On October 30, 2017, the SFC announced a thematic review on prime services and equity derivatives. Thematic reviews often result in changes to regulations and, for individual firms, may result in compliance advice letters requiring changes in operating practices or, more ominously, enforcement action. In this article, we explore possible reasons for this review, provide our perspective on how this review may affect the industry and offer suggestions on how to handle the review.
In its circular dated October 30, 2017, the Securities and Futures Commission (“SFC”) announced a Thematic Review on Prime Services and Equity Derivatives Activities with the objectives of (i) identifying potential conduct issues arising from prime brokerage practices, (ii) assessing internal controls in place, and (iii) providing guidance on how risks are managed.
Reasons for the review
The circular did not identify any specific areas of concern. In contrast, historically, the SFC has undertaken thematic reviews in reaction to specific perceived problems. For example, the SFC last year commenced a thematic review on best execution, after reportedly observing frequent deficiencies during routine inspections, such as inadequate controls to avoid conflict of interest and lack of priority to client orders over principal orders. Equally, for example, last year the SFC conducted a thematic review on algorithmic trading, in reaction to various concerns, including that firms commonly had insufficient controls to prevent the generation of algorithmic orders which might adversely affect market integrity.
Rather, the circular cites growth of the hedge fund industry and asset management business in Hong Kong as the “development” necessitating the thematic review. Notably, that growth is a multi-decade trend, not a recent phenomenon. In that context, there are a number of other possible reasons for the review:
The review may be a catch-up exercise to improve the SFC’s understanding of market practices in prime broking.
The review may be part of the SFC’s response to broader international initiatives, such as standards for custody of fund assets promulgated by the International Organisation of Securities Commissions (“IOSCO”). The standards include, for example, the appointment of a fund custodian that is functionally independent of the fund’s manager. Similarly, the review may be a step toward implementation of recommendations by the Financial Stability Board on “shadow banking” risks arising from securities lending and repos.
The review may enable the SFC to obtain further information related to its development of an OTC derivatives regulatory regime, including the new Type 11 (dealing in OTC derivatives) and Type 12 (providing client clearing services for OTC derivatives) regulated activities, in respect of which legislation has been passed but not yet brought into operation. This project dates back to an IOSCO task force in 2010. Lack of progress suggests the project fell into a black hole, but it will emerge again at some point.
What to Expect
The review is likely to result in clarifications to regulatory conduct expectations, which will likely to be expressed through changes to the Fund Manager Code of Conduct, as foreshadowed in the SFC’s November 2016 Consultation Paper on Proposals to Enhance Asset Management Regulation and Point-of-sale Transparency. Although the SFC has characterized these as high-level principles-based proposals, they include some prescriptive expectations in relation to matters such as custody arrangements, liquidity risk management controls, collateral valuation policies for securities lending, and disclosure of leverage. From the prime brokers’ perspective, these and other requirements imposed on fund managers will impact the services that prime brokers are expected or able to provide to their fund and fund manager clients.
Preparing for an inspection
Prime brokers should now prepare for SFC requests for information and on-site inspections. Demonstrating preparedness and cooperation can go a long way to dampening an inquisitive inspector’s ambitions for finding anything untoward within your firm, and encouraging them to devote their energies to targets elsewhere.
Centralizing Communications
To maximize efficiency and consistency, firms should be ready to appoint a contact person who can receive requests from the SFC for information or meetings. The person should be an employee who is familiar with the firm’s policies and procedures, although they cannot alone be responsible for answering the SFC’s questions. Rather they will need to direct the requests to appropriate individuals within the firm, if necessary after seeking clarification from the SFC to understand exactly what they are looking for, and then coordinate responses.
Control of Information Flow
Responses to SFC requests should be truthful and concise and, where appropriate, supported by relevant records or other documentation. The employee responsible for coordinating responses should check through documents before they are provided to the SFC, to ensure their relevance and to identify any possible areas of control weakness. They should keep a record of what documents have been provided and who the SFC has spoken to. As the SFC could request an inspection at short notice, prudent planning would include periodically briefing staff within your firm about the inspection process. For example, staff should be aware not to speculate in an SFC interview on work in which they have no involvement, as the SFC cannot expect a person to comment on aspects of the firm’s operations that they don’t know about.
Setting the Scene
A firm should also identify individuals within its senior management who can attend an opening meeting with the SFC, at which the company should be prepared to present the SFC an overview of its operations as well as its risk management and compliance monitoring protocols. Senior management should also be available to deal promptly with any surprises that may arise during the inspection. Finally, they should seek to schedule a closing meeting with the SFC. This will present an opportunity to probe the SFC for preliminary comments, particularly any possible areas of concern, and to try to resolve all outstanding issues before the SFC prepares its findings.
Evaluating Possible Weaknesses
Firms should also try to anticipate what documents the SFC is likely to request, such as the firm’s compliance manual, internal control procedures, business plan, organization chart, client service agreements and product documentation. They should consider whether there are any problematic issues that the SFC might ask about. In light of the current thematic review, now would be a good time for prime brokers’ responsible officers to reacquaint themselves with the SFC’s Management, Supervision and Internal Control Guidelines. Although antiquated, this document sets out a number of principles that are still relevant to prime broking services, particularly in relation to operational controls and risk management.
The SFC has endeavoured to frame this thematic review as a positive opportunity for prime brokers to share their views on existing regulatory requirements. But SFC enquiries and on-site inspections can quickly become a significant imposition on staff time and company resources. Moreover, it is inevitable that the SFC will strive to identify weaknesses within particular firms, as well as across the industry. This will likely lead ultimately to the SFC issuing compliance advice letters to some firms, and potentially in some cases to commencement of disciplinary action.
The SFC’s circular announcing the thematic review on prime services and equity derivatives activities can be accessed here.