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Financial Services Risk and Regulation

Regulatory Updates Newsletter

September 2018

PwC · 2Regulatory Updates Newsletter — September 2018

Contents

Executive Summary 3

Consultation on Incentives to centrally clear over-the-counter (OTC) derivatives 4

Circular on Internal Models Approach for Market Risk 5

Consultation on the Proposed Guidelines for Securities Margin Financing Activities 6

Circular on Margin Financing Activities Disguised as Investments 7

Circular on Mystery Shopping Programme on AIs’ Selling Practices 8

Guidance on online distribution platforms for non-SFO-regulated structured investment products

9

Other Regulatory Updates 10-11

Glossary 12

Executive Summary Consultation on

Incentives to centrally

clear over-the-counter

(OTC) derivatives

Circular on Internal

Models Approach for

Market Risk

Consultation on the

Proposed Guidelines

for Securities Margin

Financing Activities

Circular on Margin


Disguised as

Investments

Circular on Mystery

Shopping Programme

on AIs’ Selling

Practices

Guidance on online

distribution platforms

for non-SFO-regulated

structured investment

products

Other Regulatory

Updates

Glossary

Executive Summary

Emily LamPartner+852 2289 1247PwC HK FS Risk and Regulation

“Last month was active with several new regulatory developments and guidelines. With this newsletter, we will continue to keep you up to speed with significant regulatory developments from the financial services industry.”

It was a busy yet exciting month with several regulatory updates and guidelines from both international as well as local regulators.

The regulatory updates in the last month included:

• The FSB, the BCBS, the Committee on Payments and Market Infrastructures (CPMI) and the IOSCO published a consultative document on incentives to centrally clear OTC derivatives, which is a pillar of the G20 Leaders' commitment to reform OTC derivatives markets in response to the global financial crisis.

• The SFC issued a circular to show its intent to facilitate the adoption of an internal models approach to be used by LCs where appropriate to calculate the capital requirements for market risk for proprietary investments.

• Further, the SFC launched a two month consultation on proposed guidelines to clarify, codify and standardise the risk management practices for securities margin financing (SMF). The guidelines would provide qualitative guidance

and quantitative benchmarks for margin lending policies, and key risk controls to prevent SMF brokers from expanding margin loans beyond their financial capability.

• Moreover, in the course of its ongoing supervision of LCs, the SFC has observed that some LCs carrying on asset management activities may have aided and abetted unlicensed affiliates or third parties to provide securities margin financing in the guise of investments. Therefore, the SFC issued a circular warning of the provision of margin financing in the guise of investment.

• And finally, the HKMA has decided to conduct a Mystery Shopping Programme (MSP) on AIs’ selling practices with respect to investment and insurance products.

For more details of these rules and regulations and other regulatory updates such as the circular on SFC disciplinary fining guidelines, the HKMA issuing a consultation on amendments to Banking (Capital) Rules to implement BCBS standards, and the IA circular regarding matching adjustment for second QIS for

development of RBC regime, please refer to the following sections in this publication.

Emily LamFS Risk and Regulation+852 2289 [email protected]

Regulatory Updates Newsletter — September 2018 PwC · 3




(OTC) derivatives


Models Approach for

Market Risk

Consultation on the

Proposed Guidelines



Circular on Margin


Disguised as

Investments

Circular on Mystery

Shopping Programme

on AIs’ Selling

Practices

Guidance on online




products

Other Regulatory

Updates

Glossary


Consultation on Incentives to centrally clear over-the-counter (OTC) derivatives

The consultative document evaluates how post crisis reforms interact and how they could affect incentives to centrally clear OTC derivatives

The FSB, the BCBS, the Committee on Payments and Market Infrastructures (CPMI) and the IOSCO published a consultative document on incentives to centrally clear OTC derivatives.

Centrally clearing standardised OTC derivatives is a pillar of the G20 Leaders' commitment to reform OTC derivatives markets in response to the global financial crisis. A number of post-crisis reforms are, directly or indirectly, relevant to incentives to centrally clear.

The evaluation will inform relevant standard-setting bodies, and if warranted, could provide a basis for fine-tuning post-crisis reforms, keeping in mind the original objectives of the reforms.

The key findings of the evaluation, the

second under the FSB framework for the post-implementation evaluation of the effects of G20 financial regulatory reforms are:

• The changes observed in OTC derivatives markets are consistent with the G20 Leaders' objective of promoting central clearing as part of mitigating systemic risk and making derivatives markets safer.

• The relevant post-crisis reforms, in particular the capital, margin and clearing reforms, taken together, appear to create an overall incentive, at least for dealers and larger and more active clients, to centrally clear OTC derivatives.

• Non-regulatory factors, such as market liquidity, counterparty credit risk management and netting efficiencies, are also important and can interact with regulatory factors to affect incentives to centrally clear.

• Some categories of clients have less strong incentives to use central clearing, and may have a lower degree of access to central clearing.

• The provision of client clearing

services is concentrated in a relatively small number of bank-affiliated clearing firms.

The FSB, BCBS, CPMI and IOSCO seek responses to the questions set out in this consultative document by 7 September 2018 and the final report will be published at the end of November 2018.

The FSB, the BCBS, the CPMI and the IOSCO also published the second report (first report published in July 2017) that maps interdependencies between central counterparties (CCPs) and their clearing members and other financial service providers.

The analysis of interdependencies in central clearing is intended to provide useful inputs for designing supervisory stress tests and has informed the policy work as set out in the joint work-plan to promote CCP resilience, recovery and resolvability.

Michael FootmanPartner+852 2289 2747 [email protected]




(OTC) derivatives


Models Approach for

Market Risk

Consultation on the

Proposed Guidelines



Circular on Margin


Disguised as

Investments

Circular on Mystery

Shopping Programme

on AIs’ Selling

Practices

Guidance on online




products

Other Regulatory

Updates

Glossary


Circular on Internal Models Approach for Market Risk

The proposed framework aims to assess the readiness of an LC to adopt internal models approach for market risk

The SFC intends to facilitate the adoption of an internal models approach to be used by LCs where appropriate to calculate the capital requirements for market risk for proprietary investments.

In July 2015, the SFC proposed and concluded that the internal models approach would be introduced into the Securities and Futures (Financial Resources) Rules (FRR) in a manner which reflects the latest Basel standards and to respond to the industry’s need for a more risk-sensitive approach to the calculation of regulatory capital.

Given the volume and complexity of the proposed amendments to the FRR, the legislative process will take time to complete. Separately, the BCBS announced an extended implementation timeline for its new standards on

Minimum Capital Requirements for Market Risk (commonly known as the FRTB).

In the interim, the SFC will benchmark its requirements to the Revisions to the Basel II market risk framework (Basel II.5 standards), pending an update to the FRTB. Under this framework, the SFC will assess the readiness of an LC to adopt the internal models approach for market risk by focusing on the following areas:

• Fulfilment of principles-based general criteria including appropriateness of risk management system and models, adequacy and competence of staff, and soundness of stress testing programme.

• Compliance with qualitative standards in relevant areas, including board and senior management oversight, market risk management processes such as limit setting and monitoring, risk reporting, back-testing and stress testing, and other controls and infrastructure related to market risk management such as new product review, product control,

model validation, risk data and IT infrastructure and internal audit.

• Adherence to quantitative standards for the calculation of market risk capital charges based on individual components, namely value-at-risk (VaR), stressed value-at-risk and incremental risk charge, including calculation and aggregation of individual components, including the determination of capital multipliers, risk measurement parameters, such as confidence levels, holding periods and calculation frequencies for individual components, specification of risk factors across risk categories, including general risk and specific risk, and back-testing of VaR against trading outcomes and a traffic light approach to interpret results.

Brian YiuPartner+852 2289 [email protected]




(OTC) derivatives


Models Approach for

Market Risk

Consultation on the

Proposed Guidelines



Circular on Margin


Disguised as

Investments

Circular on Mystery

Shopping Programme

on AIs’ Selling

Practices

Guidance on online




products

Other Regulatory

Updates

Glossary


Consultation on the Proposed Guidelines for Securities Margin Financing Activities

Guidelines to clarify, codify and standardise the risk management practices for securities margin financing (SMF)

The SFC released a report summarisingthe findings of the recent review of brokers’ SMF activities which showed that total margin loans increased nine-fold between 2006 and 2017, reaching HK$ 206 billion.

The SFC raised concerns on the impact of deteriorating margin loan quality as well as inadequate risk controls and launched a consultation to provide qualitative guidance and quantitative benchmarks for margin lending policies. This covers the following seven areas.

Total margin loans limits

• The SFC proposes to set a quantitative benchmark, the “total margin loans-to-capital multiple”, to gauge whether a broker’s total margin loans are excessive relative to its capital.

Margin client credit limits

• The proposed guidelines emphasise that to effectively manage credit risks by way of limits, SMF brokers should ensure there is

strict enforcement of client credit limits.• Any waivers must be justified by risk

assessments, approved by management and suitably documented.

Securities collateral concentration limits

• The proposed guidelines require SMF brokers to set prudent securities collateral concentration limits to avoid building up excessive exposure to individual securities held as collateral or groups of highly correlated securities held as collateral.

Margin client concentration limits

• The SFC proposes that client concentration limits should be based on a prescribed percentage of the broker’s shareholders’ funds.

• Furthermore, SMF brokers would be required to estimate the excess liquid capital (ELC) impact before granting a significant margin loan.

Haircuts for securities collateral

An SMF broker should:

• maintain a list of securities the are eligible for margin financing;

• document the basis and factors to be considered in setting haircut percentages for the margin lending policy;

• review the haircut percentages at least annually;

• strictly apply the haircut percentages;

• document the risk assessment and risk mitigation measures to be adopted when a haircut percentage lower than the normal rate is assigned to collateral deposited by a margin client; and

• establish quantitative benchmarks for re-pledging brokers to set in-house haircut percentages.

Margin calls, stopping further advances and forced liquidation

• The SFC proposes that SMF brokers should stop granting waivers of margin calls to margin clients with poor settlement histories or whose outstanding margin loans exceed the market value of the underlying collateral.

• Further, the SFC proposes to specify certain thresholds for outstanding margin call amounts to encourage brokers to take steps to promptly collect margins.

Stress testing

• The proposed guidelines require SMF brokers to regularly conduct stress tests on their ELC and liquidity. This should also be performed when material adverse events are identified to quantify the impact of such situations.

• If an SMF broker cannot pass a stress test, it needs to provide the SFC with a detailed contingency plan.





(OTC) derivatives


Models Approach for

Market Risk

Consultation on the

Proposed Guidelines



Circular on Margin


Disguised as

Investments

Circular on Mystery

Shopping Programme

on AIs’ Selling

Practices

Guidance on online




products

Other Regulatory

Updates

Glossary


Circular on Margin Financing Activities Disguised as Investments

The provision of margin financing in the guise of investments is illegal

In the course of its ongoing supervision of LCs, the SFC has observed that some LCs carrying on asset management activities may have aided and abetted unlicensed affiliates or third parties to provide securities margin financing in the guise of investments.

The SFC warns that the provision of margin financing in the guise of investments under such an arrangement is illegal as parties involved in the illicit activities may have avoided certain capital, conduct or disclosure requirements aimed at protecting investors and market integrity.

These suspected margin financing arrangements are set up or operated in different forms. For example, they may operate through discretionary accounts or private funds with features such as:

• jointly with an LC’s clients, the unlicensed affiliates or third parties appear to fund the acquisition and holding of sizeable, concentrated

positions in one or more securities;

• the clients are required to provide additional capital or collateral when the value of these investments falls below a pre-determined level, similar to a margin call;

• the unlicensed affiliates or third parties are entitled to receive a guaranteed or predetermined yield from these investments, similar to margin interest; and

• the LC does not have actual investment discretion as the listed securities to be acquired were previously agreed between its clients and the unlicensed affiliates or third parties.

Arrangements which involve the provision of financial accommodations to facilitate the acquisition and holding of listed securities may constitute “securities margin financing” (Type 8 regulated activity) as defined under Part 2 of Schedule 5 to the SFO.

Persons conducting business activities which constitute securities margin financing are also subject to other regulatory requirements, including the

capital requirements under the Securities and Futures (Financial Resources) Rules (FRR) and the risk management requirements governing margin lending under the Code of Conduct.

The SFC warns LCs that they should not facilitate the setting up or operation of de facto margin financing arrangements to circumvent the FRR and the risk management requirements as the fitness and properness of LCs may be questioned when they aid and abet the conduct of illegal activities.

Helen LiPartner+852 2289 [email protected]




(OTC) derivatives


Models Approach for

Market Risk

Consultation on the

Proposed Guidelines



Circular on Margin


Disguised as

Investments

Circular on Mystery

Shopping Programme

on AIs’ Selling

Practices

Guidance on online




products

Other Regulatory

Updates

Glossary



Circular on Mystery Shopping Programme on AIs’ Selling Practices

AIs which engage in selling investment and/or insurance products will be subject to the Mystery Shopping Programme (MSP)

The HKMA has decided to conduct a MSP on AIs’ selling practices with respect to investment and insurance products.

MSP has been deployed as an additional supervisory tool. The objective of the MSP is to ascertain the practices of AIs in customer risk profiling, financial needs analysis (as applicable to life insurance products), suitability of recommendations, and product and risk disclosure.

The HKMA has engaged a service provider who will recruit and provide training to mystery shoppers who will then pose as potential customers.

To facilitate an objective review and assessment of the results of the MSP, the service provider will ask the mystery shoppers to audio-record their meetings with staff members of AIs. Moreover, the service provider will be required to implement appropriate controls and measures to properly handle the data collected.

The MSP is expected to commence shortly after the HKMA’s announcement through this circular on 10 August 2018.

The HKMA is expected to undertake follow-up action on certain AI’s cases, depending on the findings. The HKMA

also plans to share industry-wide issues and good practices identified through the MSP with the industry as appropriate.

AIs must communicate the contents of this circular to their relevant staff in order to make them aware of the MSP.

Hokee FuPartner+852 2289 [email protected]




(OTC) derivatives


Models Approach for

Market Risk

Consultation on the

Proposed Guidelines



Circular on Margin


Disguised as

Investments

Circular on Mystery

Shopping Programme

on AIs’ Selling

Practices

Guidance on online




products

Other Regulatory

Updates

Glossary


Guidance on online distribution platforms for non-SFO-regulated structured investment products

Guidance is a part of ‘Banking Made Easy’ initiative

Based on the feedback received on the consultation of the banking industry in May 2018 on applying the same principles to online and offline distribution and advisory platforms for structured investment products not regulated by the Securities and Futures Ordinance (non-SFO-regulated structured investment products) on a risk-based basis, the HKMA has set out detailed requirements for online distribution and advisory platforms for non-SFO-regulated structured investment products.

Key highlights of the guidance are:

Core principles for operation of online platform and specific guidance on robo-advice

• AIs should adopt the core principles and the specific guidance on robo-advice in the SFC’s Guidelines for online distribution and advisory platforms for non-SFO-regulated

structured investment products to the extent where relevant and appropriate.

Application of the Suitability Requirement for non-SFO-regulated structured investment products

• Standardised Non-SFO-regulated Structured Deposits: Where there is no solicitation or recommendation, distribution of Standardised Non-SFO-regulated Structured Deposits (i) to customers having sufficient investment experience in the product; (ii) with 100% principal protection; or (iii) in low concentration would not trigger the Suitability Requirement. Solicitation, or provision of investment recommendation or advice on Standardised Non-SFO-regulated Structured Deposits will trigger the Suitability Requirement.

• Other non-SFO-regulated structured investment products: Other non-SFO-regulated structured investment products (for example: foreign exchange accumulators /

decumulators issued by AIs; currency-linked notes issued by AIs) are complex products, and AIs should ensure suitability irrespective of whether there is solicitation or recommendation.

Minimum information and warning statements for non-SFO-regulated structured investment product

• For non-SFO-regulated structured investment product (excluding Standardised Non-SFO-regulated Structured Deposits), AIs should provide sufficient information about the key nature, features and risks of the product to enable customers to understand the product before making an investment decision.

AIs need to implement the requirements for online platforms set out in this circular by 23 August 2019.




(OTC) derivatives


Models Approach for

Market Risk

Consultation on the

Proposed Guidelines



Circular on Margin


Disguised as

Investments

Circular on Mystery

Shopping Programme

on AIs’ Selling

Practices

Guidance on online




products

Other Regulatory

Updates

Glossary

Adams ChanPartner+852 2289 [email protected]

Hokee FuPartner+852 2289 [email protected]

Other Regulatory Updates


Circular on SFC Disciplinary Fining Guidelines

The SFC published updated SFC Disciplinary Fining Guidelines (Fining Guidelines).

The original Fining Guidelines issued in February 2003 set out a number of considerations including the statutory limit of a fine under sections 194 and 196 of the SFO is HK$10 million or three times the profit gained/loss avoided by the regulated person as a result of the misconduct or other conduct which leads the SFC to form the opinion that the regulated person is not a fit and proper person, whichever is the greater.

The Securities and Futures Appeals Tribunal (SFAT) has accepted that the statutory limit is a limit on the amount of fine that can be imposed for each breach committed by the regulated person.

The updated Fining Guidelines codified the principles accepted by the SFAT and make it clear that:

• multiple culpable acts or omissions constituting misconduct may attract multiple penalties even if they are of the same generic nature;

• the SFC may use the number of persons affected by the misconduct as the multiplier in assessing the appropriate level of pecuniary penalty;

• using the number of affected persons as the multiplier may not be appropriate in every case. The appropriate approach in each case will depend on its own facts; and

• in cases where the misconduct attracts multiple penalties, the SFC will look at the totality of the penalties to ensure it is not disproportionate to the gravity of the conduct in question.

HKMA has issued a letter to consult on amendments to Banking (Capital) Rules to implement BCBS standards

The HKMA has issued a letter to consult the banking industry on the proposed draft amendments to the Banking (Capital) Rules to implement the BCBS Standardised approach for measuring counterparty credit risk exposures and its Capital requirements for bank exposures to central counterparties.

The HKMA is aiming to implement the standards by 2020, depending on the outcome of the consultation and the subsequent legislative process for rule-making.

The consultation will close on 9 November 2018.

IA issues circular regarding matching adjustment for second QIS for development of RBC regime

The IA issued a circular on 6 August 2018, inviting certain authorised insurers to participate in the second quantitative impact study (QIS) for the development of the risk-based capital (RBC) regime.

This follows the first QIS conducted last year and industry engagement in the last six months. The IA has issued another circular to inform enlisted authorised

insurers that it has finalised the remaining package of template and technical specifications on matching adjustment for insurers carrying on long term business.

Matching adjustment is an alternative approach that reflects the assets held by individual companies based on their policies for asset and liability management. QIS 2 is an important step for the IA to have a holistic view of the solvency position of individual insurers and of the industry as a whole. The IA aims to collect sufficient and relevant data from the MA package to further analyse and formulate a set of criteria in applying matching adjustment, and to determine the adjusted spread methodology.

Enlisted authorised insurers carrying on long term business need to submit the required information by 30 November 2018.




(OTC) derivatives


Models Approach for

Market Risk

Consultation on the

Proposed Guidelines



Circular on Margin


Disguised as

Investments

Circular on Mystery

Shopping Programme

on AIs’ Selling

Practices

Guidance on online




products

Other Regulatory

Updates

Glossary

Other Regulatory Updates


HKMA clarification on remote investment account opening

Further to the circular issued by the SFC to intermediaries on 12 July 2018 in relation to online client onboarding, HKMA has provided clarification on some operational issues on opening investment accounts in the context of registered institutions (RIs).

In consultation with the SFC, it is clarified that if a RI has established the true and full identity of a client when opening a bank account irrespective of using face-to-face approach or non-face-to-face approach, the procedural step in paragraph 5.1(b) of the Code of Conduct, including encashing a cheque for verifying the client’s signature, is not necessary for that RI.

By the same token, the corresponding Procedure 2 in the SFC Circular about bank transfer for opening investment account online is not necessary, if a RI has verified the client’s identity when opening a bank account (which is also the Designated Bank Account as referred in the SFC Circular).

However, all future deposits and withdrawals for the client’s trading account should still be conducted through the Designated Bank Account(s) only as specified in Procedure 3 of the SFC Circular.




(OTC) derivatives


Models Approach for

Market Risk

Consultation on the

Proposed Guidelines



Circular on Margin


Disguised as

Investments

Circular on Mystery

Shopping Programme

on AIs’ Selling

Practices

Guidance on online




products

Other Regulatory

Updates

Glossary

Glossary

AI Authorised Institutions ICO Initial Coin Offering

AML Anti-Money Laundering IFRS International Financial Reporting Standard

BC Basel Committee IOSCO International Organization of Securities Commission

BCBS Basel Committee on Banking Supervision IR-1 Interest Rate Risk Management

CFT Counter-Financing of Terrorism IRR Interest Rate Risk

CG-1 Corporate Governance of Locally Incorporated Authorized Institutions IRRBB Interest Rate Risk in the Banking Book

FinTech Financial Technology LC Licensed Corporation

FMCC Fund Manager Code of Conduct MAS Monetary Authority of Singapore

FI Financial Institutions MoU Memorandum of Understanding

FSB Financial Stability Board RO Responsible Officer

HKMA The Hong Kong Monetary Authority RE-1 Recovery Planning

IA The Insurance Authority SFC The Securities and Futures Commission

IAF Internal Audit Function SFO Securities and Futures Ordinance

IC-1 Risk Management Framework SPM Supervisory Policy Manual

IC-2 Internal Audit Function

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This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

© 2018 PricewaterhouseCoopers Limited. All rights reserved. PwC refers to the Hong Kong member firm, and may sometimes refer to the PwC network.

Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. HK-20171017-3-C1

Regulatory Updates Newsletter — September 2018 PwC · 12




(OTC) derivatives


Models Approach for

Market Risk

Consultation on the

Proposed Guidelines



Circular on Margin


Disguised as

Investments

Circular on Mystery

Shopping Programme

on AIs’ Selling

Practices

Guidance on online




products

Other Regulatory

Updates

Glossary

http://www.pwc.com/

financial services risk and regulation - pwc · new regulatory developments and guidelines. with...

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