SFC proposes to issue risk management guidelines relating to the dealing activities of futures brokers, which are intended to supplement the existing risk management requirements applicable to them

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Authored by: Stephen Tisdall

On 25 November 2022, the Securities and Futures Commission (SFC) issued its Consultation Paper on Proposed Risk Management Guidelines for Licensed Persons Dealing in Futures Contracts (Consultation Paper). The SFC’s nineteen-page draft Risk Management Guidelines for Licensed Persons Dealing in Futures Contracts (Guidelines) are included as the Appendix to the Consultation Paper.

The Guidelines are intended to supplement existing risk management requirements for futures dealing activities, which are principally set out in the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission; the Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the Securities and Futures Commission; and the Suggested Control Techniques and Procedures for Enhancing a Firm’s Ability to Comply with the Securities and Futures (Client Securities) Rules and the Securities and Futures (Client Money) Rules.

As these existing risk management requirements are principally concerned with financial futures, the SFC considers it necessary to prescribe regulatory standards for the risk management of commodity futures trading.

SFC concerns

The SFC attributes the need for the Guidelines as arising out of two years of extreme market volatility in the financial and commodity futures markets associated with the Covid-19 pandemic, which resulted in losses incurred by futures investors and by their brokers, and which underscored the challenges which futures brokers face during times of market volatility. In particular, the SFC noted the effects of some clients being unable to meet margin calls, resulting in losses to them and, in some cases, resulting in their futures brokers requiring emergency funding or financial assistance to prevent them from defaulting on their obligations to clearing houses, or to enable them to comply with their obligations under the Securities and Futures (Financial Resources) Rules.

Unsatisfactory risk management practices that have been observed by the SFC include futures brokers:

• Allowing clients with outstanding margin calls to establish new positions.

• Allowing clients to open futures positions with margin requirements which were lower than those set by the relevant clearing house.

• Failing to establish risk limits to control the exposure of their business and to manage concentration risk.

• Applying the same risk limit to every client without considering their individual circumstances.

• Failing to implement any controls to monitor clients’ positions against the limits assigned to them.

• Failing to liquidate clients’ positions after their net equity balance fell below liquidation thresholds.

• Failing to properly assess clients before they were treated as established clients and to conduct regular reviews of their eligibility.

• Failing to have proper stress testing in place to evaluate the potential losses of its option portfolios under extreme market conditions.

• Keeping some clients’ excess margins in a firm’s omnibus accounts with clearing brokers, resulting in the excess margins being used to offset the futures trading losses of other clients or to meet the clearing broker’s margin requirements for the futures trading of other clients.

Proposed obligations under the Guidelines

The Guidelines stipulate the areas in respect of which the SFC will expect compliance from licensed futures dealers, notably in respect of their:

• Risk management framework, including the designation of a responsible officer and/or Manager-In-Charge for this purpose.

• Market risk management, including management of the risk of loss due to adverse movements in the level or volatility of market prices products, or of the underlying exposures of products, held by a firm for its own account.

• Commodity futures trading, including the maintenance of a board-approved list of commodity futures products in respect of which dealing is permitted.

• Client credit risk management, including the imposition of prudent trading, position and other limits for each client, or each group of connected clients, and the setting of position limits for each client, or group of clients, to prevent breaches of statutory or regulatory position limits.

• Concessionary margining for certain clients with sound financial positions and with records of having consistently met margin requirements.

• Counterparty risk management, including the formulation of written policies and procedures, and the conduct of due diligence to manage the exposure of a firm and its clients to executing or clearing agents.

• Funding of liquidity risk management, including prudent cashflow management and ensuring that client money or collateral is sufficiently liquid for settling margin requirements for the trading of futures contracts on behalf of clients.

• Safeguarding of client assets, including ensuring that client positions in futures contracts and their related margins are booked separately from a firm’s proprietary positions and their related margins in accounts with its counterparties.

• Trading in futures markets outside Hong Kong, including the maintenance of segregated or trust accounts in the relevant foreign jurisdictions, and disclosing to clients the risks involved in the conducting of transactions in such jurisdictions.

• Stress testing involving policies and procedures, which are approved by a firm’s senior management and clearly set out the firm’s testing methodology and frequency and its relevant review and escalation mechanisms.

• Obligations to notify the SFC of breaches of the Guidelines.

The SFC is currently inviting interested parties to submit their comments concerning the Consultation Paper and the Guidelines on or before 31 January 2023.

Key Contacts

Stephen Tisdall

Counsel | Financial Services

Email or call +852 2825 9474