Late in 2002, after many months of guerrilla warfare with investment banks, Hong Kong authorities agreed to loosen the regulatory straitjacket around the city's warrants market.

The market rebounded in spectacular style. Last year's turnover of HK$524 billion was almost five times larger than that of 2002. Only 22 warrants were issued here in 2001 but, in the first seven months of this year, nearly a thousand appeared.

Hong Kong last year surpassed Germany as the world's most active warrant-trading center. But some people believe that being an international warrants mecca exacts far too high a price, both in terms of volatility of the broad market and vulnerability to share price manipulation.

Several times this year, big falls or rises in blue-chip stocks that seemed to have no explanation in terms of fundamentals have been put down to the influence of warrant trading.

Now many are asking if the regulatory pendulum has swung too far in the direction of laissez-faire, and if the time has come to bring the warrants market to heel. The question leaves the two entities that regulate stocks and derivatives trading in a distinctly uncomfortable posture.

One one side is the stock exchange and the brokers who control it, who stand to profit richly from the listing fees and commissions that the warrants avalanche has generated.

On the other side is the Securities and Futures Commission, which has been criticized for throwing away its own powers of oversight when it revamped the warrants trading structure to stimulate the market in response to appeals from investment banks.

Warrants come in two basic forms.

A call warrant gives the holder the right to buy a specific stock at a specific price - the exercise price - on a specific date. A put warrant confers the right to sell a stock, also at a set price on a given day. Prices of warrants fluctuate unpredictably along with the value of the underlying stocks, but the fact they are cheap - usually less than HK$1 each - makes them popular with retail investors seeking windfall gains from small wagers.

"Many retail investors have burned their fingers on this uneven playing field," said Stephen Hui, managing director of OSK Asia Securities. "The existing rules favor the warrant issuers. It's time for the regulators to plug the loopholes in the listing rules."

As an example of what can happen when warrant trading gets out of hand, critics of the relaxed regulatory regime point to August 18 this year, when the blue-chip Hang Seng Index slid by 1.95 percent at the close.

The trigger was a steep fall in the value of the shares of Bank of China (HK), which had just posted a disappointing set of interim financial results. As other blue chips fell in sympathy, some holders of call warrants feared the underlying stocks would soon be cheaper than the exercise price of the warrants, rendering the warrants worthless.

Availing themselves of a controversial "liquidity provider" mechanism, they sold their warrants back to the issuers in the secondary market; this exacerbated selling in the main market since the issuers had no choice but to dump some of the underlying shares to make sure their warrant trades were still profitable.

Not only was the main market hit, but the warrant market itself was seized by a veritable panic. Some warrant prices fell over 70 percent on the day.

Sometimes, the impact of warrant trading is limited to individual stocks.

During one week in August, shares of Bank of Communications jumped by 6.4 percent as issuers of 20 warrants came into the market simultaneously to buy the stock, looking to protect themselves in case its price continued to rise.

Following these two incidents, Secretary for Financial Services and the Treasury Frederick Ma called on the SFC to look into warrant trading and its impact on the broad market.

The SFC says it is examining several dubious warrant trades and has started a comprehensive review of the market.

According to a source close to the regulator, "the SFC is aware of the problem of warrant price movements that lead the movement of the underlying stocks, increasing market volatility and disturbing market order."

Prior to 2002, Hong Kong's listed warrants market was all but stagnant, and most people considered excessive regulation to blame.

Before a warrant could be listed on the stock exchange, for example, the issuer had to demonstrate proof of investor demand by lining up at least 100 "placees" committed to buying it. Moreover, issue size could not be increased at the issuer's discretion; to do so, the issuer had to begin the whole complicated process of listing all over again.

Merrill Lynch, the giant US investment bank, showed the most impatience with these constraints. In 1998 and 1999, it tried to circumvent them by lining up other brokers to pretend to be independent placees so that its warrants could be listed on the exchange. Once listing was achieved, Merrill would repurchase the warrants from the brokers.

The SFC and the stock exchange jointly reprimanded Merrill for using this tactic in 2000 and, in July 2001, the SFC threatened disciplinary action against all issuers who did not strictly observe listing rules.

This warning virtually paralyzed new issuance.

The regulators finally yielded in late 2002. The 100-placee requirement was scrapped, so that all warrants that had a prospectus and adequate legal documentation could be listed, whether there was demonstrable demand for them or not.

It also became possible to increase the size of an issue at will, provided that at least 80 percent of the original issue had been sold and the maturity of the warrant was more than six months.

But more significant than either of those changes was the establishment of a "liquidity provider" mechanism, which lets issuers buy and sell warrants at their discretion in the secondary market.

This allows the issuer to play the role of "market maker," the name usually given to a bank or broker that stands ready at all times to buy or sell a particular security - though, in most jurisdictions, banks and brokers are expected to keep their market-making activities separate from their brokerage activities.

Recent whispers out of the SFC indicate that officials there now regret having given their blessing to the liquidity provider system.

People close to the regulator say that allowing warrant issuers to act as market makers in their own instruments has made it virtually impossible to determine which trades are genuine and which are designed to manipulate the market.

"In the past, there was no such market-making system. If any warrant issuers wanted to create false turnover, they had to lend money to brokers to help them do it," one source said. "The SFC could trace the source of the funds to prove that an issuer had invented false trades.

"Now, the SFC can't collect this kind of evidence because it's lawful for the issuer to use his money to buy back warrants.

"Moreover, the liquidity provider system allows the issuers to manipulate the market in more ways than one. For instance, they can buy back warrants from brokers at above the market price.

"That's why it's so difficult for the SFC to catch the unscrupulous issuers."

According to the sources, the SFC is looking at ways of revamping the system - or even scrapping it altogether.

But the system has its defenders.

Johnny Yu, director of equity risk management at investment bank UBS, argues that without liquidity providers, false trading would be easier since there would be no one to maintain order in the market.

Yu also warns against measures that would make it harder to increase issue size. This would affect the supply-and- demand equation and concentrate warrants in the hands of a few investors, he said, making it that much easier for them to manipulate prices.

However, Raymond So, a professor of finance at the Chinese University of Hong Kong, who believes a review of the regulatory regime is long overdue, said an increase in the issue size often hurts small investors because the extra supply pushes down the price of the warrants.

While generally advising against tampering with the system, Yu said the regulators should do something to increase disclosure on the part of liquidity providers - forcing them to reveal details of their commission incentive programs, for example. It is common, he said, for warrant issuers to offer higher commissions to stock brokers who encourage their clients to trade a particular issuer's warrants.

Hong Kong Exchanges and Clearing, which runs the stock exchange where warrants are traded, believes both the liquidity provider system and the freedom to raise issue size ought to be preserved.

An even less restricted issuance system - one without any limits on issue size, and where increases in issue size take less time to complete - would produce fewer pricing anomalies, it argues.

The exchange operator also dismisses the argument that warrant trading aggravates market swings. It says the hedging activities of warrant issuers are just one of many factors that move markets.