HONG KONG: SFC Proposes Amendments to the Code on Unit Trusts and Mutual Funds

Monday December 18 2017

On 18^th December 2017, the Securities and Futures Commission (SFC) launched a three-month consultation on proposed amendments to the Code on Unit Trusts and Mutual Funds (UT Code) to update the regulatory regime for SFC-authorized funds and address risks posed by financial innovation and fast-moving market developments.

Key proposals include strengthening requirements for key operators (management companies, trustees and custodians), providing greater flexibility and enhanced safeguards for funds investment activities (particularly in relation to derivatives, securities lending, and repo and reverse repo transactions), and introducing new fund types (including active ETFs). The proposals are made in view of international regulatory and local market developments.

Summary of key proposals

Key operators – proposals to provide flexibility and strengthen requirements for management companies, trustees and custodians:

1. increase the minimum capital requirement for management companies to HK$10 million to better reflect the financial standing and commitment expected of them;
2. provide flexibility to allow management companies with multinational presence to leverage group resources in meeting the five-year public fund investment management experience requirement for key personnel;
3. enhance obligations of trustees and custodians in view of their key role in safeguarding fund assets and providing independent oversight of the management of SFC-authorized funds; and
4. expand the scope of and enhance the requirements for the annual independent audit review of the internal controls and systems of trustees and custodians to strengthen ongoing monitoring.

Investments – modernisation to provide greater investment flexibility with enhanced safeguards:

1. introduce an overall limit of 50% on the use of derivatives for investment purposes by plain vanilla public funds to allow flexibility in the deployment of investment objectives and strategies to deliver value to investors (such as yield enhancement, risk reduction, access to restricted markets and cost efficiency); and
2.  enhance and introduce additional safeguards on the use of derivatives and securities lending, repo and reverse repo transactions.

Specialised schemes – proposals to introduce new types of funds and enhance existing requirements:

1. Introduce new chapters in the UT Code for listed open-ended funds (also known as active ETFs) and closed-ended funds to facilitate the development of new products; and
2. enhance requirements on money market funds to ensure robust requirements aligned with the relevant IOSCO standards.

Consequential amendments are also proposed to relevant provisions of the SFC Code on MPF Products, the Code on Pooled Retirement Funds and the Code on Investment-Linked Assurance Schemes.

The core investment requirements for SFC-authorized funds contained in Chapter 7 of the UT Code (Core Investment Requirements) set out clear rules for funds’ investments which provide important safeguards for investor protection.

However, the existing Core Investment Requirements do not contain specific provisions covering investment activities such as securities lending, sale and repurchase (repo) and reverse repurchase (reverse repo) transactions (collectively, Securities Financing Transactions). The requirements for investments in derivatives are limited and outdated, as financial market development and innovation has led to the emergence of many new forms of derivatives. Increasingly, asset managers use derivatives to deliver value to their funds (eg, for the purposes of yield enhancement, risk reduction, access to restricted markets and cost efficiency). With proper safeguards, we believe that the use of derivatives could benefit fund investors.

In view of the above, the SFC have proposed modernise the Core Investment Requirements by including provisions to govern Securities Financing Transactions and introducing a balanced approach to provide greater flexibility for investments in derivatives. The proposals aim to reflect market development and financial innovation and to put in place appropriate safeguards which are consistent with relevant international standards and practices.

Diversification, liquid assets, loans and borrowings

Diversification requirements

The SFC has proposed  the following enhancements on the spread of investments by introducing:

(a) a group limit where the aggregate value of a fund’s investments in or exposure to entities within the same group may not exceed 20% of the fund’s net asset value (NAV); and

(b) a separate diversification limit on cash deposits where the value of a fund’s cash deposits made with the same entity or entities within the same group may not exceed 20% of the fund’s NAV.

Entities included in the same group for the purposes of consolidated financial statements prepared under internationally recognised accounting standards are proposed to be regarded as entities within the same group for the purposes of the proposed investment limits in paragraph 33 of this consultation paper.

The proposals also take into account industry comments and permit cash deposits to exceed the 20% limit in specific circumstances upon the launch, merger or termination of a fund.

Illiquid assets

Managing liquidity to meet regular redemption requests from open-ended funds is important. Hence, SFC-authorized funds are expected to invest in liquid assets. Investments in illiquid assets are subject to a maximum limit of 15% of the fund’s NAV. We propose to clarify that illiquid assets are assets which cannot be readily convertible into cash at limited cost.

Loans and borrowings

The SFC have proposed e a number of enhancements to strengthen investor protection, including:

(a) prohibiting funds from engaging in lending (excluding permitted reverse repo transactions and investments in fixed income securities), guarantee and other activities which may lead to direct or contingent liabilities or obligations; and

(b) lowering a fund’s borrowing limit to 10% of its NAV.

The public is invited to submit their comments to the SFC on or before 19 March 2018 via the SFC website (www.sfc.hk), by email to utc-consultation@sfc.hk, by post or by fax to 2877 0318.

Please click on the above link for more information.