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 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:
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:
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:
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:
The scope of the third-party review should address the following:
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.