Martin Wheatley, CEO of Hong KongÆs Securities and Futures Commission, says he and other securities regulators plan to draft new measures regarding structured products, to protect investors against credit and collateral risks.

The move has been prompted by complaints among thousands of Hong Kong investors, who have marched in the streets to protest losses in Lehman Brothers HoldingsÆ credit-linked notes, so called minibonds. Hong Kong investors put HK$12.7 billion ($1.6 billion) into these notes, along with another HK$3 billion into other Lehman structured notes.

The marchers and other investors complaining to the SFC and the Hong Kong Monetary Authority say they were misled by selling agents (notably commercial banks) regarding the productsÆ risks. Structured products are often perceived to be bank deposit substitutes.

ôIn theory, the characteristics of structured products are known up front,ö Wheatley told an audience yesterday at a retail-funds conference organised by the Hong Kong Investment Funds Association. ôBut these do not involve just market risk, but also credit risk and, in the case of the Lehman minibonds, collateral risk.ö

He says the forum for regulators to hash out a solution is within the International Organization of Securities Commissions (Iosco), and that a response is likely within three months. ôI would expect an overhaul of the structured-products market in Hong Kong, and globally,ö he says.

He emphasises, however, that the point of this review is not to stifle financial innovation, but to understand how this fiasco came to be, and find ways to ensure it is not repeated. Nor does it imply that all structured products are bad, he adds.

Fund management companies regularly complain that structured products operate without proper supervision. Whereas mutual funds require a prospectus, minimum capital, and are vetted carefully by regulators, structured products, especially notes, can be banged out by banks with relatively little supervision. These are governed by the HKMA, not the SFC.

The issue was not so pressing when structured notes first became popular in Hong Kong, and other local jurisdictions such as Singapore and Taiwan, in 2002-04. These products were usually very big and relatively few. Now, however, the structuring banks and the distributors have learned to bang them out quickly, and in smaller amounts, to cover niche or thematic investment ideas û making them harder to track, argue some fund management executives.

When asked about this lack of a level playing field, Wheatley did not comment directly on the role of the HKMA. He does note that the SFCÆs job is to approve a prospectus and marketing materials û not the product itself. The selling agents must abide by HKMA know-your-client rules, and obtain a written confirmation from customers that they understand the product and its risks.

ôThat [understanding of risk] clearly didnÆt happen,ö Wheatley says. ôBoth we and the HKMA are working closely to see whether there has been any misconduct or mis-selling of products by licensed institutions and regulated banks,ö he says.

WheatleyÆs address was sober. Noting this past weekend saw the US Congress sign off on its $700 billion bailout package, the partial nationalisation of Fortis in Europe, and a wave of local complaints regarding the Lehman minibonds. ôThis is not a good time,ö Wheatley says.

The funds industry is important to Hong Kong, and the territory feels exposed to the viability of global financial institutions. Regulators must evolve quickly to handle new asset classes, new trading strategies, increasingly complex products, and operational risks.

Regulators are now calling for investment managers to improve the due diligence they conduct on productsÆ risk characteristics, and of the suitability of such products for their clients. This includes ensuring fund houses have proper risk-management and reporting capabilities, Wheatley says, as well as the ability to communicate product characteristics to selling agents.