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Moving the Goalposts: Financial Market Regulation in Hong Kong and the Crash of October 1987

Published online by Cambridge University Press:  27 December 2018


The article examines the operation of the Hong Kong stock and futures exchanges during the crash of October 1987 and in particular the controversial decision to close the exchanges. It argues that the closure decision exposes a serious conflict of interest and abuse of power on the part of the major decision makers and fundamental flaws in Hong Kong's self-regulatory system. Moreover, these events raise broader questions about the strengths and weaknesses of different regulatory regimes and about the value of different theoretical explanations of regulatory behavior. In particular, it is argued that the most influential theory concerning the regulation of financial markets—that of certain Chicago School economists—raises as many questions as it answers, and that an alternative view which locates cultural and organizational factors at its core provides a more satisfactory explanation of the events of October 1987.

Copyright © American Bar Foundation, 1990 

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1 When dollars are used in this article, they are, unless otherwise stated, Hong Kong dollars. At the time of writing, rates of exchange were HK$7.8 = US$1.Google Scholar

2 Although the Futures Exchange had a guarantee fund intended for such contingencies, it had only modest assets and would almost certainly have been unable to cope with the likely level of default.Google Scholar

3 Turnover on the futures market grew from some 1,600 contracts a day in February 1986 to more than 14,000 a day in August 1987. The underlying value of the stocks traded on the futures market was HK$4.3 billion. The stock market traded HK$4.3 billion a day. Economist, Oct. 31, 1987, at 73.Google Scholar

4 Asian Wall St. J., Oct. 22, 1987, Oct. 23, 1987.Google Scholar

5 For details of Mr. Li's considerable personal impact on the affairs of the Hong Kong Exchange over many years, see M. F. Higgins, Securities Regulation in Hong Kong 1972–1977 11 (Sijthoff, Holland, 1978). See also Far Eastern Economic Rev., Apr. 16, 1987, at 45.Google Scholar

6 For a belated reinterpretation of these events by Mr. Jacobs (“I don't regard a single phone call as consultation”), see South China Morning Post, Dec. 24, 1987.Google Scholar

7 The Hong Kong Futures Exchange was not completely closed. It continued to trade its other products, namely sugar, soybeans, and gold, throughout the crisis.Google Scholar

8 The decision served only to defer the problem, to prevent those who wished to trade from doing so, and to drive business to other international markets, further depressing those markets.Google Scholar

9 The Hang Seng Index traded a peak of 600,000 contracts in the month of September 1987. Turnover has declined since the crash and for most of 1988 was only 30–40,000 contracts a month. In the stock market, Hong Kong also fared worse than other world markets, attributed primarily to the closure. See “World Stockmarket Review,”Australian Financial Rev., Mar. 14, 1988, at 10 and “Market Crash Batters Global Trading,”Asian Wall St. J., Mar. 21, 1988, at 1.Google Scholar

10 See, e.g., “US Markets Barely Survived the Crash,”Asian Wall St. J., Nov. 23, 1987, at 1.Google Scholar

11 To put this in context, the City of London closed down in 1939 for a day when Britain declared war on Nazi Germany and did not do so again for 17 years, when the same decision was made during the height of the Suez crisis.Google Scholar

12 This is referred to by some as the nirvana fallacy—where any discrepancy between the real and ideal is viewed as proof that the real is inefficient—the ideology of market failure and state success.Google Scholar

13 Coase, R. H., “The Problem of Social Cost,” 3 J. L. & Econ. 1 (1960).CrossRefGoogle Scholar

14 See, e.g., S. Tolchin & M. Tolchin, Dismantling America: The Rush to Deregulate (Boston: Houghton Mifflin, 1983). For a useful explanation of the deregulation initiatives, see R. Stewart, “Regulation and the Crisis in Legislation in the United States,”in T. Daintith, ed., Law as an Instrument of Economic Policy: Comparative and Critical Approach 124–26 (Berlin: De Gruyter, 1988).Google Scholar

15 See, e.g., Posner, R., “Theories of Economic Regulation,” 5 Bell J. Econ & Mgrnt. Sci. 335 (1974);Stigler, G., “The Sizes of Legislatures,” 5 J. Legal Stud. 17 (1976); R. E. McCormick & R. D. Tollison, Politicians, Legislation and the Economy: An inquiry into the Interest-Group Theory of Government (Boston: M. Nijhoff, 1981).CrossRefGoogle Scholar

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17 For general discussions of state-supervised self-regulation, see Moore, S. F., “Law and Social Change,” 7 Law & Soc'y Rev. 719 (1973).Harter, P. J., “Negotiated Regulation: A Cure for Malaise,” 71 Georgetown L. J. 1 (1983);Teubner, E., “Substantive and Reflexive Elements in Modern Law,” 17 Law & Soc'y Rev. 239 (1983).CrossRefGoogle Scholar

18 Report of the Committee to Review the Functioning of Financial Institutions (The Wilson Committee), Cmnd7937, Vol. 4 (1977), p. 89, para. 5. Evidence of Bank of England quoted in A. Page, “Self Regulation: The Constitutional Dimension,” 49 Mod. L. Rev. 141 (1986).Google Scholar

19 See, e.g., R. A. Posner, Antitrust Law: An Economic Perspective (Chicago: University of Chicago Press, 1976).Google Scholar

20 See, e.g., G. Teubner, Jurification of Social Spheres ch. 1 (Berlin: European University Institute, 1987).CrossRefGoogle Scholar

21 The interaction between these different policy mechanisms is often a complex one. For example, it has been pointed out that in the case of stock markets in particular there has been considerable deregulation in the last decade (e.g., abolition of fixed commissions and the broker/jobber distinction) accompanied, paradoxically, by the introduction of self-regulatory measures motivated largely by a desire to protect investors from the potential adverse effects of deregulation. Nowhere is this more true than in the U.K., as a result of the Big Bang and the introduction of the Financial Services Act of 1986. See, e.g., W. Kay, The Big Bang (London: Weidenfield & Nicholson, 1986).Google Scholar

22 This will not invariably occur. It has been pointed out that in England, the extra costs resulting from the new regulatory framework established by the Financial Services Act of 1986 have led to increased participation by small investors in unit trusts, where transaction costs are much lower. Large investors (e.g., pension funds) still use the market to the same extent because they are able, through volume of trade, to negotiate for lower commissions.Google Scholar

23 I am not suggesting that efficiency is the only criterion against which to judge the value or success of a particular policy. It might be argued, for example, that social justice demands that the unwary and unsophisticated market user be protected beyond the point which is optimal for efficiency.Google Scholar

24 At a microlevel there is a developing literature on self-regulation, although almost none of it directly concerns issues of financial market regulation.Google Scholar

25 R. Schmelensee, Preface, in E. J. Kane, The Gathering Crisis in Federal Deposit Insurance (Cambridge: MIT Press, 1985).Google Scholar

26 See in particular P. Stenning, C. Shearing, & S. Addario, “Insider Policing: Securing Compliance in a Financial Market” (unpublished, University of Toronto, Center of Criminology, 1986) (“Stenning et al., ‘Insider Policing’”).Google Scholar

27 See generally Ewick, P., “Redundant Regulation: Sanctioning Broker-Dealers,” 7 Law & Pol. 421 (1985);Hagan, J. &Parker, P., “White Collar Crime and Punishment,” 50 Am Soc. Rev. 302 (1985);Orrick, A. D., “Organisation, Procedures and Practices of the Securities and Exchange Commission,” 28 Geo. Wash. L. Rev. 51 (1959);Jennings, R. W., “Self-Regulation in the Securities Industry: The Role of the SEC,” 29 Law & Contemp. Probs. 630 (1964 Posner, R. A., “A Statistical Study of Antitrust Enforcement,” 13 J.L & Econ. 365 (1970 Treadway, J. C., “SEC Enforcement Techniques,” 32 Washington & Lee L. Rev. 637 (1975); S. Phillips & J. R. Zecker, The SEC and the Public Interest (Cambridge: MIT Press, 1981); S. Shapiro, Wayward Capitalists (New Haven, Conn.: Yale University Press, 1986).CrossRefGoogle Scholar

28 See also Veljanovski, C., “Organised Futures Contracting,” Int'l Rev. L. & Econ. 5, 2838 (1985).Google Scholar

29 Hedging is a form of price insurance whereby the hedger establishes a futures position that is opposite to a cash position. For example, a farmer intending to produce a wheat crop in a future month may wish to ensure that the price he receives at that time is not less than the market price projected for the time of delivery. To achieve this, he may sell a futures contract for a specified amount of wheat at a fixed price in a particular delivery month. By doing so, he loses the chance to profit from any subsequent rise in the price of wheat above that for which he has agreed to sell. On the other hand, he knows he will not suffer any loss should the market price fall below the agreed futures price.Google Scholar

30 In the U.S., commodity futures now trade more than three times the volume of stocks traded on the New York and American stock exchanges combined. In 1986, 213.5 million futures and options contracts were traded in the pits of 14 U.S. exchanges. The most explosive growth has been in stock index futures. Daily trading in the Standard and Poor's 500 stock index contract has risen from $1 billion a day in 1982 to as much as $12 billion per day in 1987. Wall St. J., 1 Nov. 1987, at 1.Google Scholar

31 A viable futures exchange could not exist without some form of regulation. Few would be prepared to trade on a market where contracts might not be honored (and where the potential insolvency of one's trading partner might preclude effective enforcement), where there were no guarantees against being defrauded and few, if any, effective remedies if such fraud took place, where traders might form coalitions with a view to exercising market power, and where market rigging and a host of other manipulative practices might be rife. Such a market could provide no stability or predictability of trading, would involve very high transaction costs, and would soon wither away. This was recognized very early in the history of futures trading. See M. Y. Abolafia, “Self-Regulation as Market Maintenance: An Organization Perspective,” in R. G. Noll, ed., Regulatory Policy and the Social Sciences 317 (Berkeley: University of California Press, 1985) (“Abolafia, ‘Self-Regulation as Market Maintenance’”).Google Scholar

32 The United States comes closest to this form of regulation. Its securities and futures markets are among the most heavily regulated institutions in the world, and the SEC has a reputation for diligence and effectiveness in regulating the securities market. How ever, even in the U.S., self-regulation has played an influential role in the governance of financial markets, particularly in the case of the futures markets, where the obligation of contract markets to regulate themselves (subject to oversight by the Commodity Futures Trading Commission) is contained in various sections of the Commodity Exchange Act and in the accompanying CFTC regulations and guidelines. As the chairman of the Commodity Futures Trading Commission recognized in 1984, “The only way that we can … support the industry growth is by increased reliance on self-regulation. We are working with the exchanges to assume more and we're also looking to [the National Futures Association] to take on more of our regulatory functions.”“CFTC Chairman Predicts Growth, Sees Challenge in International Markets,” 16 Sec. Reg. & L. Rep. 169, 177 (Bureau of National Affairs, Washington, D.C., 1986).Google Scholar

33 Coregulation can take a number of forms. In its less interventionist form it involves leaving day-to-day matters largely to exchanges themselves, with government taking a back-seat role, merely ensuring that only authorized markets are permitted to trade, and periodically reviewing exchange operations, asserting its reserve power only if the self-regulators' actual exercise of authority proves manifestly inadequate. In this case, the exchange itself will have responsibility for regulating the behavior of members by promulgating rules, monitoring behavior, and determining violations, subject to government oversight. Or it might (as under the British model following Big Bang and the enactment of the Financial Services Act of 1986) involve: “statutory regulation monitored by self-regulatory organisations recognised by, and under the surveillance of, a self-standing Commission.” See Gower, J.,” ‘Big Bang’ and City Regulation,” 51 Mod. L. Rev. 122 (1988). More generally on enforced self-regulation (though not concerned directly with financial markets), see J. Braithwaite & B. Fisse, “Self-Regulation and the Control of Corporate Crime,” in C. Shearing & P. Stenning, eds., Private Policing (New York: Russell Sage, 1987) (“Braithwaite & Fisse, ‘Self-Regulation and the Control of Corporate Crime’”).CrossRefGoogle Scholar

34 See in particular E. Bardach & R. Kagan, Going by the Book: The Problem of Regulatory Unreasonableness (Philadelphia: Temple University Press, 1982); Braithwaite & Fisse, “Self-Regulation and the Control of Corporate Crime”; Stenning et al., “Insider Policing.” More generally, see M. Moran, The Politics of Banking (London: Macmillan, 1986); Braithwaite, J., “Enforced Self-Regulation: A New Strategy for Corporate Crime Control,” 80 Mich L. Rev. 1466 (1985).Google Scholar

35 For a sophisticated critique of self-regulation by lawyers, see Abel, R., “Why Does the ABA Promulgate Ethical Rules?” 59 Tex. L. Rev. 639 (1981), in which he argues that professional ethics codes are so amorphous that they can have no function except to legitimate in the eyes of the public the bar's relative freedom from outside control. See also Abel, , “Toward a Political Economy of Lawyers,” 1981 Wis. L. Rev. 1117, 1177; and M. Larson, The Rise of Professionalism: A Sociological Analysis (1977); Akers, R. L., “The Professional Association and the Legal Regulation of Practice,” 2 Law & Soc'y Rev. 463 (1968).Google Scholar

36 Abolafia, “Self-Regulation as Market Maintenance” (cited in note 33).Google Scholar

37 F. Rohatyn, senior partner, Lazard Freres, N.Y., Wall St. J., Mar. 1985, quoted in A. Hamilton, The Financial Revolution 220 (New York: Viking, 1986).Google Scholar

38 This account is based on two periods of fieldwork in Hong Kong, the first in the weeks immediately following the crash, the second some fifteen months later. The principal method used was informal interviewing of key participants in the markets to elicit their perceptions of the structure of the markets, the system of self-regulation, and the behavior of the players in the years preceding the crash. Overall, more than 30 interviews were conducted with members of the government's regulatory body, with members of the self-regulatory bodies of the two exchanges, with brokers, and other participants in the financial community, including financial advisers and journalists, and with the Independent Commission Against Corruption. Public documents and newspaper reports were also relied upon to supplement data gathered elsewhere. Of particular note is the Report of the Securities Review Committee, Hong Kong, May 1988 (“Hay-Davison Report,” chairman Ian Hay-Davison). This document, titled The Operation and Regulation of the Hong Kong Securities Industry, was published after the initial draft of this article was completed, but it is referred to in the footnotes where its findings serve to document assertions made in the text. Two particular limitations of the research should be noted. First, some Chinese brokers declined to be interviewed. Second, I was denied access to interview junior members of the Futures Exchange's surveillance staff. Parts of this account are inevitably impressionistic. Within Hong Kong, where written documentation is unusual and independent means of verifying events rarely exist (for a graphic example, see Asian Wall St. J., June 1, 1988, at l), where corruption by its very nature is hidden and discreet, a more rigorous research methodology is not practicable.Google Scholar

39 It is not suggested that there was no government involvement in the futures markets. Rather the government's would-be regulatory bodies, the Securities Commission and the Commodities Trading Commission took a purely passive and reactive role, devoting their extremely limited resources to vetting papers rather than active surveillance and monitoring. Lacking support from government, their role in pre-crash events was minimal. See also Hay-Davison Report at 4, 5, and ch. 9.Google Scholar

40 See further at 16 below.Google Scholar

41 In any event, wishing to keep their clients' goodwill, and lacking experience of the consequences of such a sharp fall in prices, it is doubtful whether many brokers were willing to liquidate their clients' contracts.Google Scholar

42 Collective losses on speculators' open positions while the markets closed were estimated at over HK$2 billion. The Economist, Oct. 31, 1987.Google Scholar

43 Asian Wall St. J., Oct. 21, 1987.Google Scholar

44 South China Morning Post, Oct. 21, 1987.Google Scholar

45 All that the Hong Kong Futures Exchange requires is the circulation to clients of a standard risk disclosure document, which explains the possible risks of futures trading.Google Scholar

46 At one stage at least 39 brokers had failed to honor their obligations, although many subsequently did so. As of April 1988, debts amounting to an estimated HK$800 million resulting from pre-Black Monday contracts had still not been settled.Google Scholar

47 “Clearing and Guaranteeing,” Hong Kong Futures Exchange Ltd. and ICCH (Hong Kong) Ltd., 1987, at 3.Google Scholar

49 The Guarantee Corporation, which is owned by the International Commodity Clearing House and six major banks, took the view that its responsibilities extended no further than its net assets. In other futures markets the clearing house is also the financial guarantor. This was not the case in Hong Kong, where there was no direct relationship between the Guarantee Corporation and the Clearing House and the Clearing House accordingly bore no market risk. Not surprisingly, the Hay-Davison Committee recommended that the risk creators take collective responsibility for the integrity of their market and that part of the Clearing House's risk should be backed by a fund made up of deposits from members.Google Scholar

50 The failure of the guarantee fund, in particular, would have had catastrophic con sequences for the futures market. As Edwards, F. R., “The Regulation of Futures Markets: A Conceptual Framework” 1 J. Futures Markets 417 (1981), has pointed out: “It is the assurance of clearing house solvency that permits the expansion of futures contracts to levels well beyond the existing stocks of the underlying deliverable commodity. Insolvency would topple the inverted pyramid, with a thunderous crash. The soundness of the entire futures industry, therefore, depends on the policies and safeguards adopted by clearing associations.”.Google Scholar

51 Because of the enormous sums tied up in stock index futures, (a value of HK$4.3 billion), a substantial number of defaults would have had a very serious impact on the physical stock market, as those who had been arbitraging between the physical and futures markets (being short in the futures market and long in the stock market) would then be obliged to close out their uncovered long positions in the physical market. As one senior fund manager put it: “What is at risk here is the integrity of the payment system in the sense that we are talking about the market's ability to settle contracts which are supposed to be binding.” D. Gresser, GT Management (Asia) Ltd., quoted in Asian Wall St. J., Oct. 22, 1987.Google Scholar

52 Financial Secretary Piers Jacobs, Hong Kong Standard, Nov. 28, 1987.Google Scholar

53 See also Asian Wall St. J., Oct. 21, 1987.Google Scholar

54 Financial Secretary Jacobs, Hong Kong Standard, Oct. 29, 1987.Google Scholar

55 Id., oct. 26, 1987.Google Scholar

56 See, e.g., Higgins, Securities Regulation in Hong Kong 11 (cited in note 5).Google Scholar

57 Until 1970 there was no statutory restraint relating to stock exchanges, but in that year the Legislative Council passed s2A of the Companies Ordinance, whereby any stock exchange that wished to be recognized would have to comply with a list of simple conditions.Google Scholar

58 In November 1973 there were over 1,000 members of the four exchanges, 831 stockbroking firms, nearly all local traders, compared to about 120 in April 1970. See Hong Kong Legislative Council Debates, Dec. 12, 1973, at 263.Google Scholar

59 Id at 264ff.Google Scholar

60 Id, and D. Lethbridge, The Business Environment in Hong Kong 182–83 (Hong Kong: Oxford University Press, 1980).Google Scholar

61 These included the increased rate of placement of securities on the exchanges in stead of public offers, undue influencing of prices and nonrecording of transactions, and a high incidence of forgery, fraud, and insider trading.Google Scholar

62 This required the registration of all stockbrokers, dealers, and investment advisers, the establishment of a compensation fund, and the prohibition of short-selling, option dealing, and forward trading. The ordinance was to be administered by a Commission for Securities and a seven-person Securities Commission. Subsequently, a Commodities Trading Ordinance was introduced to regulate the then relatively insignificant futures market.Google Scholar

63 For a description of the government's political position in the years leading up to 1997, see Fur Eastern Economic Rev., Apr. 7, 1988, at 54.Google Scholar

64 Hong Kong Legislative Council Debates, Dec. 12, 1972, at 282.Google Scholar

65 See Securities Ordinance, §§ 7, 13, 14.Google Scholar

66 Personal communication, D. Murphy, former Commissioner for Securities, P. Thorpe, acting Commodity Trading Commissioner. See also Hay-Davison Report, para. 9.25 (cited in note 39).Google Scholar

67 See, e.g., Fur Eastern Economic Rev., Apr. 7, 1988, at 54.Google Scholar

68 Letter from the Commissioner for Securities and Commodities Trading to the Finance Board of the Government Secretariat, July 19, 1985.Google Scholar

69 See also Hay-Davison Report, p. 5 and ch. 9.Google Scholar

70 Statement by the financial secretary, Sir Philip Haddon-Cave, in the Legislative Council on January 3, 1973, announcing the establishment of the Securities Advisory Council, the forerunner of the Securities Commission.Google Scholar

71 Higgins, Securities Regulation in Hong Kong 12.Google Scholar

72 The consequence of having four stock exchanges was that no uniform set of Standards or rules applied, so listing requirements, trading practices, and financial resources of stockbrokers varied considerably from one exchange to another.Google Scholar

73 Earlier, the exchanges “had restricted the foreigners from trading directly in the market. Instead, they had to channel their business through local brokers. In a rare show of solidarity, the exchanges also agreed that none would lift the measure unilaterally.”Asian Wall St. J., Nov. 27 and 28, 1987.Google Scholar

74 Their position was that membership should only be given to expatriate brokers if reciprocal arrangements were offered by their home countries. As a fallback position it was argued that if foreign brokers were to become members of the unified stock exchange, then there should be different categories of membership, carrying different rights, and that foreign brokers should only be allowed to join at the lowest level.Google Scholar

75 To protect their interests, the constitution of the new exchange excluded corporate members from representation on the general committee of the exchange.Google Scholar

76 The international brokering houses have long complained that many exchange rules seem to rig the system in favor of local traders. See Asian Wall St. J., Nov. 27 and 28, 1987.Google Scholar

77 Even in their relatively disadvantaged position, international brokers saw considerable attractions in doing business in Hong Kong, an unregulated environment where there was ample scope to set up and to make money with no questions asked. As one of them put it, “You just delivered the stock, paid the levy, and laughed all the way to the bank.”.Google Scholar

78 According to the Far Eastern Economic Rev., Nov. 5, 1987, at least five members of the Stock Exchange Committee, including Li himself, either owned or were connected with companies that held long positions in the Hang Seng Index futures market at the time of suspension.Google Scholar

79 South China Morning Post, Nov. 19, 1987.Google Scholar

80 For a useful survey see Higgins, Securities Regulation in Hong Kong (cited in note 5).Google Scholar

81 See Rider, B. A. K., “Insider Dealing: Hong Kong Style,” 128 New L.J. 897 (1978);Krisha, V., “Hong Kong: The Status Symbol of the Insider,” Company Lawyer, 216;South China Morning Post, Oct. 26, 1987.Google Scholar

82 Alan, Au, “Hong Kong Code on Takeovers and Mergers: Toothless Watchdog or Handmaiden of Equality?” 17 Hong Kong L. Rev. 24 (1986).Google Scholar

83 See Far Eastern Economic Rev., Dec. 10, 1987.Google Scholar

84 The actual charge alleges that Mr. Li, “without lawful authority or reasonable excuse, accepted an advantage” in May 1987 in the form of 1.1 million Kumagai Gumi (Hong Kong) shares, allotted to him at HK$2.50 (32 U.S. cents) each. He allegedly accepted the shares as “an inducement or reward” to show favour to the Kumagai issue. Asian Wall St J., Jan. 18, 1988, at 3; Financial Times, London, Jan. 16, 1988, at 3; The Economist, Jan. 9, 1988, at 79.Google Scholar

85 Sydney Morning Herald, Feb. 8, 1988.Google Scholar

86 See Far Eastern Economic Rev., Jan. 14, 1988, at 64.Google Scholar

87 See, e.g., Euromoney, Apr. 1984, at 120.Google Scholar

88 Far Eastern Economic Rev., May 14, 1987, at 78.Google Scholar

89 Manipulation was readily identified by the wild fluctuations in prices on the expiration date for monthly futures contracts. For example, the Far Eastern Economic Rev., May 14, 1987, noted that: “Equity volatility was particularly pronounced on 30 March, the expiry date for the same month's contract, when share prices gyrated wildly throughout the day, and in the last hour alone the HSI swung through a range of 60 points, ending 24 points down on the day (at 2,774.88), and 44 points lower than the quote half an hour before the close.” A similar but less pronounced pattern was noticed at the end of April 1987. Those who were successful in manipulating the market could expect large rewards. For example, in March 1987 one player had reputedly sold 15,000 contracts short and stood to gain $7.5 million for every 10 points the HSI declined. By comparison, the cost of forcing the cash market down was insignificant and there is considerable evidence that this did indeed occur. See Far Eastern Economic Rev., May 14, 1987, at 80. Manipulation has been curbed by an amendment to the rules governing HSI futures trading, whereby the contract value will be determined according to the average of the index taken at five-minute intervals throughout the expiry day.Google Scholar

90 See Higgins, Securities Regulation in Hong Kong.Google Scholar

91 Australian Financial Rev., Feb. 15, 1988, at 10.Google Scholar

92 Ferguson, R. & A. Page, 12 Int'l J Soc. L. 292–99 (1986).Google Scholar

93 See further at p. 36 below.Google Scholar

94 In other exchanges, the major conflicts may be between different groups, for example between floor traders, and between locals and large brokers.Google Scholar

95 Edwards, & Edwards, , “A Legal and Economic Analysis,” 1 J. Futures Markets 356 (1984).Google Scholar

96 Edwards, , 1 J. Futures Markets 436 (cited in note 50).Google Scholar

97 See, e.g., CFTC Report to Congress in response to section 21 of the CFTC Act, Pub. 1 No. 96–276, 96th Cong., 2d Sess. 5, 7, 94 Stat. 542, June 1, 1980, at 124.Google Scholar

98 See, e.g., Marshall, T. H., “The Recent History of Professionalism in Relation to Social Structure and Social Policy,” Canadian J. Econ. & Pol Sci., 158–59 (1939); T. Parsons, “The Professions and Social Structure,”in id, Essays in Sociological Theory 34–39 (Glencoe, III.: Free Press, 1954); P. Halmos, The Personal Service Society (London, 1970).CrossRefGoogle Scholar

99 See, e.g., M. Haug, “The Sociological Approach to Self-Regulation” in R. D. Blair & S. Rubin, eds., Regulating the Professions 68–74 (Lexington, Mass., 1986), and references therein. For a cogent argument about the way lawyers use professional ethics to maintain the power of elite lawyers, see J. Auerbach, Unequal Justice (New York: Oxford University Press, 1976).Google Scholar

100 See, e.g., Rider, B. A., “Self Regulation: The British approach,” 1 J. Comp. Corp. L. & Sec. Reg. 319 (1978) and references cited therein.Google Scholar

101 H. Dykes, Foreword in D. Courtney & E. C. Bettleheim, An Investor's Guide to Commodity Futures Markets (London: Butterworths, 1986). For a less sanguine view of the activities of the city, see M. Clarke, Regulating the City (Milton Keynes: Open University Press, 1986). In any event, changes to the city following Big Bang, in particular the gobbling up of small partnerships by large conglomerates, and ensuing increased competition, have largely destroyed any remaining “village” or “club” atmosphere that may have existed. See A. Hamilton, The Financial Revolution, ch. 6 (New York: Viking, 1986).Google Scholar

102 First Report of the Companies Law Revision Committee (Hong Kong, 1971, W. Thomson, chairman), para. 9.11.Google Scholar

103 Lethbridge, The Business Environment in Hong Kong 66 (cited in note 60).Google Scholar

104 Sociologists have rightly been wary of cultural explanations, which can be invoked as a convenient catchall category to explain away otherwise incongruous evidence. However, in invoking culture in this article I have documented with considerable specificity why it is such a powerful explanatory variable with regard to regulation in Hong Kong. While ideally a broader cross-cultural study might have sharpened the analysis further, I am able to contrast local and expatriate cultures in Hong Kong and to refer to experience in financial markets elsewhere, which is entirely consistent with the arguments made here.Google Scholar

105 See S. K. Lau, Society and Politics in Hong Kong 72 (Hong Kong: Chinese University Press, 1982) (“Lau, Society and Politics”).Google Scholar

106 K. H. Wong & Y. Y. Wong, “Issues of Corporate Governance in Hong Kong” (Unpublished, University of Hone Kong); S. K. Lau & H. C. Kuan, The Ethos of the Hong Kong Chinese 48–50 (Hong Kong: Chinese Press, 1988) (“Lau & Kuan, Ethos”). As Madsen points out: “In contrast to Confucian morality, Western moral discourse is universalistic. One's moral obligations toward another are determined by general norms equally applicable to all persons of a particular category…. In such a universalistic group configuration, the nature of one's moral obligations to another is determined by what specific common groups one belongs to and by what norms govern the conduct of everyone in such groups,” R. Madsen, Morality and Power in a Chinese Village 54–55 (Berkeley: University of California Press, 1986).Google Scholar

107 Lau, Society and Politics 68–69.Google Scholar

108 R. I. Tricker, “Information Resource Management—A Cross Cultural Perspective,” 15 Information & Management 44 (1988). Lau, Society and Politics 70–71, 100–101, argues that the particular emphasis on material values in Hong Kong results from (a) a historical tradition of business shrewdness in Southern China, (b) freedom of a migrant class from traditional moral constraints on acquisitions, given the absence of a gentry class, (c) the blocking of upward mobility in a colonial society, (d) the stimuli of visible inequality and conspicuous consumption, (e) the openness of the economy and the inability of any one elite to monopolize economic opportunity. See also M. Topley, “The Role of Savings and Wealth among Hong Kong Chinese,” in I. C. Jarvic. &. J. Agassi, eds., Hong Kong A Society in Transition 187 (New York: Praeger, 1968) (“Topley, ‘The Role of Savings’”).Google Scholar

109 Quoted in S. G. Redding, The Spirit of Chinese Capitalism ch. 9 (in press, 1990).CrossRefGoogle Scholar

110 As the Far Eastern Economic Review had noted some time previously, all that was needed to become a trader was “chalk, a blackboard and a strong nervous system.”Far Eastern Economic Rev., Sept. 18, 1971, at 73. Only the technology has changed in the meantime.Google Scholar

111 Many respondents emphasized that exaggerated claims were routinely made by unqualified and inexperienced salespeople in order to drum up business, that clients were often induced to buy far in excess of what was prudent given their financial resources, and that inadequate records were kept by brokers, or even two sets of books. As a result, clients, in the absence of adequate auditing or other oversight by the exchange, were left to fend for themselves.Google Scholar

112 Economist, May 14, 1987.Google Scholar

113 Economist, May 14, 1987. See also statement by new Stock Exchange Chairman F. Yuen, Financial Times, London, Oct. 19, 1988.Google Scholar

114 The Futures Exchange allowed full membership to firms with just HK$2 million in capital. Entry was so easy that it rapidly attracted 130 members, most of them small firms.Google Scholar

115 See above at 9. Since accounting systems were inadequate and clients were often not given formal receipts, the potential for bucketing was considerable, but the actual amount impossible to quantify. Some respondents alleged that some salesmen would them selves bucket those transactions they believed to be a good risk. As one respondent put it, “Everyone was gambling. The client gambles believing the market will rise or fall, the sales man gambles with the client's money, the salesman is also gambling with his boss.”.Google Scholar

116 It must be emphasized that in the present context, “self-regulation” refers to the policy of entrusting a degree of social control to private groups as an official aspect of the regulatory pattern. Only when the term is used in a much looser sense might it be argued that it has played a role in mainland Chinese culture and to a significant extent in Hong Kong (e.g., before 1911 Chinese central government did not penetrate many aspects of people's lives. The family, the clan, and the village were important “self-regulatory” components of Chinese society. After 1911, during a period where political authority had broken down, guilds and chambers of commerce became important mechanisms of control).Google Scholar

117 See, e.g., Findlay, M., HHU 13:4 Legal Service Bulletin 144 (1988); H. Lethbridge, Hard Graft in Hong Kong (Hong Kong: Oxford, 1985); R. P. Lee, ed., Corruption and Its Control in Hong Kong, Chinese UP (1981).Google Scholar

118 See, e.g., Niang, L. S., “A New Attempt to Introduce Self-Regulation,” Company Lawyer 3, 188 (1982). See also P. Harris, Hong Kong: A Study in Bureaucratic Politics 143 (Hong Kong: Heinemann, 1978).Google Scholar

119 See Lau, & Kuan, , Ethos, 189 (cited in note 106).Google Scholar

120 Lau, Society and Politics.Google Scholar

121 Id at 72, 87, 89–90, 92–93.Google Scholar

122 G. Redding & G. Wong, “The Psychology of Chinese Organisational Behaviour,” in M. Harris Bond, ed., The Psychology of the Chinese People 275 (Hong Kong: Oxford University Press, 1986) (“Redding & Wong, ‘Psychology’”). Such companies have a number of typical features, namely they are family centered, have a limited scale of operations, centralized decision making, intuitive strategy formation, and a paternalistic management style. See R. Tricker, “Chinese and Western Windows on the Business World,” at 7 (Hong Kong University, Department of Management Studies, 1986). See also H. R. D. Baker, Chinese Family and Kinship (New York: Macmillan, 1979); F. L. K. Hsu, Americans and Chinese: Passages to Differences (Honolulu: University Press of Hawaii, 1981); Lau, Society and Politics; Redding & Wong, “Psychology”; R. Silin, Leadership and Values (Cambridge: Harvard University Press, 1976). Of these, the first aspect is of particular importance, with the head of the family fulfilling the dominant owner-manager role and close relatives being employed in key positions. This combination of familism and materialism “produces a next step which is the service of both interests by a family company” within which the boundaries between family and business are blurred and nepotism becomes routine. “The same principle is often also evident in the employment of long serving and loyal affiliates who become almost honorary family members, tied in by bonds of obligation in which patronage downwards and loyalty upwards are exchanged” (Redding & Wong, “Psychology” at 275).Google Scholar

123 See 16 above.Google Scholar

124 See 24 above.Google Scholar

125 See also Far Eastern Economic Rev., Apr. 16, 1987, at 45, 46; Asian Wall St. J., Nov. 27 and 28, 1987.Google Scholar

126 There is also, of course, an extensive legal literature, but this is primarily concerned with description and analysis of the existing law, with the scope of existing regulation, and with the remedies available to aggrieved consumers. See, e.g., Baker, R. B., “Federal Regulation of Discretionary Commodity Accounts,” 32 Hastings L.J. 871 (1981);Demartini, L. G., “Fraud in Commodity Futures Trading—An Examination of the Investor's Remedies,” 34 Vand L. Rev. 1349;Orrell, J. S., “Commodity Futures Litigation: A By- Product of Investor Roulette,” 30 Drake L. Rev. 599 (1980-81);Robertson, M. D., “The Continued Availability of Private Actions for Fraud under the Securities Statutes in Commodity-Security Transactions,” 22 B.C.L Rev. 335 (1981).Google Scholar

127 Above note 31.Google Scholar

128 Dinehart, S. J., “Insider Trading on Futures Markets,” 6:2 J. Futures Markets 325 (1986);Edwards, F. R., “The Regulation of Futures Markers: A Conceptual Framework,” 1 J. Futures Markets 417 (1981);Edwards, F. R., “Futures Markets in Transition: The Uneasy Balance Between Government and Self-Regulation,” 3:2 J. Futures Markers 191 (1983);Edwards, F. R., “The Clearing Association in Futures Markets: Guarantor and Regulator,” 3:41. Futures Markets 369 (1983);Edwards, L. N. & Edwards, F. R., “A Legal and Economic Analysis of Manipulation in Futures Markets,” 1:3 J. Futures Markets 333 (1981);Fischel, D. R. & Grossman, S. J., “Customer Protection in Futures and Securities Markets,” 43 J. Futures Markets 273 (1984);Telser, L. J., “Margins and Futures Contracts,” 1 (Summer) J. Futures Markets 225 (1981). See also the collection of articles in 59 J. Bus., No. 2, Pt. 2 (1986).Google Scholar

129 See, e.g., Edwards, , 3:2 J. Futures Markets at 193;Edwards, & Edwards, , 1:3 J. Futures Markets 333.Google Scholar

130 Fischel, & Grossman, , 4:3 J. Futures Markets at 291.Google Scholar

132 It is the assurance of clearing house solvency that permits the expansion of futures contracts well beyond the existing stocks of the underlying deliverable commodity. Insolvency would topple the inverted pyramid.Google Scholar

133 See, e.g., Edwards, , 3:4 J. Futures Markets at 391;Edwards, , 2 J. Futures Markets at 434.Google Scholar

134 R. W. Anderson, The Industrial Organisation of Futures Markets, ch. 1 (Lexington, Mass., 1984). Even the SEC has received little in the way of systemic examination. For empirical assessment of specific features of SEC regulation, see Stigler, G. J., “Public Regulation of Securities Markets,” 37 J. Bus. 117 (1964);Benston, G. J., “Required Disclosure and the Stock Market: An Evaluation of the Securities Exchange Act of 1934,” 63 An Am Econ. Rev. 132 (1973).CrossRefGoogle Scholar

135 See also Abolafia, “Self-Regulation as Market Maintenance” (cited in note 31).Google Scholar

136 As Williamson, , “The Economics of Organisations: The Transactions Cost Approach” 87 Am. J. Soc. 568, 544 (1981), puts it, “Whereas economic man engages in simple self-interest seeking, opportunism makes for self-interest seeking with guile.”.Google Scholar

137 Provided it is economically possible and worthwhile to do so. See for example Fischel, & Grossman, , 43 J. Futures Market at 290–92.Google Scholar

138 Topley, “The Role of Savings” (cited in note 108).Google Scholar

139 See also Cheng, Chu-Yuen, “Hong Kong's Prosperity: Foundation and Prospects,” 2:1 J. Chinese Stud. (1985).Google Scholar

140 In the U.S., futures contracts are not subject to federal margin levels. The CFTC has authority to prescribed margin levels for futures only in emergency situations. Other wise, margin levels are set by the commodities exchanges. See also Division of Trading and Markets of the Commodity Futures Trading Commission, Follow-up Report on Financial Oversight of Stock Index Futures Markets During October 1987 (January 6, 1988) at 27.Google Scholar

141 See further at note 155 below.Google Scholar

142 The structural flaws in the credit control system are considered above. Here the focus is specifically on the behavior of brokers.Google Scholar

143 See, e.g., R. Cyert & J. G. March, A Behavioural Theory of the Firm (Englewood Cliffs, N.J.: Prentice-Hall, 1963); Schoemaker, P. J., “The Expected Utility Model: US. Variants, Purposes, Evidence and Limitations,” 1982 J. Econ. Lit. 20, 529.Google Scholar

144 Baker, W., “The Social Structure of a National Securities Market,” Am. J. Soc. 89, 778 and references cited therein.Google Scholar

145 It might also be argued that Hong Kong was known to be a volatile and high-risk market, that investors should have taken account of the risks and balanced these against the chance of higher profits, when deciding whether to invest in Hong Kong. The failure of the futures exchange was one such risk which they should have taken account of.Google Scholar

146 Financial Times, London, Feb. 12, 1988.Google Scholar

147 For general international comparisons of post-crash trading levels, see Australian Financial Rev., Dec. 24, 1988, at 11. See also Asian Wall St. J., Apr. 18, 1988, at 1.Google Scholar

148 See further at 18 above.Google Scholar

149 South China Morning Post, Oct. 29, 1987, at 1.Google Scholar

150 For similar motives the U.S. Federal Reserve took a decision to serve as a source of liquidity and to support the economic and financial system in the middle of the stock exchange crisis of October 20. See “U.S. Markets Barely Survived the Crash,” Asian Wall St. J., Nov. 23, 1987, at 1.Google Scholar

151 Similarly, it has been argued that the existence of an international lender of last resort made the financial crises of 1824, 1836, 1847, 1866, and 1907 more or less ephemeral, whereas its absence in 1873, 1890 and 1929 produced deep depressions. See Kindleberger, C. P., “International Public Goods Without International Government,” 76 Am. Econ. Rev. 1 (1986).Google Scholar

152 Half of the $4 billion bailout package was a loan provided by the government. How much of it will be repaid is a moot point.Google Scholar

153 It is true that such intervention poses a moral hazard when the person saved from his folly by an outside force loses the incentive to be cautious, but provided there is ambiguity as to whether or not such a person will be saved, this should not be a serious problem.Google Scholar

154 Hirsch, P., Michaels, S., & Friedman, R.,” ‘Dirty Hands’ Versus ‘Clean Models’,” 16 Theory & Soc'y 317, 323 (1987).Google Scholar

155 Compare the response of the major American markets where existing safeguards proved effective during the crash. No customers lost any money as a result of the failure of futures firms, and no futures commission merchants failed. Further, clearing mechanisms operated effectively despite record volumes, price swings, and margin flows. Finally, no futures market closed because of financial or margin collection problems. See Division of Economic Analysis and Division of Trading and Markets, Interim Report on Stock Index futures and Cash Market Activity During October 1987, to the US Commodity Futures Trading Commission (1987).Google Scholar

156 For the U.K., see, e.g., Report of the Committee to Review the Functioning of Financial Institutions, Cmnd 7937, 1980, para. 1108 (the Wilson Report); L. B. C. Gower, Review of Investor Protection (London: HMSO, 1982); M. Clarke, Fallen Idols (London: Junction, 1981). For the U.S. see Seligman, , “The Historical Need for a Mandatory Corporate Disclosure System,” 9 J. Come. L 1, 54 (1983); Securities and Exchange Commission, Re port of Special Study on Securities Markets, H. Doc. No. 95, pt. 4, 88th Cong., 1st Sess., 692–728, 1964; Lownefels, A Lack of Fair Procedures in the Administrative Process: Disciplinary Proceedings at the Stock Exchanges and NASD,” 64 Cornell L. Rev. 375 (1979).Google Scholar

157 As indicated above, there have been a number of studies of government regulation and agencies, but a relative dearth of analyses of self-regulation. However, see M. Y. Abolafia, “Taming the Market: Self-Regulation in the Commodity Futures Industry” (Ph.D. diss., SUNY, 1981) (“Abolafia, ‘Taming the Market’”); Lurie, J., “Private Associations, Internal Regulation and Progressivism: The Chicago Board of Trade 1880–1923, as a Case Study,” 16 Am. J. Legal Hist. 215 (1972); L. O. Glick, “A Social Psychological Study of Futures Trading” (Ph.D. diss., University of Chicago, 1957).CrossRefGoogle Scholar

158 See at 33–40 above.Google Scholar

159 See at 24 above.Google Scholar

160 For example, in the U.S. until after the 1929 crash (and the Exchange Act of 1934) the exchanges were voluntary associations that were treated by the law, and regulated by themselves, as private clubs. This caused considerable concern that personal interests took precedence over public responsibilities and there was evidence that the self-regulatory authorities were aware of abuses but took no effective action. Indeed, the exchanges were notorious for engaging in “brazen manipulation, overreaching and self-dealing.” See also Miller, S., “Self-Regulation of the Securities Markets: A Critical Examination,” 42 Wash & Lee L. Rev. 853 (1985);Jennings, R. W., “Self-Regulation in the Securities Industry: The Role of the SEC,” 29 Law & Contemp. Probs. 630 (1964);Stock Exchange Practices: Report of the Committee on Banking and Currency, Senate Report No. 1455, 73d Cong., 2d Sess., 1934. The scandals that frequently follow such freedom from control may also have a salutary effect, or prompt more direct intervention. See Clarke, Fallen Idols (cited in note 156), Regulating the City (cited in note 101).Google Scholar

161 This is not to suggest that Hong Kong's stock exchanges had never before experienced a serious sharp financial downturn. They had, most recently in 1973. However, volume had increased greatly since that time, there was rapid turnover of brokers, and very few players on the stock market, and almost none on the futures market, would have experienced these past events.Google Scholar

162 Inside Asian Stockmarkets 132.Google Scholar

164 On the Sydney Futures Exchange, for example, over 85% of the trade involves large institutional players, well informed and capable of transferring their substantial account from any broker whose practices they find unsatisfactory, or of transferring their trade to another market should the exchange itself fail to meet their requirements.Google Scholar

165 There were no formal educational or experience qualifications for entry, nor were there any alternative controls by way of family lineage or kinship and the accompanying transition of skills.Google Scholar

166 Contrast, for example, the restrictive practices of the London stock market, where minimum commissions and a division between jobbing and brokering did much to ensure the profits of existing members. It was partly the abolition of such practices and the consequent competitive pressures that produced a need for re-regulation in the form of the Financial Services Act of 1986.Google Scholar

167 Preliminary research at the Sydney Futures Exchange suggests that this is indeed the case.Google Scholar

168 See P. Sarnoff, Silver Bulls ch. 4 (Westport: Arlington, 1980).Google Scholar

169 See Chicago Tribune, July 16, 1989.Google Scholar

170 See, e.g., Jennings, R. W., “Self-Regulation in the Securities Industry,” 29 Law & Contem Probs 630 (1964). The author cites the disproportionate number of floor professionals in the government of the exchange, stemming from the allocation of voting power under the exchange constitution. See also Securities and Exchange Commission, Report of the Special Study of Securities Markets, H. Doc. No. 95, pt. 4, 88th Cong., 1st Sess. 692–728, at 696.Google Scholar

171 See, e.g., Abolafia, “Taming the Market” (cited in note 157). Baker, W. E., “The Social Structure of a National Securities Market,” Am. J. Soc'y 775 (1984).CrossRefGoogle Scholar

172 Leblebici, H. &Salancik, G. R., “Stability in Interoganisational Exchanges: Rulemaking Processes at the Chicago Board of Trade,” 27 Admin. Sci. O. 227 (1982).CrossRefGoogle Scholar

173 See at 44 above.Google Scholar

174 See at 44 above.Google Scholar

175 See at 29–30 above.Google Scholar

176 This is not to suggest that these are the only relevant criteria. Two factors in particular that were not raised in Hong Kong—technological change and globalization of trading—may also be relevant to regulation in other markets.Google Scholar

177 As to the purported objectives of financial market regulation, at 6–7. One crucial factor in determining regulatory strategy is achieving a balance between underregulation (which can result in abuses and loss of credibility) and overregulation (which can inhibir innovation and stifle growth).Google Scholar

178 As indicated above, most other exchanges adopt some mix of the two mechanisms.Google Scholar

179 See, e.g., The Economist, Feb. 5, 1987, at 75.Google Scholar

180 As a result of recent changes, the Futures Exchange was not entirely elected by its own members, but also included, at least initially, some government nominees.Google Scholar

181 See Gower Report, and compare the arrangement of self-regulatory organizations under the Financial Services Act of 1986 (U.K.).Google Scholar

182 Id. at Gower Report at 11.Google Scholar

183 See generally D. Vogel, National Styles of Regulation: Environmental Policy in Great Britain and the United States (Ithaca, New York: Cornell University Press, 1986); J. Braithwaite, “Negotiation Versus Litigation: Industry Regulation in Great Britain and the United States,” Spring-Summer 1987 ABF Res. J. 559, 573 (1987); Kagan, R., “What Makes Uncle Sammy Sue?” 2 Law & Soc'y Rev. 717 (1988).Google Scholar

184 Vogel, National Styles of Regulation 259.Google Scholar

185 Until 1986, futures market regulation in Britain lacked any statutory basis, the Bank of England apprently believing that writing legislation would only inhibit flexibility. In support of this approach, industry officials in Britain argued that this self-regulatory approach was vindicated by the fact that the markets have performed in an orderly and efficient manner. See Rock, C., “Regulatory Control over the United States, Canadian and United Kingdom Futures Markets,” 38 Business Lawyer 616 (1982).Google Scholar

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