Laws framed in haste can hurt markets, says SFC head

A strong regulatory response is required post-crisis û but not too strong, says Martin Wheatley, Hong Kong's top securities supervisor.

Amid interruptions by recorded fire-alarm announcements, the head of Hong Kong's Securities and Future Commission (SFC) on Tuesday described the delicate balancing act of tightening rules on the sale of investment products.

It probably wasn't the toughest heckling Martin Wheatley has had to deal with in his supervisory career, and he responded good-humouredly: "If only a financial crisis was like a fire alarm -- you go to investigate, and then five minutes later you can give the all-clear."

Addressing a conference organised by law firm Allen & Overy in Hong Kong, he told the audience that recently "regulators have been somewhat higher profile than we would want". This comment was on good authority, as Wheatley has just returned from a trip to Europe where he met with bodies such as the International Organization of Securities Commissions and the UK's Financial Supervisory Agency.

Financial supervisors worldwide have certainly been busy in recent weeks and months, and the SFC is no exception. It launched a 96-page consultation in late September on rules governing the sale of unlisted investment products, in a bid to avoid a repeat of issues such as the Lehman Brothers minibond fiasco.

Changes are certainly needed, says Wheatley, "but we don't want to have such an extreme reaction that we get to the stage where it's impossible to create or sell products". He cites as one example recent restrictions in Hong Kong on the sale of renminbi sovereign bonds. These resulted in an "over-complication of the sales process that made it very difficult to sell what is fundamentally a straightforward product", he says.

Wheatley went on to discuss regulatory reactions to the crisis elsewhere that did not work as hoped, including bans on short-selling of shares, which had consequences that governments -- such as those in the UK, US, Australia and Taiwan -- did not envisage.

"If you ban short-selling, then liquidity provided by those running a long-short strategy will be withdrawn," he says. "Short-selling disincentivises long buying; the convertible [bond] market dried up, because shorting is such a crucial part of buying into any new convertibles." There was also confusion over whether short sales were "naked" or "covered".

"There were many implications [of the shorting ban]," adds Wheatley, "and the upshot was that it was negative for markets. It caused a widespread reduction in liquidity, and most markets turned round and said 'that was a mistake; it was a knee-jerk reaction to a crisis'."

He cited as another potential over-reaction by lawmakers the recent draft European Union legislation on alternative fund management. "This again is an effort that's been put together in haste that could have a detrimental impact on the global fund management industry," he says.

The current draft effectively creates a "fortress Europe", says Wheatley, meaning you have to be registered in Europe or an "equivalent jurisdiction" to sell alternative funds into the region. This sounds simple, but it is no easy task determining whether two jurisdictions are "equivalent". "It would make it very difficult for us to work out how we would regulate funds offering services into Europe," he says.

For example, one of the draft's requirements is that the regulator should have the power to reduce leverage in a fund. "I'm not sure we have the technical expertise to go in and tell a fund how and where to reduce leverage," says Wheatley.

And even if regulators realise that to act in haste means they may repent at leisure, that still leaves the big question of how much protection they should give investors.

Wheatley cites the issue of minibonds, suggesting that the man in the street should perhaps not be sold a product that effectively underwrites credit insurance for several large US institutions and includes a number of embedded derivatives contracts.

By the same token, he points out, investors could have been a little more curious about why a product being allegedly touted to them as "similar to a bank deposit" could provide annualised returns of 6%, 7% or 8% when bank deposit rates were more like 1%. Then again, says Wheatley, when presented with two 200-page prospectuses and a product flyer urging the customer to read the prospectus, most people are unlikely to wade through the former.

The overarching issue -- whether we are talking about retail investors in minibonds or high-net-worth clients buying accumulators -- is that people tend to disregard the possibility of downside risk, he says.

Wheatley says he is often asked the question: 'Why not make all investment products suitable for all investors?' -- to which he answers that doing so would "stifle innovation and we would be left with very simple products, going back to bank deposits and shares and not much else. I don't think that's where we need to go."

Of course, some response is necessary, hence the SFC's proposals. Wheatley highlights the main proposals and areas of consultation, which include:

  • A 'key facts' statement that would "sit somewhere between the product flyer and the 200-page document written to protect the issuer";
  • A consultation as to what extent brokerages and banks should disclose their own commercial interests, fees and so on upfront when selling financial products to the public;
  • A consultation on 'investor characterisation' -- whether institutions selling complex products or products that have complex derivatives embedded in them should first establish that the customer has derivatives knowledge;
  • A proposed "cooling-off" period for investors who change their mind after buying longer-term products, allowing them to get a refund subject to a reasonable administrative charge and any legitimate market-value adjustment;
  • A consultation on whether audio recording of sales conversations should be required; and
  • A discussion as to how a "professional investor" should be defined.

In his concluding remarks, Wheatley says: "We need to have a regulatory response to the problems [created by the financial crisis], but we need one that is balanced. It's very much our objective -- and I hope yours as well -- that when we come through this process, it's important that we have a market in Hong Kong that does protect investors, but continues to be an active, vibrant, competitive market."

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