Hong Kong SAR - The SFC focuses on risk amidst volatile crude oil futures markets with circulars to commodity futures brokers and managers of ETF funds

In light of the recent unprecedented volatility in overseas crude oil futures markets, the SFC issued two circulars to remind: (i) commodity futures brokers; and (ii) Management companies (“Managers”) of SFC-authorised exchange traded funds (“ETFs”) and intermediaries, to vigilantly manage their risk exposures (whether for themselves or on behalf of their investors) and maintain sufficient resources to deal with the challenges posed by extreme market conditions.

Commodity Futures Brokers

The SFC recently found that two commodity futures brokers committed significant, though short-term, breaches of the liquid capital requirements under the Securities and Futures (Financial Resources) Rules (“FRR”) due to failures to collect large amounts in margin calls amidst the volatility in overseas crude oil futures markets. The SFC is therefore using this circular to remind commodity futures brokers about risks in several areas of their business and the importance of taking more prudent risk management measures to protect the firm’s operations and ensure compliance with regulatory requirements in extreme circumstances. Note that specific mention is made in the circular that this is by no means an exhaustive list of measures. 

Firms should also note that the SFC makes several references to the potential for regulatory action if obligations are not met, so the circular serves as a reminder that unusual market volatility will not mean regulatory forbearance. In addition, it is recognised that there will be challenges and possible mistakes made at this time, but it is senior management which must responsibly manage risks, address mistakes and carry out management duties to protect clients’ interests.

Commodity futures brokers are urged to control risk exposures by:

  1. monitoring and addressing individual clients’ concentration risks in a timely manner;
  2. prudently setting clients’ trading limits and position limits to ensure that they are commensurate with the client’s financial strength and settlement history, as well as the firm’s financial resources;
  3. prudently setting margin requirements for clients;
  4. only opening new positions for clients after collecting sufficient margins; and
  5. promptly collecting outstanding margin calls from clients.

Commodity futures brokers are also required to closely monitor changes in market conditions and margin requirements set by clearing houses or clearing agents and rigorously assess their impact on the firm’s risk exposures, cash flow and liquid capital; as well as carry out stress tests and liquid capital computations regularly and at times of high market volatility. The SFC clearly states that failure to maintain sufficient liquidity to meet operating needs or maintain sufficient liquid capital in accordance with the FRR may result in serious regulatory consequences.

Due care should be taken in relation to supervision of operations, and having proper controls in place to mitigate systematic risks and ensure adequate transfer of client money to overseas clearing houses or agents in accordance to the Securities and Futures (Client Money) Rules.

Commodity futures brokers dealing through overseas counterparties should also establish and maintain policies and procedures to ensure the proper management of risks to which the firms and their clients are exposed. The SFC advises firms to refer to the SFC’s circular dated 23 November 2011.

In addition, commodity futures brokers are reminded of their obligations as licensed brokers under paragraph 5.3 of the Code of Conduct (“Code”) to assure themselves that clients trading futures, options or other derivative products understand the nature and risks of these products and have sufficient net worth to assume the risks and bear the potential losses, particularly in light of the extreme price movements.

Management Companies and Intermediaries

In the second Circular, Managers are reminded to:

  1. ensure that the relevant margin obligations are and will be fulfilled in a timely manner for ETFs that invest in futures (in particular, the futures-based ETFs);
  2. closely monitor the market movements of the underlying investments of the ETFs and ensure that there are proper contingency plans in place to respond to extreme market movements;
  3. ensure that any actions taken by the Managers must be permitted under the ETF’s constitutive documents, and comply with the applicable laws and regulatory requirements. The Managers should also consult the relevant trustee or custodian of the ETF before taking such actions;
  4. promptly and efficiently communicate these actions to investors of the ETF, taking into account any possible delay of communication due to the administrative arrangements and other requirements associated with the listing of ETFs on HKEx, including the holiday arrangement; and
  5. give the SFC early alerts of any untoward circumstances relating to the ETFs under their management, for example any issues which may adversely affect the operations, investments and secondary market trading and liquidity of their ETFs.

The SFC reminds intermediaries to ensure compliance with the requirements under paragraphs 5.1A (KYC in relation to derivative knowledge) and 5.3 (understands the risks and has sufficient net worth) of the Code in relation to derivative products (which includes futures-based ETFs). Where there has been solicitation or recommendation, intermediaries should also comply with the suitability obligations under 5.2 of the Code.