2.2.1 New market factors and pro-competition authorities

Driving forces of the evolutionary trajectory of exchanges changed after the 1970s, first in the US and then in the EU. Although the market influence continued to affect transformations of exchanges when their previous structure failed to satisfy new demands of market players, authorities began to play an important and indispensable role in orienting these transformations.

On the market side, beginning from the 1970s, trading orders on the exchanges became larger and more concentrated along with the rapid growth of institutional investors, such as mutual funds, investment banks and unit trusts.^[22] Retail investors preferred to entrust funds to institutional investors considering their professional skills and sophistication. It is said the total value of open funds had increased from nearly 448 million USD in 1940 to almost 49 billion USD in 1975.^[23] In addition, new communication and information technology began to be used in various scenarios of stock markets, such as listing, trading, clearing and settling. New technology weakened the natural monopoly of traditional exchanges, because it allowed new virtual trading systems to imitate the functions of physical exchanges at a low cost.^[24] A typical example is the launch of the national electronic system “National Association of Securities Dealers Automated Quotation System (NASDAQ)” in 1971, which later became a major competitor of the NYSE.

On the authority side, competition became an increasingly favorite notion by authorities, who treated it “not only as fundamentally fair, but as a driving force of economic innovation and a guarantor of efficiency.”^[25] The Securities and Exchange Commission (SEC) in the US has set out to reduce the market power of monopolistic exchanges since 1936.^[26] After twists and turns, it has finally triumphed over exchanges by passing the Securities Acts of Amendment 1975, which initiated a national market system (NMS).^[27] By linking “all markets for qualified securities through communication and data processing facilities,” the NMS aims to create “fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets.”^[28]

In the UK, the government in the light of a greatly altered competitive environment brought an anti-trust prosecution against the LSE in 1983. The LSE had to promise to give up its monopolistic status in order to end the government threat.^[29] Beginning from the 1990s, the EU at large also aimed to create a competitive and integrated European securities market.^[30] The EU first opened up competition among securities intermediaries (brokers and dealers) by formulating its Investment Services Directive in 1993^[31] and then improved competition between intermediaries and exchanges by adopting the Market in Financial Instruments Directive (MiFID) in 2004.^[32] The European Commission believed that

To the absence of any static efficiency benefits from directly regulating market structure must be added the dynamic costs to the marketplace as a whole of restricting participant choice, competition between trading systems and innovation. Competition between trade-execution arrangements can deliver dynamic benefits if it brings down transactions costs, brings additional liquidity to the markets, supports sophisticated trading strategies and helps to streamline transaction settlement.^[33]

2.2.2 Revocation of anti-competition rules

Fixed minimal commission rule set by the exchange requires its members to charge a minimal commission on all transactions with nonmembers.^[34] This rule is designed to eliminate competition among members and to exclude nonmembers of taking advantage of the exchange. The NYSE has had this rule since its foundation, and the LSE adopted it in 1912.^[35] However, institutional investors based on their ever-growing sizes and bargaining power required exchange members to reduce commissions. Meanwhile, members competed fiercely for institutional orders, which were often more profitable, by providing implicit rebates.^[36] For authorities, this rule restricted competition. The US was the first to dismantle this rule in 1975 as a key step to building the NMS.^[37] Other jurisdictions followed and gradually unfixed their commission rules. For example, the so-called “Big Bang” in the UK ended such rule in 1986.^[38]

Concentration rule is another exchange-imposed rule, which requires all the trading orders of exchange-listed securities handled by exchange members shall be executed on that exchange.^[39] The exchange defends the concentration rule by highlighting its effect to improve the function of price discovery. The exchange is a venue to match buy orders and sell orders, through which the price is discovered. The more orders the exchange can concentrate, the more accurate price the exchange may discover. However, the concentration rule restricts competition in securities markets^[40] and deprives the opportunity for traders to match orders in other trading systems.^[41] As a commitment to build the NMS, the SEC adopted Rule 19c-3 in 1980, which allowed exchange members to make off-board trading of securities listed on or registered with the NYSE.^[42] Later on, the EU also eliminated the rule by implementing the MiFID.

Benefiting from the abolishment of the concentration rule, off-board trading systems enjoyed a growing opportunity, because exchange-listed securities can be traded and matched on off-board systems. Furthermore, the rise of institutional investors greatly facilitated the boom of off-board systems. Transparency has long been deemed as a big advantage of the exchange, but large institutional orders do not really favor transparency. On the one hand, most traders often presume institutional orders are well-informed on future stock prices. Traders, thus, avoid matching institutional orders, which slows down execution speed and augments execution costs.^[43] On the other hand, institutional orders have bigger market impact, which refers to “the additional cost that a trader may incur to have a large order executed quickly.”^[44] There is a positive correlation between the market impact and the order size. A large buy order will pull up the executed price significantly, because the demand of a specific share suddenly goes up. Similarly, a large sell order will push down the price to the negative direction, because the supply has a sudden increment.^[45]

Consequently, institutional investors attempt to evade the well-informed presumption and minimize the market impact by disclosing as little information as possible. A popular resolution is to hide their orders in trading systems where no pre-trade transparency is provided (dark pool).^[46] Many off-board trading systems, such as alternative trading system, multilateral trading facility (MTF), systematic internaliser or crossing market, may provide the function of dark pool trading.^[47]

The three obvious changes – unfixed commission, abandonment of the concentration rule and prosperity of off-board trading – significantly undermine the monopoly of traditional exchanges by diverting a large volume of orders (especially institutional orders which accounts for the biggest piece of revenue) away from the traditional exchanges. Therefore, the exchanges confront increasing pressure from new competitors. It is reported the consolidated share volume executed on the NYSE sharply declined from 79% in 2005 to 27% in 2009.^[48] Similarly, the market share of the LSE had an 11% drop from 35% to 24% in 2009 alone.^[49] On the contrary, a successful MTF in the EU called Chi-X grabbed some 14% equity trading in Germany and accounted for 25% in London’s FTSE 100.^[50] The MiFID database shows that nearly two thirds of trading facilities have already been off-board systems in the EU.^[51] Consequently, the incumbent exchanges, including Anglo-American exchanges and exchanges located in other jurisdictions as well, are compelled to change the structure to countervail their shrinking market shares.

2.2.3 Three structural changes: a larger survey

The first and foremost structural change is demutualization, which means a mutual not-for-profit membership exchange converts into a for-profit shareholder-owned corporation. The demutualization provides several benefits. First, a mutual membership exchange, making decisions on the basis of member consensus, may not react rapidly to new business opportunities. Yet, a corporatized exchange armed with professional management team is believed to have a quick decision-making mechanism and “a particularly strong incentive to adapt”.^[52] Second, a not-for-profit exchange always suffers from funding shortage for introducing advanced trading appliances, while a for-profit exchange is more ready to collect capital.^[53] Third, a traditional exchange favors the interest of its members, while interests of other parties, such as investors, listed companies and regulators, are often overlooked. In contrast, a corporatized exchange can consider the interests of nonmembers as long as they are shareholders.^[54]

Stockholm Stock Exchange was the pioneer of demutualization in 1993 in order to be more efficient and customer-focused.^[55] The turn of the twenty-first century witnessed a worldwide trend of demutualization, such as the NASDAQ and exchanges in Frankfurt, Amsterdam, London, Paris and Hong Kong. The demutualization process of the NYSE was rather slow because of some members’ fear of losing control. However, the competitive environment finally converted the NYSE structure in 2006.^[56] The WFE reports that 74% of its members have corporatized into for-profit exchanges by the end of 2012.^[57]

The second structural change is self-listing, which means a shareholding exchange lists on its own board. Self-listing provides an easy route to access the capital market and to fund business projects. By self-listing, the exchange could improve its corporate governance and enhance its competitiveness.^[58] The vanguards of self-listed exchanges are the Stockholm Stock Exchange, the Australia Stock Exchange and the Stock Exchange of Hong Kong. The route was then also followed by the Deutsche Börse, the LSE, the NASDAQ and the NYSE.

The third structural change is that of mergers and acquisitions among exchanges. One benefit is economies of scale. As the order flow has significantly migrated to off-board trading systems, it is difficult for an exchange to sustain a fully fledge order volume to cover costs of market oversight, buildings, facilities and technologies and to generate “enough business for local investment banks, accounting firms, and other support servicers.”^[59] The mergers and alliances can help to cut down costs by sharing one set of trading devices and to offer more business opportunities to adjacent servicers. Another benefit is economies of scope. The cross-border flow of orders has been supported by modern communication tools. The mergers multiply local and non-local order volume and concentrate it on a single platform.^[60] Market traders, thus, can touch more orders originally placed on different trading systems by only accessing to one merged system.

Mergers usually commenced within national territory. For example, in Spain, Italy, Switzerland and Australia, several regional exchanges were consolidated into one national exchange.^[61] After that, international merger became popular. A typical case was the foundation of Euronext through combining the exchanges in Paris, Amsterdam, Brussels and Lisbon and the LIFFE step by step from 2000 to 2002.^[62] Later, the LSE merged with the Borsa Italiana, creating the London Stock Exchange Group in 2007.^[63] In the same year, the NASDAQ bought the OMX^[64] and the NYSE merged with the Euronext.^[65] In 2012, the Stock Exchange of Hong Kong merged with the LME^[66] and the NYSE and the Intercontinental Exchange agreed with combination.^[67] In addition to mergers among traditional exchanges, exchanges acquire off-board trading systems. For example, the NYSE acquired the Archipelago Exchange in 2005, which originally was an electronic communication network,^[68] and in 2009 the LSE took a majority ownership of the Turquoise, which initially was an MTF.^[69]

3.1.1 The emergence of stocks and primitive over-the-counters (OTCs)

The earliest stock trading in China dates back to the 1860s. The first stock exchange was founded in Shanghai in 1891, followed by several others since then.^[70] After the Chinese Communist Party (CCP) began to rule Mainland China in 1949, they continued to operate in the first three years. However, they were then deemed as a manifestation of capitalist ideology and shut down in 1952 when the CCP started a society-reconstruction project called “socialist transformation” and experimented with a Soviet-style planned economy.^[71] The operation of stock markets paused for almost three decades until China entered into a new epoch with the announcement of the Reform and Opening-up Policy in late 1978. This Policy, shifting the national focus from socialist class struggle^[72] to economic development, created a breeding ground for the gradual re-emergence of stock markets. Some communes and brigade enterprises in the countryside started to issue “stocks” to solve capital shortage in the early 1980s. This spontaneous practice was affirmed and encouraged by national authorities. In January 1984, the CCP announced that it encouraged peasants to invest in shares of enterprises and to protect their rights in shares.^[73] Later on, more and more enterprises, including state-owned enterprises (SOEs), issued stocks. Some of them were reorganized as companies limited by shares. As of 1988, there were nearly 10,000 so-called shareholding companies in China.^[74]

In stark contrast with the hot stock issuance, the stock trading was extremely depressed at the outset.^[75] First, the socialist transformation in the 1950s and the later one-decade culture revolution^[76] spanning from the mid-1960s to the mid-1970s made it difficult for the general public to quickly and ideologically accept stocks. Stocks were still treated as a manifestation of “evil capitalism” and “wicked privatization”. It is said that Party cadres themselves had to buy shares to show the public that shares were “ideologically” safe.^[77] Second, the long disappearance of stock markets made both the issuers and the public misunderstand stocks. Stocks at that time were designed as a hybrid of bond and share and “stockholders” obtained regular payoff of interest as well as dividends.^[78] They tended to hold, rather than to trade, stocks just like a fixed bank deposit or bond.^[79] They had no idea that the share value could be appreciated. Third, there was no central trading platform before 1986 and thus shareholders had to look for trading counterparties by themselves, resulting in very high transaction costs.^[80] Finally, most of these stockholding companies, if not all of them, were on the edge of bankruptcy. Shares were issued to resolve their financial distress, and thereby, many shares were unattractive in value.

The re-emergence of stocks in China was a spontaneous market phenomenon, driven by enterprises to solve capital shortage, but the formation of the secondary market was completely imposed by authorities. In order to warm up the secondary market of stocks, the People’s Bank of China (PBoC), as the central bank and regulatory agency of Chinese financial industry at that time,^[81] approved the first securities company in 1985–the Shenzhen Special Economic Zone Securities Company. As its name suggested, this company was closely correlative with the Government of Shenzhen Special Economic Zone. Besides its status as central bank and financial regulator, the PBoC also acted as an important market player by setting up many affiliated trust and investment companies (TICs) through its branches in municipal cities to trade shares.^[82] Therefore, the PBoC had a strong interest in the secondary market. In addition, the local branches of the PBoC set up securities trading counters (i.e. OTCs) together with municipal governments beginning from 1986.^[83] The municipal governments had their own interests in the OTCs. For example, they could monitor and ensure that stocks were traded in an orderly way on the OTCs.

However, these OTCs were flawed. Their circumscribed facilities failed to discover accurate prices of stock transactions and led to high transaction fees. Inside trading and manipulation were frequently observed on the OTCs. Additionally, there was no central registration for share certificates. Most trading still took place on the black market.^[84] The authorities did not pay much attention to these flaws when the stock trading was still inactive, but these flaws turned to be in the limelight as the occurrence of a “stock fever” in early 1990, which marked a major turning point of China’s stock markets.

3.1.2 The establishment of stock exchanges by local authorities

The trigger of the 1990 stock fever was a dividend plan announced by the Shenzhen Development Bank in 1989. The plan, exceedingly generous to shareholders, set fire to the previously quiet market.^[85] The public was informed that the stock value could be appreciated much more than its face value, so people started to subscribe and trade shares actively. The annual turnover in 1988 was only 4 million RMB, but the turnover in the first half of 1990 exploded to 444 million RMB.^[86] However, the craze together with poorly equipped OTCs led to more black market trading, serious price manipulation, stock counterfeit and corruption. Equity markets were heavily disordered and the public became discontent. As a response, several reports were released by the State Commission for Restructuring the Economic System (SCRES),^[87] the PBoC and municipal governments. Their proposals included a daily price limit by 10%, stamp tax on share transactions and most importantly the establishment of stock exchanges. Stock exchanges, equipped with efficient price discovery functions and central registration and settlement facilities, were supposed to bring an organized and orderly market. They also advised that all the shares should only be traded in stock exchanges or OTCs.^[88] Their proposals were soon accepted by the State Council, and the applications to set up the SSE and the SZSE were approved by the State Council in 1990 and 1991, respectively.^[89]

The establishment of stock exchanges is a milestone in the history of Chinese securities markets. As Green remarks, “[b]y institutionalizing the share market, trading would become permanent and less susceptible to criticism and/or closure if the winds of ideology or economic policy from the senior leadership changed.”^[90] However, there were debates regarding the institutional character of China’s stock exchanges prior to their establishment. One group, consisting out of scholars with overseas education background, market representatives and others outside the formal government bureaucracy, proposed a market-based institution similar to the Anglo-American exchanges: a SRO owned by members and operating independent of government. In contrast, the other group, consisting out of government officials, envisaged a bureaucracy-based institution, which was not only regulated but also administrated by authorities.^[91] The result of their debates was shown in the SSE Constitution and SZSE Constitution, both of which defined the stock exchange as a member-owned non-profit public legal person, who was regulated and administrated by local branches of the PBoC and the municipal governments (Shenzhen and Shanghai).^[92] Walter and Howie contend that although stock exchanges are owned by members on paper, in practice they have been fully integrated into their local governments and PBoC branches.^[93]

Unlike the Anglo-American counterparts, Chinese municipal governments together with local branches of the PBoC dominated the stock exchanges from the very beginning. There are three reasons. First, in a transitional nation, where social environment was ideologically inhospitable to stocks and stock exchanges as they were deemed as “bourgeois” concepts, the institution establishment was more troublesome and so the protection of this institution was necessary. As Stiglitz argues, the involvement, support and endorsement from the government bureaucracies are indispensable to the building of new institutions because they help to mitigate ideological risks and inherent limitations of institutions within a lagged market.^[94] Meanwhile, the country’s heritage of the long-term planning economy continued to affect the authorities, who had been accustomed to controlling institutions and intervening into markets.

Second, investors and brokers from the market side nearly had no influences on the creation of stock exchanges. Although the CCP took the reform and economic development as fundamental policies since late 1978, the change of ideology was a slow and gradual process. The general public could not accept stocks at once. Even though a few people bought shares, they did not trade shares. Brokers (securities companies and TICs) emerging after 1985 were unable to accumulate strong market power when the stock trading was depressed. Meanwhile, because nearly all the brokers were affiliated to the local branches of the PBoC or municipal governments, their business had to defer to the policies and orders of the PBoC and municipal governments.

Third, local authorities for various self-interests were very keen to capture the institution-building process. The local branches of the PBoC intended to underpin the PBoC’s status as regulator of Chinese nascent stock markets by creating exchanges together with the municipal governments. The municipal governments, on the other hand, were more active and enthusiastic. The stock exchanges would not only provide local governments with a better structured institution than the OTCs to monitor stock trading and control risks in stock markets but also enrich local governments with tax revenues extracted from stock trading and more jobs for local citizens. Besides, because a country could not set up too many exchanges considering the diseconomy in duplicative facilities and the downgrading price discovery function as well,^[95] there were notable first-mover advantages in this regard. The forerunner would enjoy more listing resources, better reputation, bigger influence and so on. Therefore, many municipal governments, especially Shanghai and Shenzhen, competed heavily to set up the first exchange.^[96] Additionally, municipal governors had their own career concerns. Once the proposal to set up stock exchanges was accepted by the central government, it would be an outstanding achievement in municipal governors’ career records, which was supposed to greatly facilitate their nomination and even promotion to top national leaders.^[97]

3.2.1 Devising the CSRC for institutional control by the central government

During the establishment of China’s stock exchanges, the central government was almost hands-off and the local authorities had sizable control rights. From the standard wisdom, it is surprising because a national institution like the exchange may be more efficiently and effectively built by a central bureaucracy. However, Chinese central government is not really indifferent and careless to the nascent exchanges, but there are political reasons. On the one hand, the foregoing socialist transformation and culture revolution have created a decentralized political structure in China – strong local governments and weak central government.^[98] Under this structure, the local governments are more able to initiate and promote reform proposals. On the other hand, as the famous Chinese slogan “crossing a river by touching the stones” illustrates, the experiment-based reform strategy is heavily relied on China’s transition trajectory. Because the central government is not sure of the effect of new reforms, it lets the local governments to try out first on an experimental basis.^[99] The stock exchange is the very institution shaped by this strategy. Once the SSE and SZSE had been successfully established and widely recognized, the central government intended to advance the exchanges to the central level and apply centralized control.

Of course, the centralization was resisted by the strong local authorities, because it would take away their regulatory powers. What the central government (the State Council) needed was a right time and a convincing justification. The “8.10 Incident” happened to be the one. In 1992, the Shenzhen stock market was feverish again, and around one million people from all parts of the country rushed into Shenzhen to buy shares. In August, nearly one million people lined up for over three days and nights at 303 subscription points to buy five million application forms. Ten percent of the owners of these application forms would be chosen by lottery to subscribe IPO shares. However, when the forms were handed out on 10 August, the prescribed five million forms were declared to have been sold out in less than four hours. The angry crowds suspected that most forms had been intentionally withheld by bank staff and government officials. Their dissatisfaction finally boiled over into riots and violence.^[100]

The market chaos and social unrest caused by the 8.10 Incident convinced the public that the stock market was not a local matter and it might be better regulated by central authorities. Meanwhile, the State Council refuted the local control on the stock exchanges in light of the local authorities’ incapability to keep the stock market stable. The popular slogan “stability overrides everything”, reiterated by the then general reformist Xiaoping Deng, was carried out as the golden rule of Chinese economic reform.^[101] As a result, the State Council displaced the PBoC with the newly established Chinese Securities Regulatory Commission (CSRC) to regulate the stock exchanges in October 1992, which marked the start of the central government’s effort to control the stock exchanges.^[102]

However, the central control was made over time, not overnight. The creation of the CSRC did not generate a clear regulatory structure over the stock exchanges at once. The PBoC did not fade away immediately. It neither completely disgorged its investments in brokers nor transferred regulatory personnel to the CSRC until 1997. The municipal governments continued to exert their control over the stock exchanges together with the CSRC in the first several years. In fact, Shanghai resisted the CSRC’s regulation, because Shanghai was a ministry-level bureaucracy and the CSRC was merely a vice-ministerial bureaucracy at that moment. The centralization of control was finally completed in late 1998 when the CSRC was promoted to the ministerial level^[103] and the long-awaited Securities Law was passed. The Securities Law of 1998 delegates exclusive regulatory powers over securities markets to the CSRC.^[104]

3.2.2 Shutting down OTCs for institutional control by the central government

Trading counters affiliated with brokerage firms (securities companies and TICs) were once the solely authorized system to match trading orders of shares and treasury bonds. It was reported that there had been 16 trading counters in Shanghai and 10 in Shenzhen at the end of 1990.^[105] Along with the establishment of stock exchanges, most trading counters were upgraded into independent securities trading centers (STCs) after being funded by the local governments and approved by the local branches of the PBoC. Products traded on the STCs included treasury bonds, bonds and shares issued by unlisted companies and exchange-listed shares. Over half of the STCs were equipped with advanced computer systems and connected to the SSE and SZSE by fiber-optic cables and satellite lines. These equipped STCs were stock exchanges in all, but name. The only thing missing was the State Council’s approval. The STCs illustrated the ambition and struggle of the local governments and PBoC’s branches to preserve their interests in securities markets within their administrative territories, but the STCs did provide two benefits. Due to the then quota system,^[106] the vast majority of shareholding companies were unable to make initial public offerings on the stock exchanges, so the STCs served as an alternative financing platform for these companies. On the other hand, the STCs were conducive to the development of the SSE and SZSE in terms of providing technical facilities and increasing trading volume.^[107] However, in light of their unclear legal and political status, these local STCs were destined to be closed in the end by the State Council approaching the centralization of control. In 1998, the State Council forwarded a CSRC’s Circular to local authorities and ordered shutting down all the 28 local STCs by 30 June 1999.^[108]

Besides the local STCs, there were two national OTCs: the Securities Trading Automated Quotations System (STAQ) and the National Electronic Trading System (NETS). Both of them were initiated to be a NASDAQ-like system in China. The STAQ was opened in 1990, mainly sponsored by the SCRES, while the NETS commenced operation in 1991, primarily supported by the PBoC. Equity products traded on the STAQ included negotiable shares of exchange-listed companies and legal person shares of shareholding companies.^[109] The SCRES controlled the STAQ by virtue of its authority to approve the access of legal person shares into the STAQ. However, this authority was transferred to the CSRC after 1993. To damp the SCRES’s control, the CSRC slowed down the approval of new legal person shares to be listed on the STAQ. The STAQ thus “gradually stagnated and by 1997 had ceased to function as securities trading was increasingly concentrated in the two national exchanges.”^[110] When it comes to the NETS, it shared the same business scope as the two stock exchanges. The PBoC intended to consolidate the control of stock markets by setting up its own trading system. Nonetheless, as a step to divest the PBoC’s regulatory powers regarding securities markets, the State Council compelled the PBoC to wind up the NETS in 1997.^[111]

From 1992 to 1999, there were many bureaucratic battles in controlling the securities industry and the central government triumphed over the local governments, the PBoC and the SCRES in the end. The stock exchanges were placed under the domination of the CSRC. After the shutdown of the OTCs, the SSE and SZSE became the only two remaining venues to list shareholding companies and trade their shares. In spite of the positive functions of the OTCs, the State Council believed that the stock exchanges worked better in price discovery, information disclosure and costs reduction. Most importantly, the well-organized exchanges greatly facilitated the State Council to regulate and control China’s nascent securities markets. The stock exchanges’ monopoly regarding stock trading was confirmed by the concentration rule in Securities Law of 1998, which says “[s]hares, corporate bonds and other securities that have been lawfully approved for trading shall be quoted and traded on stock exchanges.”^[112] Off-board listing and trading have become a thing of the past.

4.1.1 Creating the ASTS as a SZSE-affiliated OTC and proposing multilateral securities markets

After the closure of the STAQ and NETS, holders of legal person shares constantly appealed to revive the OTCs. As a response, the Securities Association of China (SAC) with the State Council’s approval initiated the ASTS (Daiban Gufen Zhuanrang Xitong/代办股份转让系统), or colloquially the Third Board (Sanban/三板), in 2001. At first, only legal person shares originally traded on the STAQ and NETS were allowed to transfer on the ASTS. Later on, shares of companies delisted by the stock exchanges were also traded on the ASTS.^[115] As the name ASTS suggests, it had to entrust a securities company as an agent (market maker) to trade each type of shares.^[116] The qualified securities company should obtain permissions from both the CSRC and the SAC.^[117] The ASTS was not an independent OTC, because the trading, matching and settlement completely relied on the infrastructure of the SZSE. The ASTS merely assembled trading quotations of shares of unlisted and delisted companies while the trading of exchange-listed shares continued to be concentrated on the exchanges. Therefore, the ASTS did not violate the concentration rule stipulated by the Securities Law of 1998.

The ASTS only resolved the problems of legal person shares and shares of exchange-delisted companies. The ASTS did not provide a listing function for companies, which were in capital shortage but excluded by the exchanges. These companies began to lobby the central government heavily. The central government realized that the SSE and SZSE have been unable to satisfy the growing demand of listing and the strict listing criteria have excluded a large number of companies, especially small and medium-sized companies.^[118] Therefore, the central government to honor its commitment of building the socialist market economy approved the small and medium-sized enterprise board (SMEB) on the SZSE^[119] and proposed to establish multilateral securities markets in 2004.^[120] This proposal was enacted into law by amending Article 32 of the Securities Law of 1998 in 2005. The new Securities Law of 2005 puts it as “[s]hares, corporate bonds and other securities publicly issued according to law shall be listed and traded on stock exchanges established according to law or transferred in other trading places approved by the State Council” [emphasized by the author].^[121]

4.1.2 Unfixing the commission regime

China’s exchanges initially set 0.35% as a fixed commission rate. This rate remained unchanged until the CSRC introduced a downward-floating commission regime in 2002. The commission ceiling charged by exchange members is 0.3% of the trading value, while members have full discretion to set the rate as low as zero.^[122] The reform background in China is very similar to that in the US. The trading volume in China has had a sharp increase since 2000, so brokerage members began to grab trading business by discounting the commission rate and providing rebates. Their activities breached the original commission rule and disordered the secondary market. Furthermore, institutional investors with growing size, expertise and confidence tried to negotiate lower commission rates with exchange members.^[123]

Bearing such background in mind, the CSRC asserted that the fixed commission was detrimental to competition between brokers and that the original commission rate was too high to stimulate investors’ enthusiasm to trade shares. A floating commission regime was expected to reduce trading costs and facilitate the liberalization of China’s securities market. The CSRC at the same time believed that investors may not be well protected under the fully liberal commission regime adopted by Anglo-American jurisdictions, and thereby, a ceiling was set for the commission rate.^[124] According to the new regime, brokerage members must set their own specific commission rates and report them to the CSRC, pricing administration department and taxation department.^[125] Moreover, brokerage members cannot engage in unfair competition such as inducing clients by cash rebates, gifts or services irrelevant to securities business.^[126]

4.1.3 Defining the stock exchanges as a SRO

Although the exchanges have had some disciplinary powers over listed companies and their members pursuant to the Securities Law of 1998, their SRO status was not confirmed until the definition of exchange was revised by the Securities Law of 2005. The Securities Law of 1998 defines the stock exchange as “a non-profit legal person that provides a place for the centralized trading of securities.”^[127] The Securities Law of 2005 redefines it as “a legal person that provides the relevant place and facilities for concentrated securities trading, organizes and supervises the securities trading and applies a self-regulated administration [emphasized by the author].”^[128] Furthermore, the CSRC devolved more self-regulatory powers back to the exchanges. First, according to the Securities Law of 2005, listing of shares is subject to the examination and approval of the exchanges based on listing contracts between applicants and exchanges.^[129] It overturns the administrative approval model prescribed by the Securities Law of 1998, by which listing of shares shall be verified and approved by the CSRC or the exchanges based on the CSRC’s administrative authorization.^[130] Second, the exchanges are empowered to suspend or terminate the listing of shares in certain cases.^[131] Such powers were only held by the CSRC previously.^[132] Third, the exchanges may freeze securities trading accounts immediately if abnormal trading is detected, after which they file the frozen action with the CSRC.^[133] Previously, the exchanges were merely allowed to monitor and report abnormal trading to the CSRC.^[134]

4.2.1 The rapid growth of institutional investors and their market-oriented influence

On China’s stock exchanges, institutional investors consist of securities companies, securities investment funds, private equity funds, trust companies, enterprise annuities, national insurance funds, insurance companies, qualified foreign institutional investors and so on.^[135] In spite of their steady development since 2000, China’s institutional investors took off in 2006 when a great many of legal persons became institutional investors due to the “Full Circulation Reform”.^[136] Fulin Shang, former Chairman of the CSRC, declared that nearly 70% of the total value of listed shares had been held by institutional investors by November 2010.^[137] Correspondingly, large institutional orders also had compelling growth. As Figure 1 shows, the executed block share orders^[138] on the SSE numbered 48 in 2006, but this increased approximately 42-fold up to 2024 by 2011. During that period, the total trading volume of block orders saw an ever bigger increase – around 59 times from 1.41 billion to 82.95 billion.

Figure 1

Executed block share orders on the SSE^139[139]

The rapid growth of institutional investors generated an interest group with increasing influence. Its primary target was to protect economic and industrial interests of institutional investors. It has been observed that the group intensively lobbied the authorities for enabling dynamic trading mechanisms of securities over the past few years. For example, the institutional investors with purposes to seek more business opportunities and to manage risks of stock trading have appealed to conduct margin trading and short selling of shares on the exchanges for a long time. Their appeal was finally approved by the CSRC in 2010.^[140] The rising of institutional investors are creating an environment where more market-oriented changes are possible, which may place some constraints on the authoritative influence in the long run.

4.2.2 Expanding multilateral securities markets

The Securities Law of 2005 brings China’s multilateral securities markets into an era of expansion. On the exchange side, the listing thresholds of SMEB are still too high for most SMEs, particularly for high-tech emerging companies. For example, the applicant should have a net profit of over 30 million RMB accumulatively over the last three years.^[141] For the sake of encouraging the development of emerging companies, the SZSE with the CSRC’s authorization opened up the growth enterprise board (GEB) in 2009, which set lower listing criteria. The net profit requirement over the last two consecutive years was reduced to 10 million RMB.^[142]

On the OTC side, in order to alleviate the financing difficulty of high-tech companies located in the Beijing Zhongguancun Science Park (the so-called Chinese “Silicon Valley”), the State Council allowed these companies to be listed on the ASTS in 2006. Because of this expansion, the ASTS was called the New Third Board (Xinsanban/新三板) colloquially. In 2012, the State Council further expanded the scale by permitting companies located in the high-tech zones of Shanghai, Wuhan and Tianjin to be listed on the ASTS.^[143] In January 2013, the State Council upgraded the SZSE-affiliated ASTS into an independent national OTC in order to list more SMEs from all parts of the country. The new OTC is named the National SME Share Transfer System and is regulated by the CSRC.^[144] There have been 367 listed companies on this OTC so far.^[145]

In respect of local STCs, although all of them had been closed down by the State Council before 1999, some local governments “illegally” reopened some STCs after the State Council’s rectification and clearance. Many companies were listed on these revived STCs.^[146] Meanwhile, a great deal of unlisted share trading shifted to local auction houses, which were originally created to transact real estate rights, intellectual properties and other non-equitable rights. Zhou asserts that after 2006 there have been more than 300 local OTCs (STCs and auction houses) in China.^[147] These OTCs in “darkness” play an active role in supplying local industry with funds, booming local economies and enriching local budgets with stamp tax revenues. These benefits were recognized by the State Council, but the Council worried about manipulation and fraud on these OTCs as well as systemic risk. Consequently, the State Council launched another round of rectification and clearance of OTCs in 2011.^[148] Nonetheless, different from the last round of rectification and clearance, this round is not intended to close all the OTCs, but preserve those OTCs with large scale and put them under the joint supervision of local governments and the CSRC.^[149] One securities practitioner anticipates that each province will be allowed to set up one STC in the future.^[150]