As with financial regulation anywhere, the burden to comply rests primarily with the regulated
November 17, 2018. That's the date changes announced last year to the Fund Manager Code of Conduct, or FMCC, go into effect. The Securities and Futures Commission, or SFC, regulates the Hong Kong Stock Exchange and is overseeing the changes, which are aimed at asset managers licensed and registered in Hong Kong. The new regime works to increase transparency in financial markets and reduce risk, and in so doing better align the city's investment industry overall with international standards.
As with financial regulation anywhere, the burden to comply rests primarily with the regulated. Here's an overview of what operators and observers in the city's financial industry can expect come November.
1. THOSE AFFECTED
Fund managers responsible for the overall operation of a fund will be affected. To determine whether or not this is the case a fact-based review is necessary. To that end, the SFC offers a non-exhaustive list of examples designed to help suss the answer out.
The fund manager is considered to be responsible for the overall operation of the fund if:
- The senior management of a fund manager make up a majority of the fund's board of directors.
- Representatives of the fund manager constitute a majority of the board of directors of the fund.
- The fund manager is responsible for day-to-day management of the fund, despite having to seek the agreement of the trustee on matters of significance.
The SFC is strident about the fact that these examples are only that, examples. And that responsibility for compliance ultimately rests with each fund manager, who must use due skill, care, and diligence to comply with the requirements.
2. COUNTERPARTY RISK
Counterparty risk, also known as default risk, is the risk inherent in a contract that the other side won't live up to its contractual obligations. Counterparty risk is a danger to both parties and is a source of worry to regulators, who want to make sure the possibility of default is given due consideration by asset managers.
To this end, under the revised FMCC the SFC expects fund managers to generally have collateral valuation and management policy, haircut policy, and cash collateral reinvestment policy in place to manage counterparty risk. Any policies put in place should include the methodology to calculate haircuts on collateral received in connection with securities lending.
Methodologies should be designed to cover the maximum expected decline in the market price of the collateral asset—over a conservative liquidation horizon—before a transaction can be closed out. Haircut methodologies should cover a range of risk considerations, including market risk, counterparty credit risk, and foreign exchange risk.
For cash collateral reinvestment policy, fund managers are advised to set maximum remaining terms to maturity for any single investment in which the cash collateral is reinvested, and set concentration limits in regards to exposure to individual securities, issuers, guarantors, security types, and counterparties.
3. LIQUIDITY MANAGEMENT
Another source of risk regulators worry about is liquidity: how easily and how likely an asset can be sold at its current price. The revised FMCC looks at strengthening liquidity management as follows:
- Methodologies should be appropriate to the nature, liquidity profile, and asset-liability management of each fund. This is pretty vague, and puts liquidity management in the hands of individual fund managers, calling upon them to use their best judgment on a fund-by-fund basis.
- Managers should perform liquidity stress testing on their funds on an ongoing basis to assess the impact of plausible adverse changes in the market. Per the new FMCC, the extent or frequency of the testing should be proportionate to the nature and liquidity profile of each fund. Further, fund managers should have action plans in place should any of the stress scenarios materialize.
4. DISCLOSURE OF LEVERAGE
Under the new FMCC, fund managers should disclose the expected maximum level of leverage they've employed on behalf of their funds. Here the SFC is addressing the risk of being overleveraged: dangerous to individual funds and also systemically. And here again the SFC is leaving it up to fund managers to determine how leverage should be calculated or how much is too much, offering that there's no general consensus on how leverage should be calculated.
On this subject, the SFC also advises:
- Fund managers take into account the investor base when disclosing the calculation methodology, making it easy enough for fund investors to understand.
- Fund managers clearly explain and prominently disclose the basis of calculation of leverage.
- The minimum disclosure should be that of expected maximum leverage.
5. SIDE POCKETS
Side-pocket accounts are hedge fund mechanisms, used to separate liquid assets from illiquid assets. These assets could be just about anything: real estate, old wine, vintage cars, paintings, OTC stocks. They are all hard to value versus, say, mainstream stocks and bonds. But in hedge funds pretty much anything goes, so long as investors are beating the market.
Still, mitigating risk and increasing transparency is the goal of the SFC in the new FMCC. Regarding side pockets they therefore propose:
- Fund managers should have valuation policies, risk management competency, and proper control measures in place to manage side pockets.
- Fund auditors should be consulted before side pockets are created, and when determining the valuation policy.
- Fund governing bodies should consent to the circumstances in which side pockets are used and determine whether the authority to create side pockets has been disclosed to investors in fund documents.
- That the criteria for side-pocketing individual positions are consistent, and that side pocketed investments are subject to regular review.
6. FUND PORTFOLIO VALUATION
This gets at independent fund valuation, something the SFC believes managers should perform in the cause of greater transparency. To this end, the SFC directs fund managers to a set of principles published by the International Organization of Securities Commissions. These address the valuation of collective investment schemes.
Of particular interest to the SFC are policies and procedures that address fund manager conflicts of interest. Fund managers should:
- Appoint a qualified independent third party—being a legal or natural person independent from the fund, the fund manager, and any other persons with close links to the fund or fund manager—to be involved in the valuation process.
- Appoint a trustee or custodian to ensure that the fund manager carries out the valuation of the fund assets appropriately.
- Separate the valuation and pricing function from the investment management function to ensure that the persons who are responsible for making investment decisions will not determine the valuations.
The scope of the third-party review should address the following:
- Whether valuations are consistent with the designated methodologies.
- Whether any pricing overrides and errors are handled in accordance with the policies and procedures.
- Whether the fund’s business continuity policies ensure the valuation process can be carried out in the event of an emergency or other disruption.
WATCH YOUR STEP
And while the valuation process could be done by a functionally independent internal auditor, the clear implication is that an external auditor is preferred. The operative word here is implication. Like with much financial regulation, the revised FMCC asks the regulated to do a great deal of reading between the lines to stay out of trouble.
Hong Kong exists in a strange world, straddling east and west. Between the traditionally free market west and the continually evolving command capitalism of China. Shanghai is giving Hong Kong a run for its money as a financial center and Hong Kong wants to stay at least a step ahead. The revised FMCC is a step in the right direction in this regard, though it's one fund managers must watch their footing on.