The days of physical share certificates may be coming to an end. Enter electronic or "scripless" securities – where ownership is represented only digitally. The format is expected to become the global standard in coming years. Thanks to two key initiatives relating to the digitization of securities holdings and new-listing material, Hong Kong is making significant progress in this area.
Hong Kong law currently requires paper documents i.e. share certificates to prove legal ownership of shares. Given the vibrancy of the Hong Kong securities market, this can lead to operational inefficiencies associated with paper-based operations. In January 2019, the HKEX, Securities and Futures Commission ("SFC") and Federation of Share registrar released a joint consultation paper on implementing an uncertificated securities market[1]. That was the first initiative. The second came in July 2020, when the HKEX proposed a paperless listing and subscription regime in conjunction with changes to the physical display requirements for select documents[2].
Before we explore the conclusions drawn from these initiatives and what companies should do to prepare, it's worth understanding how both proposals contribute to the development of a scripless market.
The Hong Kong Securities Market Moves Closer to the Digital Age
The first initiative on an uncertificated securities market proposed the digitization of securities holdings (known as dematerialization) and the removal of the need for manual processes. This move will enhance the efficiencies of the underlying market infrastructure, making it more competitive. Investors should then able to have direct legal ownership over their securities electronically instead of only beneficial ownership through a nominee structure. This would strengthen legal protection and provide transparency.
The second initiative recommended the introduction of a regime where all listing documents and subscriptions for new listings are only available in electronic formats. Companies only need to publish certain documents online instead of putting them on physical display.
In essence, each initiative's idea is to guide the Hong Kong securities market toward a more digital-based format without the need for share certificates. Such moves would simultaneously enhance investor's legal protection and overall efficiency.
The Revised Operational Model
The uncertificated securities initiative started back in 2010, and the original idea was to allow all securities held within the Central Clearing and Settlement System ("CCASS") to be held directly by investors rather than nominees. Yet, they faced an operational roadblock. In the CCASS system, securities settlement is done continuously throughout the day, while money settlement is done on a net basis at the end of the day.
This gap between securities and money settlement allows the CCASS to settle securities efficiently – a 99.9% settlement efficiency rate. Transferring the legal titles directly to investors would require that securities and money settlement be done almost simultaneously. This would increase costs and lower settlement efficiencies, negating much of the current benefits of the CCASS.
Ultimately, no comprehensive solution could be found. In the revised operational model proposed in 2019, it was decided that the nominee structure would remain within the CCASS. Investors who want to hold direct legal ownership of their securities must do outside the CCASS through two new account types – a USI account (an uncertified shareholder account opened with the issuer's share registrar) for retail investors and a USS account (an uncertified shareholder account opened with a sponsoring CCASS participant) for institutional investors. For both USI and USS, all legal title transfers will be done electronically.
Resistance to Digital Initiatives
The above operational compromise aside, it was interesting to see that, although most investors/stakeholders were positive, a few raised objections to these scripless initiatives. For instance, in the conclusions to the paperless listing and subscription regime[3], the HKEX noted that:
- A sizable minority of institutional investors felt that such a regime would discriminate against investors who lack access to the internet or prefer physical documents
- A few also wished to impose restrictions on printing and downloading of online display documents for fear of competitive harm, including recording viewers' personal details
While HKEX ultimately disregarded those objections, their nature raises a question: how prepared are the market participants for the coming shift?
Learn to Embrace the Digital Shift
The paperless listing and subscription regime will take effect on 5 July 2021. The amended requirements for documents on display will come into force three months later, on 4 October. Although this is a relatively small change compared to the uncertificated securities market initiative, companies should still prepare. Implementing things like hybrid meeting for AGMs and e-proxy to enable virtual participation of shareholders will put them and their investors ahead of the game when digitalization moves from optional to mandatory for the entire securities market.
Implementing the more ambitious operational model for a scripless market will take longer time. Legislation must be approved, and the underlying market infrastructure modified. The uncertificated securities market regime is targeted to begin tentatively in 2022 with a phased approach. IPOs will be the first to go scripless, followed by shares within the CCASS (under the nominee structure). Complete dematerialization currently does not have any hard deadline. Transfers or the further issuance of shares will need to be paperless. Shares in listed Hong Kong companies will also be the first to become scripless.
A Compromise Solution but Further Changes are Expected
The revised operational model that will be implemented is a compromise. As the consultation paper noted, in the UK, both securities and money settlement can be conducted simultaneously. Doing the same in Hong Kong would require "wide scale infrastructural changes", from systems and operational processes to regulations.
For the moment, the HKEX and SFC have decided not to do so, resulting in shares within the CCASS still having to be held under the nominee structure. This may change in the future. Securities markets from various jurisdictions are constantly competing to attract capital flows, meaning improvements are inevitable.
Digitalization – More Than a Passing Phase
It will be understandable if some companies assume that digitalization is a near-term fix to help them manage their way through the current operational environment. This is not the case. Businesses should grasp that these changes are permanent and, therefore, prepare accordingly. A vital part of the process is keeping up to date with the latest developments and guidance on implementing the electronic model. Industry bodies have a role here, with the HKEX hosting industry discussions to ensure that all affected parties are included in the decision-making process. Businesses are urged to be proactive and participate in these sessions. Simultaneously, they can begin the internal change process by ramping up their digital transformation programs.
[1] https://www.hkex.com.hk/-/media/HKEX-Market/News/Market-Consultations/2016-Present/January-2019-USM/Consultation-Paper/USMCP_2019_EN.PDF
[2] https://www.hkex.com.hk/-/media/HKEX-Market/News/Market-Consultations/2016-Present/July-2020-Paperless-Listing/Consultation-Paper/cp202007.pdf
[3] https://www.hkex.com.hk/-/media/HKEX-Market/News/Market-Consultations/2016-Present/July-2020-Paperless-Listing/Conclusions-(Dec-2020)/cp202007cc.pdf
