This circular sets out the standards of conduct and internal controls the Securities and Futures Commission (SFC) expects of prime brokers (PBs), ie, financial institutions providing prime services1and conducting related equity derivatives activities in Hong Kong.
More detailed guidance is set out in a report, also issued today, which provides an overview of the prime services industry landscape in Hong Kong and shares observations and good industry practices noted from the SFC’s recent thematic review of the internal controls and risk management processes of selected PBs.
In particular, the SFC would like to highlight the regulatory obligations of PBs in light of the remote booking and operating models and roles of Hong Kong entities when they provide prime services. More details about the expected standards for key processes are provided in the Annex to this circular.
1. Operating models for prime services
Operating models for prime services can be complex and may involve multiple legal entities of a financial institution across different jurisdictions for (i) contracting with clients, (ii) serving clients on a day-to-day basis, (iii) managing risks associated with clients’ activities and (iv) booking corresponding risk positions of clients. In some cases, there may be more than one location involved in serving a particular client and managing the associated risks.
Typically for prime services clients serviced in Hong Kong, overseas entities at the group level are the contracting entities for clients globally and regionally, and these entities are the ones that provide margin financing to the clients. Consequently, the associated risk positions are also booked into such overseas entities even though the risk positions are originated locally.
2. Distinctive roles of Hong Kong entities
Hong Kong entities mainly operate as the Asia hub which provide services locally to international clients conducting trading or related activities in the region, with responsibilities over:
(i) Governance and management supervision – with a Manager-In-Charge overseeing prime services activities or the wider lines of business in which prime services activities operate, and regional governance committees set up to handle specific issues in the Asia Pacific region with oversight at global level.
(ii) Client life cycle management – client on-boarding process and on-going assessments are often carried out in Hong Kong for Asia-based clients who are contracted with overseas entities at the group level.
(iii) Margin financing and risk management – while credit is provided by overseas contracting entities, the day-to-day monitoring of margined portfolios and risk management functions for clients serviced in Hong Kong are carried out by PBs locally with oversight at the group level.
(iv) Short selling and securities lending – the securities borrowing and lending (SBL) desk will source securities from lenders to facilitate PB’s agency and principal short selling transactions in global markets, where the SBL desk in Hong Kong will generally cover the Asian markets.
(v) Handling of client assets – PBs in Hong Kong act as a sub-custodian of the overseas contracting entities holding certain client assets.
3. Regulatory obligations of PBs
Given that the operating models for prime services are fragmented by nature with multiple legal entities of a financial institution involved in different aspects of a client relationship, PBs are reminded that if clients are serviced in Hong Kong or if PBs are carrying out their prime services in Hong Kong, PBs are expected to comply with the applicable rules and regulations in Hong Kong regardless of where the risk positions are booked.
While PBs usually adopt the risk management framework set out at the group level, they should take reasonable steps to ensure that they operate within a holistic and robust risk management framework, with reporting and accountability processes clearly defined and suitably integrated across the different jurisdictions involved. PBs should overlay their risk management programmes with relevant local regulatory requirements and operational needs to ensure the standards are not less stringent than the applicable local rules. In the event that:
(i) the risk positions are not booked into Hong Kong, PBs should still have adequate controls and procedures in place to follow the relevant compliance standards established by their group companies. PBs are expected to:
(a) maintain effective policies and procedures for proper risk management and ensure adequate information is provided to allow management to take appropriate and timely action to contain or manage risks.
(b) establish appropriate risk limits for on-going monitoring and assess them periodically for appropriateness.
(c) conduct regular stress testing, which should also be tailored to special situations, for example, in cases of risk mismatches or when client portfolios hold illiquid positions or products with complex features and risk profiles. Stress testing methodologies should be properly defined and periodically reviewed.
(ii) an intermediary is the contracting entity where the risk positions for prime services are booked, PBs are reminded to comply with the applicable regulatory requirements, including those related to over-the-counter (OTC) derivative transactions, securities margin financing and the Securities and Futures (Financial Resources) Rules. In particular, the SFC would like to draw PBs’ attention to the proposed margin requirements for non-centrally cleared OTC derivative transactions set out in a recent consultation paper, and PBs should keep in view the consultation conclusions.
PBs are reminded that should PBs or their group companies be impacted by breaches or severe control failures arising from operations in Hong Kong, the SFC will assess the implications of such cases on the fitness and properness of the PBs in Hong Kong.