The Securities and Futures Commission (SFC) in Hong Kong has issued a reprimand to Macquarie Equities (Asia) Ltd (Macquarie) and fined it HK$4m following an investigation into it's operation of a commission rebate scheme in relation to derivative warrants issued by Macquarie Bank Ltd (MB warrants).

An SFC investigation found that Macquarie operated the commission rebate scheme between January 2004 and January 2005 "in breach of its obligation to act with due skill, care and diligence in the best interests of the integrity of the Hong Kong market".

The SFC said Macquarie used the commission rebate scheme to reduce transactions costs for investors and stimulate trading in selected MB warrants.

Under the rebate arrangement, Macquarie has agreed to reimburse investors, through their participating brokers, either in full or in part, the brokerage costs they were charged by their brokers for trading specified warrants.

In January 2002, the SFC warned Macquarie that they should ensure their commission rebate scheme did not facilitate trading of MB warrants that was not for any genuine economic or commercial purpose. The SFC was concerned that the commission rebate scheme could encourage improper trading and lead to a false market for the MB warrants.

The SFC identified heavy trading activities in MB warrants between two clients from two participating brokerages during the period from January 2004 to January 2005. It found the two clients repeatedly traded the MB warrants at or near the same prices within short time intervals and created substantial amounts of turnover. While generating a significant amount of commission rebate from Macquarie, the two brokerages gave the clients discounts on brokerage costs for large volume trading, and were then able to generate risk-free profit from the difference between the commission rebate and the discounted brokerage costs.

The SFC confirmed Macquarie had put in place some controls to deal with the risk to market integrity and monitored the payment of commission rebate. However, it failed to check whether the commission rebate scheme was providing clients with more money than was required to rebate actual brokerage costs. In criticising Macquarie, the SFC said the volume and nature of the trading should have alerted it to make additional inquiries about the operation of the commission rebate scheme and to check whether it was distorting the market for these MB warrants.

The SFC said if Macquarie had realised the true nature of this trading activity, it would have been obliged to ban those brokers from further participation in the commission rebate scheme. But while Macquarie eventually did ban some commission rebate scheme participants, the SFC said this was too late, and Macquarie's failure to properly monitor the operation of its commission rebate scheme contributed to conditions which created a distorted market for the relevant MB warrants for more than a year.

The trading may have misled investors that certain MB warrants were more actively traded by a wider range of investors than was actually the case.

Mark Steward, executive director of enforcement at the SFC, said: "Licensed intermediaries, especially those entrusted with the function of providing liquidity in a derivative warrant market, have an obligation to help protect market integrity.

"Intermediaries should be alert to identify obviously suspicious trading especially when put on notice by the regulator and we will take action where intermediaries fail to maintain the standards of diligence expected in Hong Kong."

In deciding on the public reprimand and a fine of HK$4m, the SFC wanted to make clear it taken into account that Macquarie had taken some steps to supervise its commission rebate scheme, it was not itself a party effecting any abusive trading, it had co-operated with the SFC in the disciplinary proceedings, and its clean disciplinary record.