Risk Management for Fund Managers, Proposals of SFC, Hong Kong

Securities and Futures Commission (SFC), Hong Kong has put for public consultation certain proposals for enhancing asset management regulations. (the “Proposals”). These proposals can be seen as forced risk containment measures for the asset management industry.

The Proposals put the responsibility of compliance on the fund managers instead of the fund.   A distinction has been drawn between the fund managers with overall operational responsibility for the fund and those who manage only a portion of the fund. A fund manager with overall responsibility will have to comply with all the Proposals. Whereas, a fund manager managing a portion of the fund will not be required to comply with some of the Proposals (e.g. liquidity management policy and qualified custodian appointment). However, all fund managers acting in any capacity has to comply with generally-applicable Fund Manager Code of Conduct (FMCC) principles and requirements.

Thus, the Proposals cover all persons licensed or registered for Type 9 (asset management) regulated activity whether managing collective investment schemes (CIS) (whether authorized or unauthorized) and / or discretionary accounts. The objective is to govern the conduct of fund managers. The nature of fund is immaterial, that is, whether it’s a public or private or the domicile of the fund. Beware fund managers managing private funds!

Securities lending and repo:

The Proposals mandate that a fund manager engaged in securities lending, repo and similar OTC transactions on behalf of the fund should undertake these activities as per a predefined collateral management policy (CMP). What parameters a CMP shall cover? Many!

CMP should define eligible collateral, valuation, margin, hair cut i.e. very similar to what a clearing and settlement agency will do to protect its settlement fund. The CMP should identify the parameters for eligibility of collateral, the requirement to conduct a due diligence for determination of eligibility and a record should be kept before accepting a collateral. Depending on the nature of the collateral, a valuation methodology shall be pre-identified and used consistently (if not, necessary explanations to be made available). Liquidity of a collateral will also be factored in the valuation. Similarly, parameters for margin and hair cut will have to be defined and implemented consistently.

 Further, if the investment mandate of a fund allows for the reinvestment of the cash collateral, then the fund manager should have a cash collateral reinvestment policy. For this policy, the critical factor is to subject the cash collateral to stress test to meet planned as well as unplanned calls for the return of cash collateral on an ongoing basis.

SFC-authorized funds are not allowed to re-hypothecate non-cash collateral. However, fund managers of non-SFC-authorized funds are required to make adequate disclosures to re-hypothecate non-cash collateral and the associated risk of this.

Other parameters pertain to disclosures in the offering document and reporting of such transactions on an annual basis.

Safe custody of fund assets:

A slew of measures are proposed for ensuring the physical and legal integrity of the assets. To meet this objective, the fund assets of a client should be segregated from the assets of the fund manager, assets of affiliates and assets of other clients. Further, it is mandated that the fund assets should be held with a custodian that is functionally independent from the fund manager. However, the scope of “functionally independent” has not been clarified. Whether an affiliate under a separate management but same owner qualifies to be functionally independent is not clear. The fund shall conduct a due diligence on the custodian before selection and the relationship between the fund and the custodian should be documented through an agreement.

If fund assets are kept in an omnibus account, a proper record of the assets and frequent reconciliation shall be done so that assets are at all times readily identifiable. For private funds, self- custody is acceptable provided the internal custody activity is functionally independent.

Liquidity management and disclosure of leverage:

The stand of SFC is that the liquidity issues apply to all funds and therefore SFC will not provide exemption to anyone on the ground of private fund, close-ended fund etc. The policy on this should have a robust stress testing features and this cannot be a periodic exercise. Since the market fluctuates on a continuous basis it is understandable that SFC wants liquidity parameters to be assessed on a continuous basis. It is also proposed that in case of any provision on redemption restrictions in the offer document, the fund manager shall use liquidity management tools and exceptional measures.

 In addition, impact of leverage whether financial or synthetic and the basis of calculation shall be disclosed to the investors.

It is apparent the intent behind these provisions is to safe guard the interest of the investors and to force the actual decision maker i.e. the fund manager to introduce robust risk containment measures supported with documented policies. Moreover, any inspection by SFC is likely to be quite extensive and thorough. To comply with the rigor of the inspection, fund manager will have to keep audit trails for the decisions made on these parameters. To implement the Proposals, fund manager will have to invest in human capital, system applications and third party service providers. Needless to mention, the cost of fund management will increase for the fund manager and so the fund management fees for the investors.