Warning on the provision of margin financing in the guise of investments
On 3 August 2018, the Securities and Futures Commission (SFC) issued a circular regarding arrangements which might involve a licensed corporation (LC) assisting unlicensed persons to provide securities margin financing (SMF) in the guise of investments.
The provision of SMF is a regulated activity under the Securities and Futures Ordinance. Unless exempted, any person carrying on SMF business is required to obtain a Type 1 or Type 8 licence (in either case with stringent financial resources requirements) and is also subject to other regulatory requirements including the capital requirements under the Securities and Futures (Financial Resources) Rules and the risk management requirements governing margin lending under the Code of Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct).
In the circular, the SFC emphasised that LCs should not facilitate the setting up or operation of SMF business to circumvent these requirements. The SFC provides examples of features of discretionary accounts or private funds which may raise questions about whether the arrangement constitutes SMF. These features include:
- a sizeable, concentrated investment position in one or more security and the funds for the acquisition of such investment(s) were provided by the LC’s clients and the unlicensed person(s);
- a mechanism, akin to a margin call, where the LC’s clients are required to provide additional capital or collateral when the value of the investments fall below a certain level;
- the unlicensed person is entitled to receive a guaranteed yield; and
- the clients and the unlicensed person(s) pre-agreed the securities to be acquired, with the asset manager having no investment discretion.
The SFC warned that provision of SMF in the guise of investments is illegal and anyone involved in these activities may be liable to prosecution.
The circular of 3 August 2018 is not the first time the SFC raised with fund managers its concerns regarding SMF activities. The SFC highlighted irregularities, deficiencies and common instances of non-compliance in managing funds and discretionary accounts in its circulars dated 31 July 2017 and 15 September 2017.
Ongoing supervision of SMF activities
Back in October 2017, the SFC called for prudent risk management by LCs engaged in SMF and reminded senior management to ensure compliance with the relevant regulatory requirements for margin financing business.
On 17 August 2018, the SFC published a review of SMF and issued a two-month consultation on proposed guidelines that will apply to all LCs carrying on SMF activities. The report revealed a number of control deficiencies and imprudent margin lending practices which give rise to concerns. The SFC considers some brokers have taken on unacceptable financial and concentration risks which weaken their resilience in stress situations.
The existing conduct requirements for SMF activities are mainly set out in the Code of Conduct and the Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the SFC. These requirements are high level and principle-based, and SMF brokers apply their own interpretations in designing their risk control policies and procedures. The proposed guidelines provide for quantitative benchmarks for measuring and monitoring key SMF risks and qualitative requirements for seven key risk control areas. The guidelines aim to standardise the risk management practices for SMF businesses and prevent the SMF brokers from operating its SMF business beyond its financial capability.