SFC proposes issuing risk management guidelines related to the trading activities of futures brokers to complement the existing risk management requirements applicable to them

On November 25, 2022, the Securities and Futures Commission (SFC) published its consultation paper on proposed risk management guidelines for licensed persons trading futures contracts (consultation paper). The SFC’s nineteen-page draft risk management guidelines for licensed persons dealing in futures contracts (guidelines) are attached to the consultation paper as an appendix.

The policies are intended to complement existing risk management requirements for futures trading activities primarily set forth in the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission; the management, regulatory and internal control policies for persons licensed by or registered with the Securities and Futures Commission; and the proposed control techniques and procedures to improve a firm’s ability to comply with the Securities and Futures Regulations (customer securities) and the Securities and Futures Regulations (customer funds).

Since these existing risk management requirements mainly relate to financial futures transactions, the SFC considers it necessary to prescribe regulatory standards for the risk management of trading in commodity futures transactions.

SFC concerns

The SFC attributes the need for the guidelines to two years of extreme market volatility in the financial and commodity futures markets related to the Covid-19 pandemic, which has resulted in losses for futures investors and their brokers and underscored challenges facing futures brokers in times of market volatility. In particular, the SFC found that some clients were unable to meet margin calls, resulting in losses for them and, in some cases, their futures brokers requiring emergency funding or financial assistance to prevent them failed to meet their clearing obligations or to enable them to meet their obligations under the Securities and Futures (Financial Resources) Rules.

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

• Allow clients with pending margin calls to build new positions.

• Allowing clients to open futures positions with margin requirements lower than those set by the relevant clearinghouse.

• Failure to set risk limits to control the risk of their business and manage concentration risk.

• Applying the same risk limit to each client regardless of their individual circumstances.

• Failure to implement controls to monitor clients’ positions against their assigned limits.

• Failure to liquidate client positions after their net equity balance falls below the liquidation threshold.

• Failure to properly assess customers before treating them as established customers and to conduct regular reviews of their eligibility.

• Failure to conduct adequate stress testing to assess the potential losses of its options portfolios under extreme market conditions.

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

Proposed commitments under the guidelines

The guidelines establish the areas in which the SFC expects compliance from licensed futures traders, specifically with respect to their:

• Risk management framework, including the designation of a responsible officer and/or manager for this purpose.

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

• Trading in commodity futures, including maintaining a Board-approved list of commodity futures for which trading is permitted.

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

• Discounted margining for certain clients with sound financial positions and a record of consistently meeting margin requirements.

• Counterparty risk management, including formulating written policies and procedures and conducting due diligence to manage a firm’s and its clients’ exposure to execution or clearing houses.

• Funding of liquidity risk management, including prudent cash flow management and ensuring that client funds or collateral are sufficiently liquid to meet margin requirements for trading futures contracts on behalf of clients.

• Protection of client assets, including ensuring that client positions in futures contracts and associated margins are booked separately from a firm’s own positions and associated margins on accounts with its counterparties.

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

• Stress testing involves policies and procedures approved by a firm’s senior management that clearly establish the firm’s testing methodology and frequency, and its relevant review and escalation mechanisms.

• Obligations to report policy violations to the SFC.

The SFC is currently inviting interested parties to submit their comments on the consultation paper and guidance by January 31, 2023.