Hong Kong - SFC Circular To Prime Brokers – Risk, Rules And Reward.

Legal News & Analysis – Asia Pacific - Hong Kong - Regulatory & Compliance

25 June, 2019


The Securities and Futures Commission (the “SFC”) has put out a circular to intermediaries conducting prime services and related equity derivatives activities, accompanied by a report on the thematic review which the SFC carried out on the topic, with an annex (the “Annex”) which provides a summary of the standards of conduct and internal controls the SFC expects in this area. The documents highlight some key recurring SFC themes of wider application, as well some specific points which prime brokers (“PBs”) should look at. 


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There has been a steep growth of hedge funds’ assets under management over the last ten years in Hong Kong, and the SFC believes this increase means that prime brokers play an increasingly significant role in the Hong Kong financial markets. The SFC therefore started a thematic review of prime brokers in October 2017 to assess practices, controls and risk management processes. The thematic review consisted of questionnaires and follow up prudential visits across a number of financial institutions in Hong Kong which provide prime services. The findings arising from the thematic review have resulted in the circular and the Annex setting out reminders of and expectations for PBs’ standards of conduct and internal controls. 


SFC Verdict


The SFC recognises that PB client relationships involve services provided through various group entities in multiple jurisdictions, and often result in complex operating models. The circular notes that Hong Kong is often the Asia hub for the provision of these global PB service offerings and breaks down the responsibilities for Hong Kong PBs as covering six areas. We highlight some of the SFC’s observations and expectations in each of these areas below.


Governance and Management Supervision


Effective oversight and governance of PB services must be implemented and continuously ensured, with procedures to allow for escalating matters to senior management for review.

PBs are expected to comply with Hong Kong rules and regulations, regardless of where risk positions are booked…


However, in recognition of the importance of Hong Kong as an Asia hub within larger groups, the SFC recognise the need for PBs to also have controls and procedures in place to ensure compliance with standards and requirements to be applied on a group wide basis.


The SFC findings show that in practice there is usually a manager in charge with responsibility for oversight of PB services, or at least oversight over the wider area in which PB services sit.


Governance committees should have clearly demarcated responsibilities and terms of reference to ensure the structure, purpose and operation of each committee are clear.


PBs should employ a second line of defence for oversight and management of the risks and controlling key processes.


There should be formalised governance procedures in place with continuous monitoring for identifying and managing or eliminating conflicts of interest.


In addition, there should be staff training in identifying conflicts of interest, and controls to detect conflicts, rather than solely relying on post-conflict escalation.


Client Life Cycle Management 


Paragraph 2.1 of the Annex reminds PBs that they must establish the true and full identity of their clients, their creditworthiness and overall risk profile. 


Establishing the true and full identity requires a deep dive into structure, governance, risk management, investment expertise with more detail provided in paragraph 2.1 of the Annex than in paragraph 5.1 (Know your client: in general) of the SFC’s Code of Conduct for Licensed Persons. The SFC finds good practices amongst the in-depth investigation into potential clients seen in the thematic review and highlights requiring updated information to be provided during lengthy application processes as a good practice.


Clients serviced from Hong Kong must be subject to Hong Kong anti-money laundering/counter terrorist financing CDD, even if the clients have been onboarded using contracts with overseas affiliates.


PBs should carry out ongoing assessments of clients (including creditworthiness, risk and so on), for example on an annual basis, and any ad-hoc reviews, such as an event driven review, should not generally push back the standard periodic reviews in place.


Margin Financing 


In recognition of the multi-jurisdictional practices involved in providing credit to clients, PBs should have guidelines in place, along with controls and procedures, to follow group-wide margin financing standards and the relevant rules and regulations.


Clear and well documented controls and procedures must be in place for the provision of margin financing, including monitoring margin terms are appropriate, enforcing or waiving margin calls and the use of manual price overrides.


Criteria for deviations from policies should be clearly set out and be approved independently or by management, as well as being documented.


Short-selling and Securities Lending


Pre-trade controls over both agency and principal short selling should be established to ensure that cover has been obtained for all short selling orders, and post-trade controls are also required to ensure that orders were correctly tagged long or short, and any uncovered short selling is caught.


The SFC expects timely post-trade reviews in order to identify uncovered short selling or tagging errors and noted that reviews carried out on a quarterly basis would not meet this expectation.


The SFC highlights as good practice requiring compliance to review internal transfers between accounts across aggregation units to ensure the movement of internal inventory across trading books and aggregation units as in compliance with regulatory requirements. 


The SFC also encourages the use of compliance where changes are being made to standards procedures, for example approval of changes to, and periodic reviews of, aggregation unit structures.


Handling of Client Assets


PBs should have sufficient controls in place to ensure client assets are promptly and properly accounted for and adequately safeguarded.


PBs should properly maintain a client’s entitlement to the relevant assets in their own books and records and keep client assets separate from the assets of the PB. 


Management oversight should be in place for the rehypothecation of client assets with adequate monitoring and controls established to ensure assets which are no longer available for rehypothecation are returned to clients in a timely manner.


Risk Management and Controls


As with governance and margin lending, the SFC observes that while PBs usually adopt the risk management framework set out at the group level, they should overlay their risk management programmes with relevant local regulatory requirements and operational needs to ensure local standards are met. 


PBs must ensure the proper management of the risks to which they are exposed, and that adequate information is provided to enable management to take appropriate and timely action to contain and otherwise adequately manage risks. The SFC suggests implementing the following at a minimum: Risk limits should be established and periodically assessed for individual funds, clients, counterparties, business units, specific risk categories, legal entities and others as appropriate. 


Monitoring procedures should be established to ensure that any breaches of risk limits are escalated to management as well as independent control functions. 


Stress testing should be conducted regularly to assess the impact of market stress on prime services activities. It should also be tailored to special situations, for example, when client portfolios hold illiquid positions or products with complex features and risk profiles and in cases where risk mismatches exist. 


Stress testing methodologies should be properly defined and periodically reviewed. They should cover extreme scenarios e.g. market illiquidity and flash crashes. 


When issues are identified, they should be escalated to management in a timely manner for appropriate follow-up action. Contingency plans should be in place in the event of a “black swan” market scenario.



For further information, please contact:


Annabella Fu van Bijnen, Partner, Linklaters