Conclusion of SFC consultation on proposed changes to the code on unit trusts and mutual funds

On 6 December 2018, after extensive consultations with the industry, the Securities and Futures Commission (SFC) published its conclusions to its Consultation Paper on Proposed Amendments to the Code on Unit Trusts and Mutual Funds (UT Code). The revised UT Code is tentatively scheduled to take effect from 1 January 2019 (Effective Date).

One of the more controversial issues in the consultation involved the SFC’s proposal to classify funds with derivatives investments exceeding a 50% limit as derivative products, which would be subject to enhanced distribution requirements. The asset management industry was concerned that this proposal would have a significant negative impact on the distribution of UCITS funds, in particular fixed income which make use of derivatives for efficient portfolio management. Having considered representations by the industry, the SFC has decided to refine the proposal as mentioned below.

Key issues

Derivatives investments

The SFC acknowledges that the use of derivatives is quite common, although the use of derivatives may increase the overall leverage of a fund, derivatives are often being used for hedging and “efficient portfolio management”, and the latter would not necessarily make a fund any riskier. As a result, the SFC has decided to refine the calculation methodology for a fund’s derivatives investments to exclude the use of derivatives which would not result in an increase in the level of leverage. In general, such usage may be carved out from the 50% threshold for calculating the fund’s net exposure to derivatives.

The SFC will publish further guidance on the use of derivatives for SFC-authorised funds, which will deal with the calculation methodology and criteria for exclusions from the 50% limit as well as examples. Such guidelines may be updated from time to time.

Going forward, the SFC will conduct surveillance and monitoring of the use of derivatives by SFC-authorised funds and may require management companies to provide data on derivative usage as part of this process.

Enhanced disclosure in the product key facts statement

Enhanced disclosure about derivatives investments will need to be included in the key facts statement for authorised funds following the expiry of a 12-month transition period, from the Effective Date.

The list of SFC-authorised funds shown on the SFC website will include a new column indicating whether an SFC-authorised fund is or is not a derivative fund. The management company will be responsible for making such determination (and keeping the same under review) based on the net exposure arising from the fund’s derivatives investments.

Management companies must ensure that distributors have all necessary product information to understand the fund products to carry out their duties accordingly. In particular, they will need to inform distributors whether their funds are to be classified as derivative funds so that distributors can conduct the necessary enhanced due diligence and suitability assessment required for distribution of derivative funds.

Management companies

The SFC has decided to proceed with the proposed increase in minimum capital for management companies from HK$1 million to HK$10 million (or its equivalent in foreign currency). The minimum capital requirements are applicable to management companies but not investment delegates.

The SFC has also introduced flexibility around the key investment personnel requirements by allowing multinational management companies and investment delegates belonging to well-established fund management groups to utilise group resources and expertise in fulfilling the SFC’s key personnel requirements.

Trustees and custodians

The SFC has decided to expand the scope and review of the internal controls and systems of trustees and custodians, with Appendix G of the UT Code being substantially revised.

Money market funds

The SFC has decided to accept high quality government securities with favourable credit quality assessments as collateral for reverse repo transactions, and to lower the minimum levels of daily and weekly liquid assets required to be held by a money market fund to align with requirements in comparable jurisdictions.

Implementation

• Existing SFC authorised funds will have a 12-month transitional period from the Effective Date to comply with the revised UT Code, save for certain changes in connection with scheme changes, notifications and reporting requirements under Chapter 11 which will apply from the Effective Date.

• New schemes with new key operators (i.e. new management companies and new trustees / custodians) will be required to comply with the revised UT Code from the Effective Date.

• In respect of new schemes with existing SFC approved operators, they will enjoy the 12-month transitional period for most parts of the revised UT Code, including Core Investment Requirements. Nevertheless, for certain specialized schemes such as money market funds, active ETFs and closed-ended funds (the last two being newly introduced specialized schemes), as well as scheme changes, the provisions on relevant notifications and reporting will apply from the Effective Date.

The consultation conclusions can be viewed here.