Hong Kong's new investment rules get mixed reception

The new code for unit trusts wins broad support, but question marks remain over fund statements and the use of VaR for valuing derivatives.
Hong Kong's new investment rules get mixed reception

It was clear that Hong Kong, like other jurisdictions, would tighten rules on the manufacture and sale of investment products. Having begun a three-month consultation to this effect in September, the Securities & Futures Commission (SFC) on Friday (May 28) issued the consultation conclusions and the final version of the regulations. 

The full title of the document -- SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Products -- is something of a mouthful, but it makes clear the scope of coverage. The implementation date, however, is yet to be decided.

Most of the proposals contained in the consultation paper will be adopted in the handbook and revised codes, says Clifford Chance in a note to clients released on Monday. But there are some helpful modifications and amendments which take into account responses received during the consultation process, adds the law firm.

There are also, inevitably, some areas where fund managers would have preferred to see a different outcome. After all, as Clifford Chance points out: "This is the biggest shake-up of the regulatory landscape in Hong Kong since the introduction of the Securities and Futures Ordinance in 2003."

"There are not really any surprises [in the new rules]," says Mark Shipman, a partner at Clifford Chance in Hong Kong. "I haven't got into all the detail as yet, but there are certainly some things that have moved in the right direction. But there are also some provisions that we would have liked to have seen ease, but which haven't been so."

One area that Shipman feels could have been dealt with better is that of the product key facts statement (KFS).

The issue is not that the KFS will form part of the product offer document -- it has been decided that it will, a move that Shipman supports. It is rather that "Hong Kong is going it alone with the KFS at the moment, as we don't know how it will sit alongside the [awaited] key information document [KID] from the European Union", he tells AsianInvestor

Shipman says he understands that the SFC will provide more detail on this once there is more certainty regarding the KID and that the regulator did not want to hold up the introduction of the KFS. "But it may disappoint some that they couldn't hold [the KFS] up for a period while the EU sorts out its act," he says.

A spokesman at the SFC says the product KFS was proposed with Hong Kong investors in mind, so it needed to be delivered in a timely manner."The Commission has considered among other things the proposal of KID in the EU," he says. "We will continue to monitor the development of KID in the EU."

Another area where fund managers may be unhappy with the outcome is in relation to the use of financial derivatives for Ucits III-compliant products, for example. For the purposes of calculating global exposure to derivatives, the SFC will require managers to use a 'commitment approach' rather than the value-at-risk (VaR) approach, whereas managers have tended to use the latter for Ucits III funds.

The commitment approach is more conservative and possibly easier to understand, says Shipman, but it gives the manager less flexibility with regard to derivatives exposure. The SFC has taken the view that Hong Kong firms need to get familiar with the simpler approach first before they are allowed, potentially, to use the VaR approach.

The SFC responds that the ability to use derivative instruments in SFC-approved funds is new to Hong Kong investment managers, which explains its staged approach to adopting an expanded regime, particularly when it comes to risk management.

"The issue of allowing the VaR approach for risk management may be examined at a later stage, after the market has familiarised itself with the new concept of financial derivative investment now provided under the revised unit-trust code," says the SFC spokesman.

Product distributors are also affected by the new SFC rules. For example, there is a new obligation on product providers to "exercise reasonable care and diligence in the selection and appointment of distributors for a product, in particular, having regard to whether such distributor is suitably qualified and competent to discharge its obligations properly".

As a result, product providers will need to revisit their distributor due-diligence process to ensure they are comfortable with the adequacy of their distributors' processes, says Clifford Chance. They will also need to check that distributors have appropriate and properly trained personnel who can understand and advise on particular products.

Another change that will concern distributors is the requirement to disclose the monetary or non-monetary benefits they receive. They will have to disclose the percentage or dollar amount of benefits up to a percentage ceiling of the investment amount.

But the SFC's final ruling on this is less strict than it might have been, says Shipman. The consultation had suggested that distributors may have had to disclose the full actual cash or percentage amount of benefits, rather than the amount up to a ceiling, he says. "So [the actual outcome] is relatively good news for distributors," he adds.

Another piece of good news for distributors is that audio recording of the client risk-profiling process and the advisory or selling process will not be made mandatory. This sets the SFC apart from fellow regulator the Hong Kong Monetary Authority, says Shipman.

SFC chief executive Martin Wheatley is widely regarded as a relatively progressive and reasonable regulator, a view that Shipman shares. Certainly, Wheatley has always stressed the importance of striking the right balance between strict regulation to ensure investors are protected and allowing the industry to prosper.

Moreover, at the time the consultation was released last year, financial firms were supportive of tighter rules and felt a regulatory overhaul was required, according to findings from a survey by law firm Allen & Overy and information provider Complinet.

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