of stocks of small to medium capitalization companies. However, in order to promote the improvement of the stock trading conditions of small to medium capitalization companies in the secondary market, it is first inseparable from strict screening and quality control on the asset side.

Currently, the overall fundamentals of Hong Kong GEM (GEM) listed companies are poor. By the end of 2022, there were 340 listed companies on the Hong Kong GEM, with an average market value of only HK$250 million; of these, only 98 companies achieved profits in 2022, accounting for 28.82% of the overall GEM market; therefore, the relatively poor quality of listed companies made it difficult for GEM to attract the attention of investors, especially institutional investors. On the other hand, increasing the liquidity and attention of stocks of small to medium capitalization companies is also inseparable from the participation of more institutional investors.

With the advantage of large amounts of capital, if institutional investors participate more in stock trading of small to medium capitalization companies, it is easier to significantly increase their market turnover and liquidity levels. Furthermore, since institutional investors have mature investment systems and strong research resources, the participation of institutional investors will significantly enhance market transparency and interest in the stocks of small to medium capitalization companies, thereby further promoting the increase in their liquidity levels.

Earlier, the Financial Secretary of the Hong Kong Special Administrative Region Government, Mr Chan Mao-po, stated in the government's “Budget” for the 2023-24 fiscal year that the Hong Kong Stock Exchange will put forward specific reform proposals on GEM within this year and begin formal consultations. Meanwhile, according to the Secretary for Financial Services and the Treasury of the Hong Kong Special Administrative Region Government, Hui Ching-yu, has now requested the Hong Kong Stock Exchange to “make comprehensive considerations when reviewing related matters, including reviewing the listing system and the secondary market trading mechanism.” It is expected that in the future, under the impetus of relevant measures, GEM's appeal to issuers and investors will increase significantly. In the future, more high-quality issuers will be listed on GEM and more institutional investors will participate in GEM transactions.

2. Market transaction costs are expected to decrease, attract more investors to participate, and encourage more transactions

The mechanism of influence of market transaction costs on market transaction activity is quite clear and obvious. As mentioned earlier, the Hong Kong stock market currently has high transaction costs, including stamp duty, etc., and the stock transaction stamp duty rate collected by the Hong Kong SAR government has reached 0.13%, and is collected on both sides. There is a big gap between the transaction costs of US stocks after the stamp duty was abolished. It is also significantly higher than 0.1% before the adjustment in mainland China and 0.05% after the adjustment. It is not conducive to quantitative investment, high-frequency trading, etc., participating in Hong Kong stock market investment and increasing the transaction activity of current investors.

Earlier, the Hong Kong Securities and Futures Professional Association publicly called for the Hong Kong government to cancel stamp duty on stock transactions; on August 27, in response to reporters' questions about whether stock stamp duty would be reduced, the Chief Executive of the Hong Kong Special Administrative Region, Li Ka-chao, also stated that “we will study different possibilities”. If future cuts in Hong Kong stock stamp duty may be expected to attract more types of investment, including quantitative investment and high-frequency trading, to participate in Hong Kong stock trading, it is also expected that existing participants will be encouraged to trade more, thereby helping to improve the long-term competitiveness and liquidity level 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

Objectively speaking, compared to stocks of large star companies, stocks of small to medium capitalization companies themselves receive less attention in the market. Due to lack of investor participation, it is more likely that orders cannot be executed in a timely manner and the trading price difference is too large. In turn, it may further suppress investors' enthusiasm to participate in small to medium capitalization company stock transactions, which is not conducive to the increase in market liquidity. Active market makers, on the other hand, can act as liquidity providers, improve transaction execution speed and certainty by continuously providing bilateral offers for trading to the market and accepting transaction requirements from investors, and can also reduce trading price differences, thereby continuously injecting sufficient liquidity into the market.

Judging from NASDAQ's successful experience, it guarantees good liquidity for stocks traded on NASDAQ through high transaction rebates and an effective competitive market maker system, especially stocks of small to medium capitalization companies, thus achieving a gradual increase in the market share of the trading business.

Meanwhile, in the Hong Kong stock market, the bookmaker mechanism currently introduced by the Hong Kong Stock Exchange under the ETF product and dual counter model has also made a very positive contribution to the corresponding increase in market liquidity; while the continued healthy operation of the bookmaker mechanism has also accumulated rich experience for market infrastructure providers such as exchanges, bookmakers, and regulators, and other market participants, and regulators, providing conditions for the smooth operation of possible future bookmaker mechanisms.

If the Hong Kong Stock Exchange spot market can introduce an effective market bookmaker mechanism in the future, it is expected to significantly improve the current unfavorable situation where some Hong Kong stocks have insufficient liquidity and long-term low turnover, thereby helping to improve the overall liquidity of the Hong Kong stock market.

4. Continue to expand connectivity and actively attract more international capital to participate

As a typical offshore market, in order to further increase the turnover and liquidity of Hong Kong stocks in the future, it is necessary to attract more international capital to participate. Currently, foreign investors account for a relatively high share value in the Hong Kong stock market; in 2020, 41.2% of the total turnover of Hong Kong stocks came from foreign investors outside Hong Kong, China (including mainland China), a year-on-year decrease of 2.1 pct, but it has remained around 40% since 2008; while local investors from Hong Kong, China only accounted for 30.8% of the turnover. Furthermore, 28.1% of the turnover comes from exchange participants, that is, the brokerage firm's own directional self-operation and derivatives hedging transactions.

In terms of investor sources, 47.7% of the total trading volume generated by foreign investors in the Hong Kong stock market in 2020 came from Asian investors (including mainland Chinese investors), +5.4 pct over the previous year. Moreover, in recent years, with the continuous expansion of connectivity between mainland China and Hong Kong and the rapid development of the Asian region's economy, the total amount of transactions from Asian investors has continued to rise, from 25.6% in 2008 to 47.7% in 2020. Furthermore, investors from Europe, the US and other regions accounted for 24.4/23.2/4/ 7% of total foreign investor transactions in 2020, respectively.

In the future, on the one hand, the Hong Kong Stock Exchange will continue to expand and deepen the connectivity mechanism with the mainland. For example, it can continue to attract more RMB capital to participate in Hong Kong stock trading by accelerating the RMB pricing of the Hong Kong Stock Exchange, promoting the introduction of a bulk trading mechanism, and the inclusion of more products such as REITs in the target; on the other hand, in the future, the Hong Kong Stock Exchange can also actively attract incremental capital participation from more countries and regions, including the Middle East.

The CEO of the Hong Kong Stock Exchange, Ou Guan Sheng, once said that currently the size of large sovereign wealth funds in the Middle East is about 4 trillion US dollars, and their capital investment in mainland China through Hong Kong, China only accounts for 1% to 2% of their total assets. However, with the continuous improvement of the Hong Kong Stock Exchange market ecosystem and its increasing demand for Chinese asset investment, it is expected that its investment position in China will have huge room for improvement.

Currently, the Hong Kong Stock Exchange is actively expanding its international influence. The Hong Kong Stock Exchange has opened offices in New York, London, UK, etc., and the first FII PRIORITY Asia Summit organized by the Hong Kong Stock Exchange, the Hong Kong Special Administrative Region Government, and FII (Future Investment Initiative) will be held from December 7 to 8, 2023 in Hong Kong, China. If more capital from the Middle East and other countries and regions participate in Hong Kong stock market transactions in the future, it will bring rich incremental capital to Hong Kong stocks, thereby significantly enhancing their international competition power and market liquidity.

Risk warning

The implementation of the policy fell short of expectations: Currently, the Chief Executive of the Hong Kong Special Administrative Region, Li Ka-chao, has announced that the government will set up a working group headed by Financial Secretary Chan Mao-po to study how to increase the liquidity of the stock market. Details are expected to be announced soon. If the implementation and implementation of relevant policies falls short of expectations, it may be difficult to raise the overall liquidity level of the Hong Kong market.

The results of the market system reform fell short of expectations: Earlier, Hong Kong Securities Regulatory Commission Chief Executive Leung Fung-yee said that the Hong Kong Stock Exchange may conduct a public consultation on GEM reform in the second half of this year; if the relevant market system reforms fall short of expectations, it may be difficult to improve the quality and liquidity of stocks of small to medium capitalization companies in the Hong Kong market, which is not conducive to an increase in overall market liquidity.

Fluctuations in the macro environment exceeded expectations: As a typical offshore market, the asset side of the Hong Kong stock market is dominated by listed companies in mainland China, while the capital side is dominated by international investors, which is more likely to be affected by fluctuations in the domestic and international macro environment. If future macroeconomic environment fluctuations exceed expectations, it may put a lot of pressure on the Hong Kong market, which is not conducive to improving market liquidity and international competitiveness.

Editor/Somer