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TOPIC 1 – REGULATORY FRAMEWORK

 

1. Definitions of Futures Contracts
  • Under the Securities and Futures Ordinance, futures contracts are defined to include:
    • Contracts for differences (meeting either the futures contract or options on futures contract definitions)
    • Forward contracts (but only when they are traded on an exchange)
    • Futures contracts and option contracts (options on futures contracts and traded on an exchange)
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

2. Structure of Legislation and Regulation
  • The SFO came into effect in April 2003 to meet challenges being faced and replaced 10 previous ordinances which had been drafted at various times to meet needs as they arose
  • Reasons for overhauling Hong Kong’s financial legal framework included meeting changes due to:
    • Globalization
    • Technological innovations
    • Introduction of new products, services and trading methods
  • SFO empowers SFC to publish rules, codes of conduct and guidelines, guidance notes and circulars
  • Rules have status of subsidiary legislation and have the force of law. Breaches of rules can be a criminal offence
  • Codes of conduct and guidelines set out practices and standards and do not have the force of law. Failure to follow may reflect on fitness and properness of persons licensed or registered and may result in fines or license suspension/revocation
  • Guidance notes and circulars provide interpretations and SFC’s views on particular issues
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

3. Regulatory Objectives of the SFC
  • As stated in the SFO, the objectives of the SFC, in relation to the securities and futures industry, are:
    • Maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness of the industry
    • Promote understanding by the public of financial services including the operation and functioning of the industry
    • Provide protection to the investing public
    • Minimize crime and misconduct in the industry
    • Reduce systemic risks in the industry
    • Assist the financial secretary in maintaining the financial stability of Hong Kong by taking appropriate steps in relation to the industry
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

TOPIC 2 – LICENSING AND REGISTRATION

 

4. Dealing in Futures Contracts
  • The SFO definition is that a person deals in futures contracts if he:
    • makes or offers to make an agreement with another person to enter into, acquire or dispose of, a futures contract; and
    • induces or attempts to induce another person to enter into, acquire or dispose of a futures contract
  • Excepted from the definition are:
    • Persons engaging in the above acts through a Type 2 licensed/registered person (no exception if for remuneration)
    • Persons entering into market contracts (contracts entered into by the clearing house with a clearing participant pursuant to a novation)
    • Persons acting as principal with a professional investor in dealing in futures contracts
    • Persons engaged in the above acts on markets referred to in the Commodity Exchanges (Prohibition) Ordinance
    • Type 9 licensees who engage in the above solely for the purposes of the type 9 activity
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

5. Advising on Futures Contracts
  • Advising on futures contracts is defined in the SFO as:
    • The giving of advice
    • The issuing of analyses or reports to allow recipients to make decisions on the buying or selling of futures contracts
  • Persons exempted from requiring a Type 5 license are:
    • Solicitors, counsel, professional accountants, trust companies and Type 9 licenses who give advice wholly incidental to their professions
    • Financial journalists and broadcasters who give investment advice or issue analyses/reports on investments through the public media
    • Corporations giving advice/issuing analyses and reports to wholly owned subsidiaries/holding companies/fellow wholly owned subsidiaries
    • Type 2 licensees giving advice wholly incidental to their dealing activities
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

6. Providing Automated Trading Services (ATS)
  • ATS describes any automated system that provides, by means of electronic facilities, a trading mechanism for securities and futures contracts (including clearing services), other than the operations of recognized exchange company or clearing house
  • The services provided include:
    • Trade confirmation and matching systems provided by brokers *
    • Full trading and settlement systems for non-local securities #
  • ATS are covered in two Parts of the SFO:
    • #Part III – a person may be authorized to provide ATS similar to the services provided by a recognized exchange or clearing house
    • *Part V – a person may be licensed/registered to provide ATS as a regulated activity
  • ATS, in relation to futures contracts (other than those provided by HKFE), which require a license/registration, are defined as those where:
    • Offers to sell or purchase futures contracts are regularly made in a way that results in a binding transaction; and/or
    • Persons are regularly introduced, or identified to other persons, to negotiate/conclude sales or purchases of futures contracts
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

7. Financial Resources Requirements
  • A licensed corporation must meet the requirements before obtaining a license and continue to maintain sufficient capital at all times.
  • The required level of paid-up share capital for a licensed corporation is:
  • Dealing in futures contracts: HK$5 million
  • Advising on futures (except if client assets not held): HK$5 million
  • If a corporation is licensed for more than one activity, the capital requirement will be the highest amount for all such activities.
  • Approved introducing agents and securities advisers not holding client assets do not have paid-up share capital requirements
  • A licensed corporation must maintain at all times minimum Liquid Capital as follows:
  • Dealing in futures contracts: HK$3 million
  • Advising on futures contracts:
  • where it does not hold client assets: HK$100,000
  • where it holds client assets: HK$3 million
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

8. Responsible Officer
  • A responsible officer is a licensed representative who:
    • Actively participates in or supervises a regulated activity;
    • Is nominated by the licensed corporation; and
    • Is approved by the SFC
  • Although the SFO does not provide a definition of responsible officer, the SFC has stated:
    • Every executive director* of a licensed corporation is required to obtain the approval of the SFC as a responsible officer; and
    • Every licensed corporation must have, for each regulated activity for which it is licensed, at least two responsible officers approved by the SFC – at least one of them must be an executive director and at least one must be based in Hong Kong

*  A director who actively participates in, or is responsible for directly supervising, the business of a regulated activity for which the corporation is licensed (s113, SFO)

  • For registered institutions: the Banking Ordinance requires at least two executive officers to be responsible for supervising regulated activities – at least one to be available at all times
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

9. Licensing of Representatives
  • Individuals conducting regulated activities within licensed corporation need to be individually licensed with SFC as licensed representative
  • Individuals may act for more than one licensed corporation, within the same group of companies
  • The SFC may grant a temporary license to representatives of a licensed or a temporary licensed corporation, for not more than 3 months. This would enable someone based overseas to conduct a regulated activity in Hong Kong
  • On application for a representative license, a person may be given a provisional license to cover the period before a decision is made on the licensing application
  • If a licensed representative ceases to be employed by the licensed corporation, the corporation must notify the SFC within seven business days of cessation. If the license is not transferred to another licensed corporation within 180 days, the license is deemed to have been revoked
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

10. Substantial Shareholder
  • Substantial shareholders have a special relevance in the licensing regime
  • All substantial shareholders of licensed corporations must be approved by the SFC
  • Under this legislation, a substantial shareholder is a person who, alone or together with his associates:
    • Has an interest of more than 10% of the nominal value of the issued share capital
    • Directly or indirectly has more than 10% of the voting power of the company at a general meeting
    • Is able to exercise 35% or more of the voting power of another company at a general meeting which in turn has more than 10% of the voting power of the company at a general meeting
  • A substantial shareholder must keep the SFC informed of his contact details and notify the SFC of any changes within 14 days
  • A person who becomes a substantial shareholder without obtaining permission from the SFC commits an offence and is liable to a fine and/or imprisonment
  • Someone who becomes a substantial shareholder, without being aware, must apply for approval when he discovers the fact. Time limit for approval is “as soon as reasonably practicable” or within three business days from becoming aware)
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

TOPIC 3 – CLIENT SECURITIES AND MONEY

 

11. General Requirements
  • Intermediaries are called upon to handle client assets, including money, in a fiduciary capacity. The SFC protects the assets of investors by making rules regarding:
    • The holding of and dealing with client assets and securities collateral
    • The holding of and dealing with client money
  • No person may receive or hold client assets of an intermediary in Hong Kong, unless the person is:
    • The intermediary
    • An associated entity of the intermediary
    • An excluded person
      • Any AFI
      • Another intermediary holding securities collateral
      • Any company approved by the SFC
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

12. Securities and Futures (Client Securities) Rules
  • The Client Securities Rules apply to client securities or securities collateral of an intermediary that are:
    • Listed on a recognized stock market (ie SEHK);
    • Interests in an SFC authorized CIS; and
    • Received or held in Hong Kong by an intermediary (or its associated entity) in the course of conducting a regulated activity
  • The Client Securities Rules do not apply to securities held by an intermediary in an account in a client’s name, set up by that client with persons other than the intermediary or its associated entity:

[Rules only apply to Hong Kong stocks held in Hong Kong received by an intermediary or associated entity in the course of conducting regulated activities]

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

13. Requirement for Deposit or Registration of Securities
  • The intermediary shall, as soon as reasonably practicable after receiving client securities/securities collateral, deal with them as follows
    • If a deposit is to be made, it must be with
      • An AFI
      • An approved custodian
      • Another intermediary licensed for dealing in securities
    • Any deposits
      • Must be in separate segregated accounts for each category, designated as trust or client accounts
      • Which are securities collateral, may be deposited in an account in the name of the intermediary/associated entity
    • If registered, it must be in the name of:
      • The client
      • The associated entity of the intermediary
      • For securities collateral only, the intermediary itself
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

14. Standing Authority
  • A written notice authorizing the intermediary/associated entity to deal with client assets in specified ways
  • Effective for a period not more than 12 months (no time limit for PIs)
  • May be renewed on the written request of the client for a period not more than 12 months
  • May be deemed to be renewed by the intermediary/associated entity giving written notice at least 14 days prior to expiry reminding client of impending expiry. Deemed to be renewed on date of expiry, unless client objects
  • Intermediary/associated entity must provide written confirmation of deemed renewal to client within a week of expiry date
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

15. Relevance to Trading in Futures Contracts
  • Generally, the Client Securities Rules allow the disposal of client securities or securities collateral in settlement of a clients’ liability to the intermediary, associated entity or a third person
  • One situation where the Rules can be applied to dealing in futures contracts is the accepting of securities collateral from clients to cover derivative margin obligations
  • HKFE Clearing Corporation Limited allows its participants to use cash and non-cash collateral to discharge their margin liabilities from dealing in futures contracts
  • An intermediary licensed/registered for dealing in futures contracts may deposit the securities collateral with:
    • A recognised clearing house; or
    • Another intermediary licensed/registered for dealing in futures contracts as collateral for settlement obligations
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

16. Mode of Treatment of Client Money on Receipt
  • The licensed corporation/associated entity holding client money should have one or more segregated accounts (designated as a trust or a client account) maintained with an AFI or another SFC-approved person (ie open a separate bank account)
  • Within one business day of receiving client money, the licensed corporation/associated entity should pay the money:
    • Into a segregated account
    • To the client directly
    • In accordance with a written direction
    • In accordance with a standing authority
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

17. Payment of Money Out of Segregated Account
  • Money should be held in the segregated account until payment has to be made
    • To the client
    • In accordance with a written direction
    • In accordance with a standing authority
    • To meet settlement or margin requirements
    • To meet amounts due from the client to the licensed corporation/associated entity
  • Money held in a segregated account, which is discovered not to be client money, must be moved out of the account within one business day of discovery
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

TOPIC 4 – CONDUCT OF BUSINESS

 

18. Code of Conduct Principle 2 – Diligence
  • A licensed/registered person should act with due skill, care and diligence, in the best interests of its clients and the integrity of the market. Some practical examples of this are:
    • Client orders should be executed promptly in accordance with clients’ instructions – prompt execution
    • Client orders should be executed on the best available terms – best execution
    • Orders executed for clients should be promptly and fairly allocated to those clients – prompt and fair allocation
    • Clients’ orders should not be withheld for convenience
    • Advice should be given to clients with due skill, care and diligence
    • Separate accounts should be kept for each client and for securities, futures, cash and margin accounts
    • Clients must be informed of derivative position and reporting limits
    • All orders should be time-stamped
  • Telephone orders should be centrally recorded. Recordings should be kept for at least 6 months
  • The use of mobile phones for taking client orders is discouraged, but not banned – time of order receipt and details should be recorded immediately
  • The best interests of the clients should be considered when recommending the services of an affiliated person
  • Collect promptly from clients any amount due as margin
  • Not offer any gift other than a discount on fees or charges when promoting a specific investment product
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

19. Omnibus Accounts
  • An omnibus account is an account opened with an exchange participant by a client who operates the account for a customer, or a number of customers, of the client and not the client itself
  • Information that should be kept for all omnibus accounts:
    • Name of client and whether it is an HKFE Participant
    • Client’s address and account title
    • Whether transactions are HKFE or non-HKFE trades; and
    • Whether the client is a registered dealer authorized to operate an omnibus account
  • A licensed/registered person which is an HKFE exchange participant must ensure that a client who is not an HKFE exchange participant, but operates an omnibus account should:
    • Comply with and enforce the HKFE margin and variation adjustment requirements
    • Deal with instructions so that there is no unlawful dealing in differences in market quotations and no betting
    • Ensure that the persons who give instructions to the client comply with the HKFE margin and variation adjustment requirements
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

20. Client Agreements
  • Full names and addresses of client (verified by reliable proof) and licensed/registered person
  • Undertakings by parties to notify material changes of information to each other
  • Full description of services to be provided and charges to be paid by the client
  • Full explanation of the margin procedures, the circumstances under which a client’s positions may be closed without the client’s consent and a statement that a report may need to be made to HKFE and the SFC, if margins are not paid on time
  • A statement that the licensed person will provide the client, upon request, with product specifications and prospectuses
  • An explanation that, if the client suffers loss because the intermediary defaults, the liability of the Compensation Fund will be limited and, accordingly, there can be no assurance that any or all of the loss will necessarily be recouped
  • A statement that trades are subject to the rules of the HKFE including:
    • Client’s identity will be disclosed if a request is received from the HKFE
    • HKFE may limit positions or close out contracts if client’s trading affects the fair and orderly operation of the market
  • A statement (prominently displayed in bold type) that the intermediary may take the opposite position to the client’s order provided that the opposing trade is executed competitively on or through the facilities of the HKFE
  • Clarification that, with regard to any account that the intermediary maintains with the clearing house as principal, any assets lodged with the clearing house for such an account are not held in trust for the client
  • From 9 June 2017, the Code of Conduct requires:
    • A clause stating that any financial product solicited for sale or recommended will be suitable for the client
    • No provision in the client agreement that is inconsistent with the Code of Conduct obligations
  • Appropriate risk disclosure statements
  • Client agreements should not remove, exclude or restrict the legal rights of a client or the legal obligations of the licensed/registered person
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

21. Risk Management Techniques

Credit risk

  • Establish and maintain effective system to evaluate client and counterparty credit worthiness
  • Set Appropriate credit limits for all clients
  • Check
    • Client’s credit rating
    • Past payment record and defaults
    • Client’s capital base
    • Known events which might have an adverse impact
  • Monitor exposure to clients, including pre-settlement and settlement
  • Make appropriate haircuts to market value of securities pledged where credit extended for margin trading

Market risk

  • Place restrictions on instruments which can be traded
  • Establish controls to ensure restrictions complied with
  • Place trading and position limits on proprietary trading
  • Risk managers should control open positions
  • Establish measures to check effect of adverse market conditions, such as
    • Value at Risk methodology for general market risk
    • Sensitivity checks
    • Stress testing

Liquidity risk

  • Use liquidity measures
  • Set concentration limits for products, markets and business counterparties
  • Measure mismatches in timing of receipts and payables, receipt and delivery of products
  • Monitor level of arrears and defaults
  • Establish default procedures so liquidity managers have adequate time to take action

Operational risk

  • Segregation of duties
  • Keeping secure, reliable, proper and up-to-date records
  • Analysis of records to highlight adverse trends and to detect errors
  • Employment of skilled and experienced staff
  • Effective business continuity and disaster recovery plan
  • Adequate insurance
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

22. Market Misconduct – False Trading
  • Occurs in relation to securities and futures contracts when:
    • A person intentionally or recklessly creates a false or misleading appearance of active trading or the market or the price
    • A person is involved in transactions, intentionally or recklessly, which create an artificial price or maintains a price at an artificial level
  • A person is presumed to have engaged in false trading if he enters into wash trades or matched orders:
    • Wash trade: any transaction involving a sale and purchase of securities without a change in beneficial ownership
    • Matched order: an offer to sell (or buy) securities that is matched by an actual or proposed offer to buy (or sell) the same securities
  • Defence can be that acts were not for the purpose of creating a false market
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

23. Orders Made by the Market Misconduct Tribunal
  • Orders that may be made by MMT against those found to have committed market misconduct include:
    • disqualification for up to 5 years from holding office as director, liquidator, receiver or taking part in the management of a corporation;
    • prohibition on investing or trading in HK markets for up to 5 years (cold shoulder order);
    • prohibition of further market misconduct as specified in the order (cease and desist order);
    • payment of profits made or loss avoided, plus compound interest, to the Government;
    • payment of reasonable costs incurred by the Government and the SFC; and
    • disciplinary referral orders recommending that a professional body of which the person is a member should take disciplinary action against him
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

24. Unsolicited Calls
  • Unsolicited calls include most possible forms of communication made by an intermediary with any person without his express invitation
  • Persons exempt from the prohibition:
    • Existing clients
    • Licensed persons
    • Registered institutions
    • PIs
    • Solicitors/accountants acting in their professional capacity
    • Money lenders
  • It is an offence to engage in the following acts during an unsolicited call:
    • Offering to make agreements to buy/sell financial products regulated by the SFC
    • Offering SMF
    • Offering to provide profits, income or other returns from dealing in such financial products
  • The provisions are intended to protect the investing public from:
    • Recklessly giving personal details and money to a stranger
    • Believing a person giving financial advice without checking the person’s status or background
    • Buying stock without checking the background of the issuer
    • Opening an account without taking proper precautions
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

TOPIC 5 – RECORD KEEPING AND CONTRACTS LIMITS AND REPORTING

 

25. Keeping of Records Rules
  • Keeping of Record Rules (KRR) require intermediaries to maintain comprehensive records relating to their business and client transactions
  • Records must be in sufficient detail to ensure proper accounting for business operations and financial position, including a true and fair view of profit and loss and balance sheet, and client assets
  • Generally, records should be kept for 7 years, although there are some specific requirements under SFO and other legislation
  • Records must be written in Chinese or English or in any electronic form, readily convertible into writing
  • An intermediary must keep sufficient accounting, trading and other records in accordance with generally accepted accounting practices in sufficient detail to:
    • Explain financial position and operations of business
    • Prepare financial statements
    • Show all client assets and movement in assets
    • Reconcile positions each month with external parties
    • Demonstrate system of controls to ensure compliance with SFC Rules
    • Enable audits to be performed
  • Records must show particulars of:
    • All money received and disbursed
    • All income received
    • All expenses, commissions and interest incurred or paid
    • All orders or instructions received or initiated (with detail of transactions, the account and ability to trace transaction through systems)
    • All disposals of client securities or collateral
    • Assets and liabilities, including commitments and contingencies
    • All securities held belonging to intermediary
    • All securities held not belonging to intermediary
    • All bank accounts, including segregated accounts
    • All off-balance sheet transactions or positions
  • Records of all contracts, standing authorities, written directions and evidence of PI status must be kept
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

26. Associated Entities (AEs)
  • An AE of an intermediary must, in respect of client assets of the intermediary, keep copies of all contracts, order forms, confirmations, statements and receipts.
  • An AE must also keep sufficient records in accordance with GAAP to:
    • account for all client assets that it receives or holds
    • enable all movements of client assets to be traced through its systems
    • enable monthly reconciliations with external parties
    • demonstrate compliance with the client money and securities Rules
    • demonstrate that it has systems of control in place to ensure compliance with the Rules
    • enable an audit to be conveniently and properly carried out
    • show separately and account for all receipts, payments, deliveries and other uses of client assets made by it; and
    • demonstrate that it has kept contracts with clients, agreements with PIs, and authority or specific directions from clients.
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

27. Books and Accounts

Code of Conduct requires intermediaries who are participants of HKFE to maintain proper books and records which correctly and clearly record:

  • Financial position of each client’s trading account
  • Time, date and complete particulars of instructions received and trades executed
  • Particulars of all intermediary and client open positions
  • Amount of margin deposited with clearing houses and individual agents
  • Amount of variation adjustment and interest rate cash adjustment paid to clearing house and each executing agent
  • Amount of margin deposited or required to be deposited for each client
  • Amount of variation adjustment collected or required to be collected from each client
  • All payments and assets received or held to satisfy margin requirements
  • Particulars of all margin calls and demands for variation adjustments
  • Any other particulars as required from time to time by HKFE
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

28. Client Ledgers

Code of Conduct requires intermediaries who are participants of HKFE to:

  • Maintain separate ledger accounts for every client for HKFE, non-HKFE and all other trades
  • Record details of all collateral received from clients and send statements to clients with details
  • Segregate clients’ ledger accounts for HKFE, non-HKFE and other accounts so there is no offset between accounts
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

29. Daily Statements of Account
  • A daily statement must be prepared:
    • By intermediaries providing securities margin finance and their associated entities when client assets are deposited or withdrawn
    • By intermediaries conducting margined transactions, such as futures contracts, both when the margined transaction is entered into, and when it is closed
  • A daily statement must be issued to the client no later than the end of the second business day after the specified event and should include:
    • Intermediary company name and name of any associated entity that holds client assets
    • Client name, address and account number
    • Date when statement prepared
    • Information for that day, including:
      • Opening and closing balances with details of day’s movements
      • Quantity, market price and market value of each type of collateral provided by client that day
      • Details of all contracts closed during the day
      • Details of all income and all charges that day
      • All floating profits and losses at the end of the day
      • Net equity at the end of the day
      • A list of all open positions at the end of the day
      • Minimum margin requirement for all open positions
      • Amount of margin excess/shortfall at the end of day
      • Client’s position limit and trading limit
      • Expiry date of the margined transactions arrangement
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

30. Contracts Limits and Reportable Positions Rules (CLRP)
  • The CLRP Rules seek to prevent/discourage the large build-up of derivative positions that could adversely affect the orderly functioning and stability of HK’s financial markets
  • The CLRP Rules apply to futures contracts/stock option contracts listed in the CLRP Rules schedules and traded through the HKFE and the SEHK
  • The CLRP Rules primarily operate by specifying:
    • reportable positions, being the aggregate number of open positions in futures or stock options contracts that have reached a certain level; and
    • prescribed limits, being limits on the aggregate number of futures or stock options contracts that are permitted to be held or controlled.
  • The CLRP Rules apply to any person who holds a relevant position in futures or stock options contracts, whether or not such person is licensed by or registered with the SFC
  • SFC has issued the Guidance Note on Position Limits and Large Open Position Reporting Requirements (“CLRP Guidelines”).
  • The CLRP Rules have the force of law and breaching them is a criminal offence that can result in the imposition of a fine of up to HK$100,000 and/or imprisonment for up to 2 years
  • On the other hand, the CLRP Guidelines do not have the force of law and primarily operate to inform market participants of the SFC’s policy intent in relation to the CLRP Rules.
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

31. Reportable Positions
  • The person holding or controlling a reportable position must report the position to the HKFE or SEHK, according to the exchange on which the futures or stock options contract is traded
  • The report must be made in writing within one business day of there being a reportable position, and each day thereafter for so long as the person continues to hold a reportable position, even if the position remains unchanged
  • The reporting obligation will only cease once the position is reduced to below the reporting level
  • The person holding or controlling a reportable position may also appoint an agent to make a report on its behalf, however, as the obligation to make the report is non-delegable such person bears the ultimate responsibility to satisfy the reporting obligation
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

TOPIC 6 – FUTURES TRADING AND SETTLEMENT

 

32. Hong Kong Futures Exchange Limited (HKFE) Participantship
  • To trade on the Hong Kong Futures Exchange, a licensed corporation/registered institution must become an HKFE Participant
  • All HKFE Participants must be licensed/registered for Type 2 regulated activity (dealing in futures contracts)
  • An applicant for HKFE participantship must:
    • be a Hong Kong incorporated company
    • fulfil the FRR requirements
    • pay all required HKFE fees
    • acquire an HKFE trading right
  • There are four categories of HKFE Participant:
Ø  Traderentitled to trade in futures contracts and/or options contracts on his own account only
Ø  Brokerentitled to trade in futures contracts and/or options contracts on his own account and as agent of an HKFE Participant for the sole purpose of concluding trades on HKFE markets
Ø  Futures Commission Merchantentitled to trade in futures contracts and/or options contracts on his own account, for the account of other HKFE Participants and for the account of any other persons
Ø  Merchant Traderentitled to trade in futures contracts and/or options contracts only on its own account and only ancillary to its principal business or that of its holding company
  • With the Trader category, the ownership of share and loan capital, as well as the management and control, must be effectively vested in one individual
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

33. HKFE Clearing Corporation Limited (HKCC) Participantship
  • Every HKCC Participant must be a HKFE Participant
  • Applicants for HKCC participantship must:
    • be HKFE participants
    • operate under the same name which it is registered under as an HKFE Participant
    • satisfy FRR requirements
    • agree to abide by HKCC Rules
  • An HKFE Participant can register with the HKCC as either a General Clearing Participant or a Clearing Participant
  • An HKFE Participant which is not a HKCC Participant must clear its futures trades through a General Clearing Participant

Rights to record, register and clear through HKCC

 

Rights

 

General Clearing ParticipantClearing Participant
Record, register and clear contracts entered by itself with HKCCYesYes
Record, register and clear contracts with HKCC for othersOnly for contracts of other Clearing Participants and Non-Clearing Participants with appropriate clearing agreementOnly for contracts of other Clearing Participants with HKCC approval
  • HKCC Participants may have the following types of account:
    • House Account: records proprietary trades and positions margined on a net basis
    • Omnibus Client Account: records, on an omnibus basis, client trades and positions margined on a gross basis
    • Individual Client Account: records trades and positions for an individual client (margined on a net basis)
    • Client Offset Claim Account: records positions of individual clients of an offset nature.  Maintained on a gross basis but margined on a net basis
    • Market Maker Account: records and maintains positions from market making activities conducted by a HKCC Participant.  Margined on a net basis
  • HKCC Participants use the Omnibus Client Account as the default account for their trades – positions are maintained on a gross long and short basis
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

 34. Position Closing
  • HKCC allows position closing between the following:
ProductsRatio
HSI futures and Mini-HSI futures1 HSI to 5 mini-HSI futures
HSI options and Mini-HSI options1 HSI to 5 mini-HSI options
HSCEI* futures and Mini-HSCEI futures1 HSCEI to 5 mini-HSCEI futures
HSCEI options and Mini-HSCEI options1 HSCEI to 5 mini-HSCEI options

*HSCEI:  Hang Seng China Enterprises Index

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

 35. Futures Trading Rules
  • All futures trading shall be conducted on HKATS
  • Chief Executive of HKFE can ban anyone from using HKATS
  • All futures trading must be through the HKFE facilities during trading hours
  • No HKFE Participant shall knowingly take the opposite side of a client order, unless the following requirements are met:
    • The client has given consent in writing
    • The trade has been bid, offered and reported as laid down in the Board of HKFE procedures
  • An HKFE Participant must not bid/offer to confuse other HKFE Participants or fail to confirm a transaction
  • HKFE Participants must not disclose information of buy/sell orders in hand and pending for execution to any party except HKEX staff
  • Block trades not executed in the prescribed manner or within prescribed trading hours will not be considered valid trades
  • An error trade can only be cancelled when:
    • The trade takes place on HKATS outwith the price parameters set by HKFE
    • The trade is notified to the HKFE within 10 minutes of the trade being made; and
    • The parties to the error trade consent to its cancellation
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

36. Block Trades
  • Block trades are large buy/sell orders privately negotiated outwith the public auction market
  • Block trades must satisfy the following criteria:
    • Must be in block trade contracts, as designated by HKFE
    • Must be at or above the minimum volume threshold. Minimum thresholds are:
Stock index futures/stock futures100 contracts
Stock index options100 contracts
Currency options50 contracts
HIBOR futures80 contracts
RMB currency futures50 contracts
Treasury bond futures50 contracts
Metal futures traded on the London Metal Exchange50 contracts
  • Participants cannot aggregate separate orders to meet minimum volume thresholds
  • Block trades must be negotiated during trading hours
  • Once a block trade has been negotiated, it must be immediately executed on HKATS via the block trade facility
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

 37. Default
  • HKCC has prepared contingency plans for an HKCC Participant defaulting on its obligations, including
    • Closing out, settling and/or selling any or all of the open contracts registered in that HKCC Participant’s name
    • Suspending HKCC participantship
    • Realising deposited non-cash collateral and applying proceeds to amounts due to HKCC
    • Executing a buy-in or borrowing the underlying asset for delivery to the HKCC Participant
  • If the defaulting HKCC Participant’s obligation cannot be settled after the above actions, the HKCC Reserve Fund can be used to settle the outstanding amounts
  • Under no circumstances will customer-segregated margin deposits held by HKCC for an HKCC Participant be used to cover either a house or customer default of another HKCC Participant
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

 38. Margin Requirements
  • HKCC determines the level of margin required from each HKCC Participant on its open positions using a risk-based algorithm
  • HKCC has the right to increase the amount of margin to be paid by any HKCC Participant at any time

Client’s Minimum Margin

  • HKFE sets the minimum margin required to be collected by each HKFE Participant
  • No HKFE Participant may deal for a client until the client has posted the minimum margin
  • For established clients, limited exceptions are allowed where:
    • A call for minimum margin must be issued by close of business for a new transaction
    • The minimum margin is due no later than the next business day; and
    • New positions are not established until overdue minimum margins are settled
  • HKFE Participants may demand higher levels of margin from their clients to protect against potential losses
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

TOPIC 7 – OVER-THE-COUNTER (OTC) DERIVATIVES TRADING, REPORTING AND CLEARING

 

 39. Reporting and Record Keeping

Means and Timing of Reporting

  • All transaction information must be reported to the HKMA via the Hong Kong Trade Repository (HKTR) electronic reporting system operated by the HKMA
  • HKTR membership is required to make a report
  • Reports must be made within two business days of a transaction (T+2)
  • A licensed corporation that ceases to be exempt will have a grace period of three months from the date it ceased to be exempt, to submit the information

Information to Report

  • Information to be reported includes:
    • Product class and type
    • Dates: transaction; effective and maturity
    • Particulars of counterparties
    • Clearing information
    • References assigned to the transaction
    • Transaction particulars (notional amount, currency rate, interest rate etc)
    • Subsequent events
  • The primary reporting obligations rests with the licensed corporation, however if the transaction is conducted on behalf of a Group company, the Group company may make the report. In such a case, the licensed corporation needs written confirmation from the Group company to demonstrate compliance with the reporting requirement

Exemptions

  • A licensed corporation is exempt from the reporting requirement if the notional amount of all outstanding OTC Derivative transactions does not exceed US$30 million in aggregate over all product classes collectively
  • The exemption is lost permanently once the notional value exceeds US$30 million

Record Keeping Obligations

  • Transaction records must be kept for at least five years after the maturity date
  • Records must be sufficient to demonstrate compliance with reporting requirements
  • Where a licensed corporation is exempt from reporting, records should still be kept to justify the exemption
[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 

 40. Clearing and Record Keeping

The Clearing Obligation and Designated CCP

  • Where an OTC derivative clearing obligation exists, the transaction must be cleared through a designated central counterparty (CCP) within one business day of the transaction
  • Eligible CCPs are:
    • Recognised clearing houses under the SFO
    • Persons authorized by the SFC to provide automated trading services
  • Transactions that cannot be cleared in time will be terminated
  • As at 1 September 2016, there were four designated CCPs:
    • Chicago Mercantile Exchange
    • Japan Securities Clearing Corporation
    • Clearnet Limited
    • OTC Clearing Hong Kong Limited

Nature of Persons Who Are Counterparties

  • For a transaction to be subject to the clearing obligation, either:
    • Both counterparties to the transaction must be prescribed persons; or
    • One counterparty is a prescribed person and the other is a financial services provider
  • If one of the counterparties is a designated financial services provider, the clearing obligation falls on the prescribed person
  • Prescribed persons include authorized financial institutions, licensed corporations and others who are listed in the OTCD Clearing Rules as being subject to the clearing obligation
  • A financial services provider is a person actively engaged in OTC derivative transactions or OTC derivative products outside Hong Kong
[For Paper 3 practice questions, go to Examinator.online – Paper 3]
TOPIC 1 – OVERVIEW OF THE DERIVATIVES MARKETS

 

1. Exchange-Traded Derivatives
  • In recent years, the global value of exchange-traded futures contracts has grown significantly. Three features of exchange-traded markets are:
  • Novation
    • Once a completed trade is ready to be cleared and settled, the contract between the two parties is novated by the exchange
    • This means that the clearing house becomes the counterparty to the buyer and the counterparty to the seller
    • The clearing house buys from the seller and sells to the buyer, thereby guaranteeing settlement
    • Novation means that the buyer and the seller do not have to concern themselves with the creditworthiness of the other party – no counterparty or settlement risk
  • Centralised marketplace
    • By offering standardised derivative products, an exchange provides a centralised marketplace for buyers and sellers to come together and trade
    • Liquidity and price discovery give confidence to both buyers and sellers that they are trading at the best possible prices
  • Standardised contract specifications
    • All derivative products traded on exchanges have standardised contract specifications, including the quantity, price, expiry date and settlement date
    • Through standardisation, an exchange eliminates the contract terms risk for both buyers and sellers, so that there can be no dispute over the terms
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

2. Uses of Derivative Products

Hedging

  • Derivatives can be used to hedge against adverse movements in price
  • There are two types of hedging:
  1. Hedging a current market position
  2. Hedging a future transaction

 Asset Switching

  • Switching funds from underperforming classes to outperforming ones is an important task for a portfolio manager in generating returns from the portfolio
  • Derivatives can help fund managers re-weight their portfolios, as exposure to certain asset classes can be achieved without having to alter in any material way the physical asset mix of the portfolio
  • Example: an asset manager wishing to move out of interest-rate securities and into equities could buy equity derivatives (gaining exposure to increases in equity values) and sell interest rate derivatives (locking in a selling price)

Making a Profit

  • There are three trading strategies to make a profit from derivatives:
  1. Directional trading occurs when there is an expectation of the future direction of prices and a trade is implemented to take advantage of it
  2. Spread trading involves a long and a short position to take advantage of an expected movement in price
  3. Arbitrage trading occurs when a mispricing is identified between the cash and derivative prices and exploited through the simultaneous purchase/sale of the underlying asset and the sale/purchase of the derivative
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

3. Participants in Derivatives Markets

Hedgers

  • Financial institutions such as banks, fund managers, insurance companies and large trading companies have substantial portfolios (debt, equity, FX) exposed to price risk
  • Consequently, they are major users of derivatives to hedge current and future market positions

Speculators

  • Speculators add liquidity and depth to the market
  • They trade derivatives to make a profit, not to hedge. They buy low and sell high
  • Some hedge funds specialise in speculating on the future direction of prices by using derivative markets
  • Use of derivatives avoids the need to outlay large amounts of capital and can allow investors to profit in both rising and falling markets

Arbitrageurs

  • Arbitrage is the making of risk-free profit by exploiting price differences of securities
  • Arbitrage activity accounts for a substantial proportion of market turnover and contributes to market efficiency
  • Examples of investment products used in arbitrage are depositary receipts and underlying stocks, and an index futures contract and the index’s constituent stocks
  • In practice, most arbitrage activity involves securities listed on SEHK and futures traded on HKFE. Such arbitrage tends to be conducted by the proprietary trading desks of EPs
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

TOPIC 2 – GENERIC DERIVATIVE PRODUCTS

 

4. Features of a Futures Product

Contract Value

  • This refers to the notional value of the contract and is based on the price of the underlying asset multiplied by the contract multiplier
  • The contract multiplier for the HSI contract is HK$50 per index point
  • If the HSI futures were quoted at 26,450 points, the contract value for the HSI futures contract would be HK$1,322,500 (22,450 x HK$50)

Contract Price

  • Generally, the futures price is quoted using the same convention as for the pricing of the underlying asset
  • The quotation price for the HSI futures contract is whole index points, as is the underlying HSI

Minimum Fluctuation

  • This is the minimum movement in the price of the futures contract that can occur
  • The amount of a single movement is referred to as a “tick”
  • The minimum price fluctuation for HSI futures contract is one index point

Contract Months

  • Futures contracts are quoted in terms of the month when they expire – for example, a June 2020 contract will expire in June 2020
  • “Contract months” refers to the contracts that are available for trading and the months in which they expire
  • Short-dated contract months for HSI futures are the “spot” (current) month, the next calendar month and the next two calendar quarterly months (March, June, September and December)
  • If it was November 2020, the short-dated contract months would be November and December 2020 and March and June 2021
  • Long-dated contract months for HSI futures are the following five December months. If it were now December 2020, you could trade futures that expire in December 2021, 2022, 2023, 2024 and 2025

Last Trading (or expiry) Day

  • The last trading day refers to the day in the month when the contract expires
  • For the HSI futures contract, the last trading day is the second-last business day of the month

Final Settlement (or delivery) Day

  • This is the date when the buyers and sellers of a futures contract have their open positions settled
  • Either cash payments are made/received with the exchange clearing house, or there is a physical delivery/receipt of the underlying assets
  • HSI futures: the final settlement day is the last business day of the month

Final Settlement Price

  • This is price used to settle expiring contracts
  • The final settlement price for the HSI futures contract is the average of quotations taken at: (i) five-minute intervals from five minutes after the start of, and up to five minutes before the end of, the continuous trading session of the SEHK; and (ii) close of trading on the last trading day

Large Open Positions

  • This refers to the number of open contracts (in any one contract month) that are required to be reported to the Exchange by an Exchange Participant
  • These reportable positions and position limits (the maximum number of contracts that can be held in any one contract month) are determined by the Exchange and may change from time to time
  • The large open position for the HSI futures contract is 500 contracts in any one contract month

Settlement Method

  • There are two methods of contract settlement: cash settlement or physical delivery
  • HSI futures contracts are cash-settled
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

5. Forward Rate Agreements
  • A forward contract to borrow/lend money at a specific rate on a set date in the future
  • FRAs settle in cash but no loan is made at the settlement date.
  • FRAs are described by the length of the contract and the term of the interest rate in the contract
  • If rates rise above the contract rate, the long receives a payment at settlement and the short makes a payment; if the specified rate falls below the contract rate then the short receives from the long
  • A borrower entering into an FRA with a bank is the long party (buying an FRA)
  • An investor entering into an FRA with a bank is the short party (selling an FRA)
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

6. Features of a Swap
  • Two parties agree to exchange (swap) income streams derived from a portfolio of assets or liabilities
  • The most popular types are interest rate swaps and currency swaps, which are traded OTC and are highly customized
  • With interest rate swaps, loan principals are not swapped and net interest is exchanged between parties
  • With currency swaps, principals are swapped and gross interest payments are exchanged
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

7. Credit Default Swap
  • The credit default swap (CDS) is the most popular type of credit derivatives
  • The notional amount of CDS increased from USD6.4 trillion in 2004 to USD57.9 trillion 2007 and then fell to USD41.9 trillion by the end of 2008
  • The buyer of a CDS receives credit protection by making a series of payments (like insurance premiums) to the seller in return for the right to receive a payment if a credit instrument (eg a bond) defaults (like an insurance claim)
  • The buyer does not have to own the underlying credit instrument
  • The CDS market was originally over-the-counter (OTC) and not regulated, however efforts are now being made to regulate it
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

8. Options
  • A call option is the right to buy an underlying asset at a specified price (strike price) on or before a specified date (expiry date)
  • A put option is the right to sell an underlying asset at a specified price (strike price) on or before a specified date (expiry date)
  • Taking up the right is known as exercising the option
  • The seller (writer) of an option has an obligation to sell/buy when the option is exercised by the buyer (holder)
  • Unlike futures and forwards, the buyer of an option has no obligation to sell or buy the underlying asset, but will exercise if it is profitable to do so
  • The price paid to purchase an option is known as the option premium and is paid to the option seller
  • Examples of exchange-traded options are: options on shares; options on indices; and options on futures
  • Examples of OTC options are: interest rate options; currency options; and exotic options
  • A swaption is an option to enter into a swap agreement
  • American style options can be exercised up to and on the expiry date
  • European style options can only be exercised on the expiry date
  • Important contract specifications for the HSI option contract are:

Underlying index              HSI

Contract multiplier          HKD50 per index point

Contract value                  Option premium x contract multiplier

Exercise style                    European

Settlement on exercise    Cash settlement

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

9. Features of an Option

Exercise Style

  • American style options can be exercised up to and on the expiry date
  • European style options can only be exercised on the expiry date
  • The value of an American style option should not be less than the value of the equivalent European style option
  • On the SEHK, HSI options are European style and stock options are American style

Moneyness

  • Depending upon the strike (exercise) price of an option and the current market price of the underlying asset, an option will be:
    • In-the-money
    • At-the-money; or
    • Out-of-the-money

Cash or Physical Delivery

  • On a cash basis, the party exercising the option receives a cash payment from the option seller – HSI options are cash settled
  • With physical delivery, the underlying asset is delivered in the event of an option being exercised
  • Hong Kong stock options are settled on a physical delivery basis with the exercise date counted as the trade date

Option Premiums

  • Value of an option = intrinsic value + time value
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

10. Factors that Affect the Time Value of an Option Premium

Time to Expiry

  • With American-style options (as with all SEHK traded stock options), the longer the time to expiration, the higher the value of the option (both call and put)
  • With European-style options that have long times to expiration, the effect of the time to maturity is less certain than with American-style options

Market Volatility

  • As the volatility of a stock price increases:
    • The probability of a call option increasing in value is higher
    • The probability of a put option increasing in value is higher
  • So, as the price volatility of an underlying security increases, so does the value of both call and put options

Interest Rate

  • Instead of buying a security now, an investor can choose to buy a call option and then exercise, thereby buying the stock. In the interim, funds to buy the stock can be put on deposit, earning interest.  The higher the interest rate, the more popular this strategy and the higher the call option price
  • So, call options increase in price when interest rates rise
  • Instead of selling a security now, an investor can choose to buy a put option and then exercise, thereby selling the stock. In the interim, funds required now would need to be borrowed, incurring interest.  The higher the interest rate, the less popular this strategy and the lower the put option price
  • So, put options fall in price when interest rates rise

Dividends

  • When a dividend is paid, the stock price will fall
  • Accordingly, a dividend payment will lower the value of a stock’s call option and increase the value of a stock’s put option

Current Price vs Exercise Price

  • The closer an option is to being in-the-money, the higher the time value
  • An option that is 100 points out-of-the-money will be worth less than an option that is 10 points out-of-the-money
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

11. Exchange-traded Options (ETOs)
  • ETOs have standardised contract specifications detailing product features such as expiry dates, exercise prices, quantity of underlying asset and option type
  • In Hong Kong, there are six main ETO products:
    • Stock options
    • HSI options
    • Mini-HSI options
    • Hang Seng China Enterprises Index (HSCEI) options
    • Mini-HSCEI options
    • USD/CNH options
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

12. Over-the-Counter Options
  • Similar to ETOs, except:
    • Strike price, expiry date and quantity and quality of underlying asset are usually tailored to investor needs
    • Pay-off characteristics can be tailored to the investor’s needs
  • Options with both tailored aspects are known as exotic options, including the following seven instruments:

Binary Options

  • A bet on the movement and/or direction of prices
  • A binary option could be based on the HKD strengthening to 10 against the UK Pound – If the HKD strengthens to 10, the option seller must pay out to the buyer an agreed amount (eg 10 or 20 times the premium)

Barrier Options

  • Options that come into effect (or cease to be in effect) when prices move through a predetermined level, known as a “knock out” feature
  • For example, a French importer wants protection from a fall in the value of the Euro, however is comfortable with the Euro anywhere between 1.2 to 1.3 to the USD. As the importer cannot tolerate the Euro weakening beyond 1.1, a barrier option can be used to provide coverage for the importer, if the Euro falls below 1.1
    • There are numerous varieties of barrier options
    • As they provide limited cover, they cost less than a vanilla option
  • Similar to ETOs, except:
    • Strike price, expiry date and quantity and quality of underlying asset are usually tailored to investor needs
    • Pay-off characteristics can be tailored to the investor’s needs
  • Options with both tailored aspects are known as exotic options, including the following seven instruments:

Compound Options

  • An option on an option
  • For example, a call on a put, where the buyer purchases the right to buy a put option

Lookback Options

  • An option that gives the buyer the right to buy or sell an asset at the most advantageous price achieved during an elapsed period of time

Chooser Options

  • An option that gives the buyer the right to choose, at a later date, whether the option will be a put or call option
  • Complex chooser options also allow the buyer to choose the expiry date and strike price

Average-Rate (or Asian) Options

  • An option that does not have a set strike price – instead, the buyer can exercise the option based on a price that is determined by taking the average of prices over a specified period of time

Rainbow Options

  • An option that has more than one underlying asset
  • Rainbow options can pay out according to the best, or worst, performing of the underlying assets
  • Spread options are a subset of rainbow options where the payout depends upon the difference in the performance of two or more assets
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

13. Put-call Parity
  • This is a fundamental concept in understanding options and their ability to create synthetic positions
  • Put-call parity is based on the assumption that the put and the call options expire at the same time and have the same strike price
  • Long put + short call =  synthetic short underlying
  • Long call + short put =  synthetic long underlying
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

14. Futures and Options Combined Strategies
  • We can combine futures and options on futures to create various futures and options positions
  • Benefits of creating a synthetic long/short futures position using options on futures:
    • Traders can be more flexible in the execution of their trading strategies – synthetic long or short futures positions can be created by buying and selling options on futures
    • Traders can explore whether there is any mispricing between futures and the options on futures – an arbitrage profit can be made by buying and selling the futures and and options on futures simultaneously
Transaction 1+Transaction 2=Synthetic Instrument
Long ATM call+Short ATM put=Long synthetic futures
Short ATM call+Long ATM put=Short synthetic futures
Long put+Long futures=Long synthetic call
Short put+Short futures=Short synthetic call
Long call+Short futures=Long synthetic put
Short call+Long futures=Short synthetic put
  • Benefits of creating a synthetic long/short position of call or put options using options on futures and futures contracts:
    • Traders can be more flexible in the execution of their trading strategies
    • Traders can explore if there is any mispricing
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

15. Black-Scholes-Merton Model (BSM)
  • The BSM model was first published in the early 1970s and has been one of the most significant developments in the pricing of financial instruments
  • The option price is affected by five variables in the BSM model:
    • Price of the underlying asset (stock price)
    • Time to expiry
    • Exercise price
    • Annualised volatility of underlying asset
    • Risk-free rate of interest

C  =  S0N(d1) – Xe-rTN(d2)

Where:

C = Call-option price

d1  =  [ln(S0/X) + (r + σ2/2)T]/(σT-2)

d2  =  d1 – σT-2

T  = time to expiry

σ  =  annualised volatility of underlying asset

r  =  risk-free interest rate

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

16. Risk Measurement for Options
  • To describe the sensitivity of the option price relative to certain variables, the names of Greek letters are used, known as “the Greeks”

Delta (∆)

  • The delta of an option measures the sensitivity of the option price to changes in the price of the underlying stock
∆  =Dollar change in option price
Dollar change in underlying stock price
  • The delta value of a long call/short put is always between 0 and 1
  • The delta value of a long put/short call is always between -1 and 0

Gamma (Γ)

  • Gamma measures the rate of change in the option delta:
Γ  =Change in delta
Dollar change in underlying stock price
  • Gamma represents the sensitivity of delta to underlying stock price changes
  • If gamma is low, delta changes slowly and little adjustment is required to keep the delta of a portfolio at the required level
  • If gamma is large, delta is very sensitive to changes in the underlying stock price and frequent changes will be required to maintain a portfolio delta

Vega (ν)

  • Vega measures the change in option price for a 1% change in volatility of the underlying stock price
ν  =Dollar change in option price
1% change in volatility of underlying stock price

Theta (θ)

  • Theta measures the effect of the passage of time on the option price
θ  =Dollar change in option price
Decrease in time to expiration
  • Theta is always negative, as option values always decrease as time passes

Rho (ρ)

  • The Rho of an option measures the rate of change in the value of an option with respect to changes in the risk-free interest rate
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

17. Option Trading Strategies

Long Straddle – buy call and put at same strike

  • Expectation: HSI will move out of its current range

Short Straddle – sell call and put at same strike

  • Expectation: HSI will not move out of its current range

Long Strangle – buy call and put at different strike prices

  • Expectation: HSI will move out of its current range and you want to reduce the option premium paid (or received)

Short Strangle – sell call and put at different strike prices

  • Expectation: HSI will not move out of its current range but wider than that of the straddle – less option will be received as a result
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

18. Options with Underlying Assets

Covered Call

  • A strategy used by fund managers to enhance portfolio income by selling call options with the underlying being stock held by the fund manager
  • Used when the fund manager expects the price of the stock in question to trade within a narrow range with low price volatility
  • The written call option is “covered” as the fund manager can deliver the stock if the option is exercised
AdvantagesDisadvantages
Ø  Income enhancement

Ø  A lower break-even price

Ø  Any fall in the stock price will be cushioned by the option income

Ø  Limited profit potential – the stock will need to be sold if the call option is exercised

 

Protective Put

  • A strategy used by fund managers to protect portfolios from downward price movements
  • If the price of the underlying asset drops significantly, the fund manager can sell the stock at the exercise price
AdvantagesDisadvantages
Ø  Upside profit potential is retained

Ø  If the stock price falls, the fund manager will only suffer a limited loss

Ø  An increase in the break-even price

 

Collar

  • A strategy used by fund managers to protect portfolios from downward price movements. The cost of buying puts is financed by selling calls
  • The put option has a lower exercise price than the current stock price and the call option has a higher exercise price than the current stock price
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

TOPIC 3 – EQUITY DERIVATIVES

 

19. Exchange-Traded Equity Derivatives

Hang Seng Index Futures

  • The most popular futures contract traded in Hong Kong
  • Global fund managers use HSI index futures and options to hedge or speculate on the direction of the Hong Kong market
  • Cash settled
  • Underlying instrument: HSI comprising 55 constituent stocks

Hang Seng Index Options

  • Cash settled European options that can only be settled on the day of expiry
  • Underlying instrument: HSI comprising 55 constituent stocks
  • Flexible index options provide flexibility in strike prices and expiry days

Mini-Hang Seng Index Futures/Options

  • Mini-HSI derivatives are smaller versions of HSI products designed for retail investors with a multiplier of HKD10 instead of HKD50 per index point
  • Note that the Mini-HSI futures contract has a value one-fifth of that for HSI futures
  • Cash settled
  • Underlying instrument: HSI comprising 55 constituent stocks

Hang Seng China Enterprises Index (HSCEI) Futures/Options

  • HSCEI derivatives are offered by HKEx to meet the growing needs of investors interested in China related securities
  • The options are European options
  • Cash settled and the contract multiplier is HKD50 per index point
  • Mini-HSCEI futures have a contract multiplier of HKD10
  • Underlying instrument: HSCEI reflecting the overall performance of Mainland securities listed in Hong Kong, including H-shares, Red-chips and P-chips
    • H-shares – shares issued by companies incorporated in Mainland China and listed on SEHK
    • Redchips – Mainland securities that have least a 30% shareholding directly held either by Mainland entities or by companies controlled by such entities, and at least 50% of sales revenue derived from the Mainland
    • P-chips – companies that have more than 50% of their sales revenue derived from mainland China but are not H-shares or Red-chips
  • HSCEI is compiled and calculated by Hang Seng Indexes Company Limited (HSIL)

Stock Futures

  • Underlying instrument is a specified quantity of an individual stock or exchange-traded fund (ETF)
  • Cash settled
  • Underlying instrument: differs between stocks. For example, HSBC stock futures are based on the value of a parcel of 400 HSBC shares; China Mobile 500 shares; and CK Hutchison 500 shares

Stock Options

  • Settled by physical delivery
  • Can be exercised at any time up to expiry (American style)
  • Stock options include options on ETFs
  • Underlying instrument: as with stock futures, the quantity of the underlying asset differs between stocks and the number in each case is the same as futures (ie HSBC is 400 shares)

Dividend Futures

  • As equity indexes generally exclude dividends, the HSI and HSCEI dividend futures allow investors to hedge their dividend exposure, to bet on expected dividend outlook and to exploit arbitrage opportunities
  • Underlying instrument: the dividend point index (calculated by HSIL) measuring the cumulative total cash dividend value for all constituents of the corresponding index

HSI Volatility Index (VHSI) Futures

  • Measures the expected volatility of the corresponding market and is perceived as a barometer of investor sentiment (aka the “fear index”)
  • Compiled and calculated by HSIL
  • Allows investors to manage volatility risk in HSI or Hong Kong’s stock market in general
  • Underlying instrument: VHSI that aims to measure the 30-calendar-day expected volatility of the HSI and is derived from HSI put and call options
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

20. Types of Warrants
  • There are two broad types of warrants traded on the SEHK: equity warrants and derivative warrants

Equity (Subscription) Warrants

  • Equity warrants carry the right to subscribe for the underlying stock of the issuer
  • Although warrants are less certain, as to the funds raised in the future, than rights issues, there will in general be no immediate dilution effect to shareholdings before the warrants are exercised
  • They involve the physical delivery of shares
  • Expiry for equity warrants is between one and five years
  • Exercise usually follows the American style, although European-style warrants are also available
  • Dilution of shareholdings occurs when warrants are exercised as new shares will be issued
  • Holders are not entitled to dividends

Derivative Warrants

  • Derivative warrants are similar to equity warrants but are issued by a party that is independent of the issuer of the underlying securities of the company and its subsidiaries – usually investment banks and other institutions
  • Exchange-traded and usually have an expiry of between six to nine months
  • Majority in Hong Kong are settled in cash
  • Can be call or put warrants
  • Derivative warrants with a physical delivery are for shares that are already in issue, so there is never a diluting effect on shareholdings
  • May be issued over assets other than securities (such as currencies or commodities)
  • Index warrants, basket warrants and single stock warrants are commonly issued in Hong Kong
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

21. Reasons for Investing in Warrants
  • Advantages of investing in warrants:
    • Suit investors with longer term views, as they have longer expiry periods than options
    • They are available over baskets of stocks, providing exposure to a certain sector of sub-sector
  • Drawbacks of investing in warrants:
    • As warrant supply is controlled by issuers, market prices can sometimes be distorted by a demand and supply imbalance
    • Short-selling is not possible for exchange-traded warrants
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

22. Equity Swaps
  • Similar to an interest-rate swap, an equity swap involves two parties who agree to swap cash flows for a specified period of time, linked to the performance of a stock, a basket of stocks or a stock index
  • A common situation would be one party swapping the cash flows from a portfolio of short-dated debt securities for the returns of an equity index
  • Equity swaps enable parties to swap returns on their portfolio of investments to better suit their needs and views of the market
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

23. Inline Warrants
  • A type of structured product arranged by the HKEX, entitling investors to receive a specified amount at expiry
  • Payment at expiry is conditional upon either of the following two conditions:
  • An underlying asset’s price falls within a specified range (in-the-range, ITR)
  • The asset price falls outside the specified range (out-of-the-range, OTR)
  • HKEX limits underlying assets for Inline Warrants to the Hang Seng Index and a small number of actively traded stocks
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

24. Cost of Carry
  • Central to calculating the theoretical value of a futures contract is the concept of “cost of carry”
  • Cost of carry is the cost involved in holding the underlying asset
  • For financial futures, the cost of carry represents the opportunity cost of having capital invested in the underlying asset that could be more productively invested elsewhere
  • For commodity derivatives, the cost of carry relates to the costs involved in physically storing the commodity
  • Fair value =  spot price + cost of carry
  • The nearer a contract is to expiry, the less the cost of carry
  • On the day of expiry, there will be zero cost of carry, therefore the futures and spot price must be equal
  • How to think about cost of carry for HSI futures contracts:
    • If an investor wishes to gain exposure to equities, she has two choices: (i) invest capital in stocks and receive dividends; or (ii) buy HSI futures
    • When buying futures, the investor is required to pay out a small amount of capital, in the form of an initial margin
    • The balance of the capital that would have been needed, had the investor bought the physical stock, could be invested and earn interest at the current rate
    • If current interest rate > gross dividend yield, the seller of the futures product will want to be compensated, so the futures price will be higher than the spot price
    • Or, if current interest rate > gross dividend yield, the buyer of the futures product will enjoy a higher interest income over the dividend forgone, so will be willing to pay a higher futures price over the spot price
    • In both cases, if current interest rate < gross dividend yield, the futures price will be lower than the spot price
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

25. Trading Futures to Profit from Stock Outperformance
  • It is August and Ivan Investor expects the pharmaceutical industry to outperform the overall Hong Kong stock market due to the spread of a new infectious disease and the measures that will be taken to contain it
  • Ivan believes that the share price of Philly Pharma, a Hong Kong listed pharmaceutical company, will rise by more than the Hang Seng Index over the next 4 months
  • Ivan decides to:
    • Buy 10 December Philly stock futures, priced at HK$125 with a contract size of 1,000 shares; and
    • Sell one December HSI futures contract currently trading at 25,000

Closing the Trade

  • Once again, Ivan got it right. In late December, the HSI futures contract is trading at 25,100 and the December Philly stock futures contract is trading at HK$135
  • To exit the trade, Ivan sells 10 December Philly stock futures and buys one December HSI futures contract
  • Profit on Philly stock futures: (HK$135 – HK$125) x 1,000 shares x 10 contracts
    =  HK$100,000
  • Loss on HSI futures: (25,000 – 25,100) x HK$50 =  -HK$5,000
  • Overall profit: HK$100,000 – HK$5,000 =  HK$95,000
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

TOPIC 4 – INTEREST-RATE DERIVATIVES

 

26. Hong Kong Interbank Offered Rate Futures
  • There are two types of Hong Kong Interbank Offered Rate (HIBOR) futures:
    • Three-month HIBOR futures contracts introduced in September 1997
    • One-month HIBOR futures contracts introduced in October 1998
  • HIBOR futures contracts are cash-settled
  • They are designed to enable management of interest-rate risk
  • HIBOR is the rate on which all Hong Kong dollar-denominated instruments are traded between banks in Hong Kong
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

27. Interest-Rate Swaps (IRSs)
  • Transactions in which two parties agree to make periodic payments to one another computed on the basis of specific interest rates on a notional principal amount
  • Usually, there are two legs or payments: a payment based on a floating rate of interest (LIBOR or HIBOR); and a payment based on a fixed rate of interest
  • The swap market began in 1980 and is now the largest type of traded interest-rate derivative in the OTC market
  • The largest swap market is in US dollar, followed by the Euro, Japanese Yen, and the British pound sterling. IRSs are traded in many countries
  • Hong Kong is one of the most active markets in the Asia Pacific region
  • In Hong Kong, certain types of IRS transactions are subject to mandatory reporting to the Hong Kong Trade Repository, operated by the Hong Kong Monetary Authority, and mandatory clearing at SFC designated central counterparties
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

28. Caps, Floors and Collars
  • Caps and floors are options that can be bought to hedge against a rise or fall interest rates
  • The seller of a cap agrees to compensate the buyer if interest rates rise above a specified strike rate. The buyer pays the seller a premium
  • Borrowers can hedge the cost of borrowing by buying caps. If interest rates do not rise, beyond the strike rate, the seller is ahead by the premium
  • The seller of a floor agrees to compensate the buyer if interest rates fall below a specified strike rate. The buyer pays the seller a premium
  • Lenders can hedge the interest-rate received by buying floors. If interest rates do not fall, beyond the strike rate, the seller is ahead by the premium
  • For both caps and floors, the agreement is for a specified period over a notional amount
  • A collar is a combination of a cap and a floor – by combining the two, both upside and downside risks can be hedged
  • If both cap and floor were set at the same strike price, the net effect would be the same as entering into a swap
  • A zero-cost collar can be established by:
  • Selecting the appropriate floor (or cap)
  • Selecting the opposite cap (or floor) with a net present value which, when added to the premium of the floor (or cap), will result in a zero net premium
  • The purchase of either a cap or a floor can be offset by the sale of a cap or a floor
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

29. Swaptions
  • A swaption is the option to enter into a swap
  • Two types of swaptions: calls and puts
  • A receiver swaption, like a call option on a swap, gives the buyer the right, but not the obligation, to receive a fixed rate
  • A payer swaption, like a put option on a swap, gives the buyer the right, but not the obligation, to pay a fixed rate
  • There are several types of expiry for swaptions, including American, European and Bermudan (the last is not described)
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

30. Hedging Using Interest Rate Futures
  • With debt securities, there is an inverse relationship between yield and price:
    • When price rises, yield falls
    • When price falls, yield rises
  • Similarly, with interest-rate futures contracts, there is an inverse relationship between the interest rate and the interest-rate futures contract price
  • When interest rate rises, futures contract price falls
  • When interest rate falls, futures contract price rises
  • When an investor buys an interest-rate futures contract, his bond portfolio’s exposure to a change in interest rate increases
  • Conversely, when an investor sells an interest-rate futures contract, her bond portfolio’s exposure to a change in interest rate decreases
  • Therefore, interest-rate futures contracts can be used to change the duration (bond price sensitivity to a change in interest rates) of a bond portfolio
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

31. Trading strategies Using HIBOR Futures
  • To speculate on interest rates rising:
    • Sell HIBOR futures now at current HIBOR futures price
    • Buy back same number of futures contracts at HIBOR futures price when the reversing trade takes place
    • If interest rates have risen, a profit will be made; if interest rates have fallen, a loss will be made
    • The settlement value will be:
      change in futures price x HK$125 x 100 x number of contracts
  • To speculate on interest rates falling:
    • Buy HIBOR futures now at current HIBOR futures price
    • Sell same number of futures contracts at HIBOR futures price when the reversing trade takes place
    • If interest rates have fallen, a profit will be made; if interest rates have risen, a loss will be made
    • The settlement value will be:
      change in futures price x HK$125 x 100 x number of contracts
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

TOPIC 5 – CURRENCY AND COMMODITY DERIVATIVES

 

32. Currency Swaps
  • In principle, the same as an interest-rate swap, except that it involves two currencies
  • A currency swap is an agreement between two parties to exchange their financial obligations (interest payments) for a portfolio of liabilities that are denominated in difference currencies
  • Currency swaps usually involve an exchange of principals at the beginning and end of the swap period, such that the common stages of a currency swap are:
    • Exchange of principal amounts
    • Exchange of interest-rate payments
    • Reversing exchange of principal amounts
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

33. Exchange-traded Currency Derivative Products in Hong Kong
  • HKEX has introduced the world’s first deliverable RMB currency futures, which allows investors to hedge or take on RMB exposure
  • The futures contracts are traded on a margin basis and settled at expiration with delivery of US$ by the seller and payment of RMB by the buyer – USD/CNH futures
  • The underlying asset is US$100,000 of CNH
  • The contract is quoted in standard interbank FX terms: RMB to USD (eg RMB6.5 per USD)
  • In March 2017, HKEX launched its first RMB currency options to help market participants hedge currency risk more efficiently against the backdrop of increased volatility of the CNH
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

 34. Pricing Currency Forwards
  • Currency forwards are agreements to buy or sell a quantity of currency for delivery at some time in the future, at an exchange rate fixed at the time of the agreement
  • F  =  S x [(1 + in)/(1 + id)]

Where:

  • F – Forward rate
  • S – Spot rate
  • in – interest rate of numerator currency
  • id – interest rate of denominator currency

Currency Forward Exchange Rate Example

Calculate the 1-year forward exchange rate with the following information:

  • GBP/USD spot rate: 35
  • UK interest rate: 3% pa
  • US interest rate: 0.75% pa

Answer

F = 1.35 x (1 + 0.0075)/(1 + 0.03)

= 1.32

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

 35. Commodity Derivative Products

Agricultural Instruments

  • Agricultural instruments can be further broken down into:
    • Grains: corn and soybean
    • Softs: coffee, sugar, cocoa and orange juice
    • Meats: live cattle and pork bellies
  • While primarily used as hedging instruments, speculators often trade particular futures, such as orange juice and coffee
  • Some of the major agricultural derivatives exchanges are: the Chicago Board of Trade, Dalian Commodity Exchange, the Intercontinental Exchange (ICE) and the Tokyo Commodity Exchange

Metal-Based Instruments

  • Metal-based instruments can be further broken down into:
    • Base: nickel, aluminium, copper and tin (used by heavy industries)
    • Precious: gold, silver and platinum
  • They are traded OTC and on exchanges, such as the Commodity Exchange Inc, the London Metals Exchange (LME) and Shanghai Futures Exchange

Energy Instruments

  • Energy instruments can be further broken down into:
    • Crude oil: West Texas Intermediate (WTI) and Brent Crude oil
    • Refined products: heating and gasoline oil, natural gas and electricity
  • Market analysts watch crude oil instruments closely, since they are seen as important economic growth leading indicators
  • They are traded OTC and on exchanges, such as the New York Mercantile Exchange and the ICE
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

36. Hedging Using a Gold Swap
  • A miner and producer of gold, who is concerned about a fall in the price of gold, could hedge price risk in any of the following ways:
    • Enter into a gold forward contract for the sale of its production
    • Sell gold futures
    • Enter into a gold swap
    • Purchase gold put options
  • In reality, the miner/producer would probably enter into a swap for the following reasons:
    • A swap agreement is longer term than the other instruments
    • A swap agreement requires less on-going management than options and shorter-dated forwards
    • Compared to futures, a swap agreement does not involve the tying-up of capital in initial and variation margins
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

TOPIC 6 – DERIVATIVES: TRADING, CLEARING AND SETTLEMENT

 

 37. Risks of Derivative Products

Market Risk

  • The chance of losing money from movements in price as a result of changes in market conditions, be it interest rates, exchange rates and volatility
  • Given the element of leverage with derivative products, market risk can be substantial

Liquidity Risk

  • The chance of losing money from there being no buyers or sellers when you want to enter or exit a position
  • Liquidity risk is greater in OTC markets than in exchange-traded markets

Credit Risk

  • The chance of losing money from a counterparty failing to meet its financial obligations
  • Credit risk is not an issue with exchange-traded markets as clearing houses guarantee settlement through novation – it is more of an issue with OTC markets
  • OTC risk is being addressed by regulators worldwide after the 2008 episode

Basis Risk

  • The chance of losing money from differences between the prices in the physical and futures markets. Basis risk can be broken down into three sub-categories:
    • Delivery basis: Cost of delivery, including storage, insurance and funding costs
    • Grade basis: Difference between grade of asset being hedged and underlying asset of derivative product
    • Hedge basis: Hedging an exposure using closely related, but not perfectly correlated, reference underlyings. For example, bonds with different tenors
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

 38. Types of Orders
  • All trading on the Hong Kong Futures Exchange (HKFE) is conducted electronically using the Hong Kong Automated Trading System (HKATS)

Order Types on HKATS

  • Two primary types of orders in HKATS:
    • Limit order: a price limit is assigned by the user
    • Auction order: an order with no specified price – unfilled orders are automatically cancelled at the end of the pre-opening session

Orders Managed by a Broker

  • A broker is involved in several other types of order:
    • Market order: the broker is instructed to execute the trade at the best price currently available
    • Limit order: the broker is instructed to buy or sell at a specified price. Usually, the price for a “buy” limit order is below the current market price, while a “sell” order is above it
    • Stop-loss/gain order: a stop-loss order is used for risk management purposes to ensure that market movements do not erode an open position and cause a loss greater than an amount the investor is comfortable with. A stop-gain order is the reverse, used to lock in a profit before market movements erode the profit
    • Spread order: a broker is instructed to buy one contract and sell a related contract
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

 39. Dealing with Clients
  • This section looks at some of the requirements that must be met when dealing with clients in relation to trading futures and options on HKFE
  • The Code of Conduct stipulates that an intermediary has a duty to know the full identity of each client (KYC) as well as each client’s financial situation, investment experience and investment objectives
  • Clients should understand the nature and risks of derivative products and have sufficient net worth to be able to bear risk
  • Intermediaries should assess clients’ understanding of the nature and risks of derivative products
  • Risk disclosure: Brokers must ensure that clients are given and sign a risk disclosure statement and a client information statement
  • Client agreement: This should cover an individual account that can only be used by the broker to transact futures and/or options contracts on behalf of the client that are traded on HKFE
  • Dealing with client transactions: Brokers are not permitted to trade their own accounts until all executable orders for clients have been transacted and they are not permitted to take the opposite side of a client’s order unless (i) the client has given written permission; and (ii) open interest and/or turnover is lower than the level prescribed by HKFE
  • Responsibility for collecting margins: A broker must ensure that, before a trade is executed, the client has deposited sufficient collateral to cover the minimum HKFE margins and the client’s expected trading liabilities. HKFE margins must be cash-settled by the client
  • Monitoring the performance of client accounts: A broker must monitor a client’s ability to meet margin calls or demands. Should a client fail to meet two successive margin calls, which exceed the prescribed threshold, the broker must inform HKFE and provide the client’s account details.  A broker may also liquidate a client’s collateral if the client fails to meet any margin calls
  • Client money: Brokers should keep a segregated bank account for each client
  • Client ledgers: Brokers must maintain a ledger account for each client. Information in each ledger account should cover all HKFE trades, all non-HKFE trades and all trades that are not futures/options transactions
  • Commissions: Brokers can negotiate commission levels with clients
  • Large open positions: Brokers must report any large open positions held by either themselves or their clients to the HKFE
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 

 40. Margining Methods
  • Margin levels required by HKFE vary with changes in the values of underlying assets and any changes in the volatility of futures prices
  • There are four margin categories:
    • Initial margins
    • Maintenance margins
    • Intra-day margins
    • Clearing House margins
  • The first three apply to clients, while the Clearing House margins apply to HKCC Participants
  • Client margins are calculated by HKCC Participants – it’s the HKFE that specifies the minimum margin that an HKCC Participant must collect from its clients

Initial Margins

  • An initial margin is paid when opening a position – it provides cover against any loss that occurs when the position is first opened

Maintenance Margins

  • A maintenance margin is a safety level maintained once the initial margin is paid
  • When the margin level falls below the maintenance level, a margin call for a deposit is issued to restore the account balance back to the initial margin level

Intra-day Margins

  • In certain volatile market conditions, an HKCC Participant is entitled to make an intra-day margin call, rather than waiting to the end of the day

Clearing House Margins

  • Every HKCC Participant has a continuing obligation to maintain Clearing House margin at the level and during the period from time to time stipulated by the Clearing House
[For Paper 9 practice questions, go to Examinator.online – Paper 9]

A regular analysis of HKSI Paper 5 pass rates to help you gauge exam difficulty

 

HKSI Paper 5 – Pass Rates (%)

2020

2021

Change

Comments
January
February
March
April
May
June
July
August
September
October
November
December
74.4
76.47
81.25
58.33
66.67
64.52
70.00
76.00
85.71
86.67
86.67
66.67
69.23
84.62
84.21
58.33
75.00
.
.
.
.
.
.
.
-4.81
8.15
2.96
0.00
8.33
.
.
.
.
.
.
.
.
February pass rate increases significantly
.
.
.
.
.
.
.
.
.
.
  Mean74.4274.28-0.13Average monthly pass rate steady
Standard deviation9.4311.021.60Pass rate variability increases

 

TOPIC 1 – REGULATORY OVERVIEW OF THE HONG KONG FINANCIAL INDUSTRY

 

1. Philosophy and Systems of Regulation

Share offers and listing matters can be referred to as merit-based or disclosure-based.

Merit-based Regulation

  • Objective is to screen out undesirable players and undesirable offerings
  • Ensure a fair balance between promoters and investors
  • Provides the investing public with a fair balance between risks and returns
  • It has been claimed that the HK Listing Rules are merit-based, although they are primarily a system of disclosure

Disclosure-based Regulation

  • the focus is on maximizing disclosure and provision of information regarding public offerings
  • UK and US are disclosure-based
  • HK New Companies Ordinance (NCO) is disclosure-based and has legal force
  • the idea is that maximum disclosure is required to enable investors to make their own investment decisions

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

2. Hong Kong Monetary Authority
  • Headed by a Chief Executive with several deputies
  • Manages the Exchange Fund
  • Manages Hong Kong’s monetary policy
  • Required to maintain currency stability
  • Ensures the safety and stability of the banking system
  • Promotes the efficiency, integrity and development of the financial system
  • Supervises the banking system
  • Under the SFO and the Banking Ordinance, Authorized Financial Institutions (AFI’s), which are regulated by the HKMA and include banks, have to be registered with SFC as registered institutions if they wish to carry out an SFC-regulated activity
  • HKMA is frontline regulator of AFIs and takes the leading role in vetting applications for registration with the SFC and in supervising their SFC-regulated activities, including on-site inspection
  • HKMA applies all SFC criteria in supervising AFIs registered with the SFC

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

3. Ten SFC-regulated Activities

 

1.Dealing in securities
2.Dealing in futures contracts
3.Leveraged foreign exchange trading
4.Advising on securities
5.Advising on futures contracts
6.Advising on corporate finance
7.Providing automated trading services
8.Securities margin financing
9.Asset management
10.Providing credit rating services

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

4. Regulatory Objectives of the SFC

As stated in the SFO, the objectives of the SFC, in relation to the securities and futures industry, are:

  • Maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness of the industry
  • Promote understanding by the public of financial services including the operation and functioning of the industry
  • Provide protection to the investing public
  • Minimize crime and misconduct in the industry
  • Reduce systemic risks in the industry
  • Assist the financial secretary in maintaining the financial stability of Hong Kong by taking appropriate steps in relation to the industry

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

5. SFC Committees, Tribunals and Panels

Examples of regulatory committees established by the SFC, to which it has delegated some of its functions, are:

  • Takeovers and Mergers Panel
  • Takeovers Appeal Committee
  • Products Advisory Committee
  • Investor Compensation Fund Committee
  • Academic and Accreditation Advisory Committee
  • Share Registrars’ Disciplinary Committee

The following tribunals and panels are independent of the SFC:

  • Securities and Futures Appeals Tribunal – statutory body with full-time members headed by a judge appointed by the Chief Executive to hear appeals against decisions made by the SFC
  • Arbitration Panel – hears disputes relating to leveraged foreign exchange trading
  • Process Review Panel – reviews and monitors the operational processes of the SFC, reporting suggested improvements to the Financial Secretary
  • Market Misconduct Tribunal – see Topic 9

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 6. Disciplinary Powers of the SFC

The SFC may investigate suspected breaches of the SFO, subsidiary legislation, codes and guidelines:

  • Breaches of SFO and subsidiary legislation are legal offences. Serious cases may be referred to law enforcement agencies such as the Commercial Crime Bureau (CCB – part of the police force), or the Independent Commission Against Corruption (ICAC)
  • SFC can apply to the courts for an injunction to stop someone dealing with his assets or from carrying on his business, if it can be shown to be in the public interest
  • Codes and guidelines do not have the force of law and are not legally enforceable. Breaching the codes and guidelines may result in a licensed or registered person not being considered ‘fit and proper’ to remain licensed or registered
  • The SFC has the power to:
    • Reprimand (privately or publicly)
    • Fine
    • Suspend or revoke a license or registration

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

TOPIC2 – PRINCIPLES OF RELEVANT HONG KONG LAW AND THE NEW COMPANIES ORDINANCE

 

7. Primary and Subsidiary Legislation
  • Primary legislation consists of Ordinances enacted by the Chief Executive, with the advice of LegCo (drafted by Government)
  • Subsidiary legislation is drafted by non-Government bodies, as delegated by LegCo, and referred to as Rules
  • SFC has extensive powers to make rules under SFO

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

8. Independence of the Judiciary
  • Judiciary is completely independent of other parts of Government
  • Judges are not politically appointed; decisions based on interpretation of law
  • Judges are not pressurized by Government, LegCo, media or pressure groups

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

9. Redeemable Shares
  • Redeemable preference and ordinary shares may be issued if authorized by articles of association
  • May be redeemed at the option of the shareholder or company
  • May only be issued if company has already issued shares that are not redeemable
  • Redemption must be paid out of distributable profits, the proceeds of a new share issue, or share capital
  • Redemption can only occur if shares are fully paid

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

10. Special Resolution
  • Passed by at least 75% of members at a general meeting
  • 21 days notice of the meeting is required
  • Printed copy of resolution must be lodged with Company Registrar within 15 days
  • Special resolution required for:
    • Reduction of share capital
    • Company liquidation
    • Alteration of articles of association

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

TOPIC 3 – SECURITIES AND FUTURES ORDINANCE (SFO)

 

11. Objectives of the Securities and Futures Ordinance

To provide a regulatory framework which:

  • Promotes a fair, orderly and transparent market
  • Is flexible enough to cope with new products and other innovations, and further advances in technological infrastructure
  • Is administered by a regulator with sufficient powers and discretion whose operations are transparent and who is accountable to the stakeholders through a system of adequate checks and balances
  • Is on a par with international standards and compatible with international practices, but tailored to meet local needs and circumstances

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

12. Associated Entity
  • The Client Securities Rules apply to intermediaries and their associated entities.
  • An associated entity (AE) of an intermediary is defined as a company which:
    • Is in a controlling entity relationship (>20% voting power) with the intermediary; and
    • Receives or holds client assets of the intermediary in Hong Kong
  • An AE is required to notify the SFC in writing within 7 business days of becoming or ceasing to be an AE
  • An AE cannot conduct any other business unless authorized in writing by the SFC

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

13. SFO Audit Provisions
  • The audit provisions apply to licensed corporations and their associated entities, but not to registered institutions
  • The main requirements relating to audits are in the SFO, although the contents of audited accounts and audit reports are given in the Accounts and Audit Rules
  • Audited accounts of a licensed corporation must be submitted to the SFC not later than 4 months after the end of the financial year, or the date of cessation of the business
  • Licensed corporations and any associated entities must appoint auditors within one month of being licensed – the appointment must be notified to the SFC within 7 business days
  • Removal or resignation of auditors should be notified to the SFC within 1 business day from giving notice of the required resolution
  • If an auditor becomes aware of a reportable matter, a written report must be made to the SFC as soon as practicable (or to HKMA if AE is an AFI). [A reportable matter is a failure to comply with a prescribed requirement and anything that adversely affects a financial position to a material extent or breaches the FRR]

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

14. Discipline of Regulated Persons
  • The disciplinary provisions in this part of the SFO relate to:
    • Licensed corporations, licensed representatives, responsible officers and persons involved in the management of licensed corporations;
    • Any person involved in the management of a licensed corporation, including managers-in-charge of core functions. Such individuals are not necessarily SFC licensed; and
    • Registered institutions, executive officers and persons involved in the management of registered institutions
  • If a regulated person (any of the above) is guilty of misconduct, or is not a fit and proper person, the SFC may:
    • Revoke or suspend the license/registration in respect of all or part of the regulated activity
    • Revoke or suspend approval as a responsible/executive officer
    • Publicly or privately reprimand the regulated person
    • Prohibit the regulated person from applying for a license, registration, approval as a responsible officer, or entry in the HKMA register, or to act as an executive officer
    • Separately, or in addition, order the regulated person to pay a penalty up to the greater of HK$10million or 3 times any profit gained or loss avoided as a result of his misconduct
  • Misconduct includes contravention of:
    • Provisions of the SFO and certain parts of the NCO
    • Terms and conditions of any license or registration with the SFC
    • Any act or omission relating to regulated activities which is prejudicial to the public interest

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

15. Investor Compensation
  • SFO empowers SFC to establish and maintain a single Investor Compensation Fund to cover losses incurred by clients of intermediaries in general, including non-exchange participants
  • The Investor Compensation Company Limited has been established to administer, manage and operate the Investor Compensation Fund and process claims made against the fund
  • Detailed legislation contained in three sets of rules:
    • Securities and Futures (Investor Compensation – Levy) Rules: funded by a levy on buy and sell transactions on the SEHK and HKFE
    • Securities and Futures (Investor Compensation – Claims) Rules: prescribe who can make claims from the Fund and how claims may be made and paid
    • Securities and Futures (Investor Compensation – Compensation Limits) Rules: prescribe that the maximum amount of compensation that can be paid per person is HK$500,000

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

16. Duty of Disclosure
  • Reflects modern trend towards greater disclosure and transparency
  • Two basic rules concerning the duty to disclose interests in the relevant share capital of a listed company:
    • Directors and chief executives are required to disclose all interests
    • Other persons must make disclosures once their interests in the relevant share capital reach 5%
  • ‘Interest in relevant share capital’ is widely defined to include:
    • Both long and short positions, without any netting
    • Interests in equity derivatives
    • Attributed interests, including trust arrangements, corporate shareholdings and family arrangements
  • Persons subject to disclosure requirements are required to make disclosures when:
    • Having reached (and reported) the 5% disclosure level, their holdings rise or fall through a whole percentage level
    • The level of interest falls below 5%
    • The nature of their interest changes (eg acquiring shares on the exercise of a call option)
  • Disclosure must be made:
    • To the listed company
    • To the exchange on which the company is listed
    • Within 3 business days after the relevant date

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 17. Miscellaneous Provisions of SFO
  • Statutory immunity is provided to persons performing the SFCs statutory functions in good faith
  • Auditors of listed companies reporting suspected fraud and other improper practices are given immunity from civil liability
  • A person commits an offence if he knowingly or recklessly provides false or misleading information regarding a material matter to the SFC – also applies to filing of public statements and disclosure obligations imposed by the listing rules
  • SFC can intervene in civil proceedings between third parties which concern matters under the SFO or certain parts of the NCO
  • If an offence under the SFO committed by a company is aided or abetted by an officer of the company, that officer will be guilty of that offence. “Officer” includes senior management and managers-in-charge
  • Powers are given to the Financial Secretary to prescribe, by notice in the Gazette, new financial products, including OTC derivatives
  • SFC is given powers to make rules, codes and guidelines (eg Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the Securities and Futures Commission)

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

TOPIC4 – LICENSING AND REGISTRATION AND SUBSIDIARY LEGISLATION

 

18. Responsible Officer
  • A responsible officer is a licensed representative who:
    • Actively participates in or supervises a regulated activity;
    • Is nominated by the licensed corporation; and
    • Is approved by the SFC
  • Although the SFO does not provide a definition of responsible officer, the SFC has stated:
    • Every executive director* of a licensed corporation is required to obtain the approval of the SFC as a responsible officer; and
    • Every licensed corporation must have, for each regulated activity for which it is licensed, at least two responsible officers approved by the SFC – at least one of them must be an executive director

*  A director who actively participates in, or is responsible for directly supervising, the business of a regulated activity for which the corporation is licensed (s113, SFO)

  • For registered institutions: the Banking Ordinance requires at least two executive officers to be responsible for supervising regulated activities – at least one to be available at all times

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

19. Substantial Shareholder
  • Substantial shareholders have a special relevance in the licensing regime
  • All substantial shareholders of licensed corporations must be approved by the SFC
  • Under this legislation, a substantial shareholder is a person who, alone or together with his associates:
    • Has an interest of more than 10% of the total number of the issued shares of the corporation
    • Directly or indirectly has more than 10% of the voting power of the company at a general meeting
    • Is able to exercise 35% or more of the voting power of another company at a general meeting which in turn has more than 10% of the voting power of the company at a general meeting

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

20. Exclusions from Regulated Activities

A number of parties are not required to be licensed for certain activities, including:

  • Professional accountants, solicitors, and counsel conducting Types 4, 5, 6 and 9 regulated activities that are wholly incidental to their profession
  • Trust companies conducting Types 4, 5, 6 and 9 regulated activities, wholly incidental to the discharge of their trustee duties
  • Persons licensed or registered to conduct Type 9 regulated activity who carry out Types 1, 2, 4 and 5 regulated activities solely for the purposes of their Type 9 regulated activity
  • Corporations carrying out Types 4, 5, 6 and 9 regulated activities solely for their wholly owned subsidiaries, holding companies holding all their issued shares or other wholly owned subsidiaries of the holding company

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

21. Temporary and Provisional Licenses

Temporary Licenses

  • The SFC may grant a temporary license to a corporation, for not more than 3 months:
    • Which principally carries on its business overseas
    • For specified SFC regulated activities, other than Types 3, 7, 8 and 9
  • The SFC may grant a temporary license to representatives of a licensed or a temporary licensed corporation, for not more than 3 months
  • The total period for which temporary licenses can be held by the same person may not exceed 6 months over a 24-month period

Provisional Licenses

  • On application for a representative license, a person may be given a provisional license to cover the period before a decision is made on the licensing application

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

22. Fitness and Properness
  • Corporate and individual applicants for licensing and registration must satisfy fitness and properness requirements as stated in the Fitness and Properness Guidelines. These relate to:
    • Financial status or solvency
    • Educational or other qualifications/experience
    • Ability to carry on the regulated activity competently, honestly and fairly
    • Reputation, character, reliability and financial integrity

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

23. Guidelines on Continuous Professional Training
  • Every individual licensee is expected to undertake a minimum of 5 CPT hours every calendar year for each regulated activity competence group (eg Types 1 and 4 are in the same Group; Types 1 and 9 are in different Groups)
  • Activities allowed as CPT:
    • Attending courses, workshops, lectures and seminars
    • Distance learning
    • Self-study with submission of assignments to recognized institutions
    • Research
    • Publications
    • Speeches
  • Activities not allowed as CPT:
    • Reading financial journals, newspapers and other technical publications
    • Normal work
    • Activities which do not involve interaction with other individuals

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

24. Applicability of SFC Rules
Licensed CorporationsRegistered InstitutionsAssociated Entities
Financial Resources Rules

YES

NO

(HKMA)

NO

(Not an issue)

Client Securities Rules

YES

YES

YES

Client Money Rules

YES

NO

(HKMA)

YES

(if not an AFI)

Keeping of Records Rules

YES

YES

YES

Contract Notes Rules

YES

YES

YES

Accounts and Audit Rules

YES

NO

(HKMA)

YES

(If not an AFI)

Insurance Rules

YES

(Those holding client assets)

NO

NO

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

25. FRR: Required Liquid Capital

LIQUID CAPITAL     =    LIQUID ASSETS     –     RANKING LIABILITIES

Liquid capital must be greater than Required Liquid Capital  at all times

Liquid assets are cash and close to cash (eg treasury bills after haircuts)

Ranking liabilities are total liabilities less approved subordinated loans

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

26. FRR: Paid-up Share Capital Requirements
  • Licensed corporations are required to maintain, at all times, paid-up share capital ranging from HK$5m to HK$30m depending on their regulated activity
    • Approved introducing agents, securities advisers, corporate finance advisers, asset managers and credit rating agencies, which do not hold client assets, do not have paid-up capital requirements

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

27. FRR: Notifications to the SFC
  • A licensed corporation, unable to comply with capital requirements (Required Liquid Capital (RLC) and paid-up capital) must:
    • Notify the SFC in writing asap
    • Cease conducting the regulated activity immediately, unless permitted by SFC to continue
  • A licensed corporation must also notify the SFC in writing if:
    • Liquid Capital (LC) falls below 120% of RLC
    • LC falls below 50% of last LC reported
    • Information submitted in an earlier return becomes materially false or misleading

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

28. CSR: The Assets
  • The Client Securities Rules (CSR) apply to client securities or securities collateral of an intermediary that are:
    • Listed on a recognized stock market (ie SEHK);
    • Interests in an SFC authorized CIS; and
    • Received or held in Hong Kong by an intermediary (or its associated entity) in the course of conducting a regulated activity
  • The Client Securities Rules do not apply to securities held by an intermediary in an account in a client’s name, set up by that client with persons other than the intermediary or its associated entity:

[Rules only apply to Hong Kong stocks held in Hong Kong received by an intermediary or associated entity in the course of conducting regulated activities]

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

29. CSR: Standing Authority
  • A written notice authorizing the intermediary/associated entity to deal with client assets in specified ways
  • Effective for a period not more than 12 months (no time limit for PIs)
  • May be renewed on the written request of the client for a period not more than 12 months
  • May be deemed to be renewed by the intermediary/associated entity giving written notice at least 14 days prior to expiry reminding client of impending expiry. Deemed to be renewed on date of expiry, unless client objects
  • Intermediary/associated entity must provide written confirmation of deemed renewal to client within a week of expiry date
  • The standing authority cannot be used by the intermediary/associated entity to:
    • Transfer client securities/securities collateral to an account of the intermediary, its associated entity or any entity which has a controlling entity relationship with the intermediary
    • Make any such transfer to any officer or employee of these entities
    • Deal with client securities/securities collateral in an unconscionable manner
      (Unconscionable = contrary to a sense of justice, decency or reasonableness)

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

30. Client Money Rules
  • The Client Money Rules prescribe how licensed corporations and their associated entities should deal with client money received or held in Hong Kong
  • The Rules do not apply to client money that:
    • Is received or held outside Hong Kong
    • Is moved outside Hong Kong
    • Is held in a bank account by the client in his own name
  • Within one business day of receiving client money, the licensed corporation/associated entity should pay the money:
    • Into a segregated account
    • To the client directly
    • In accordance with a written direction
    • In accordance with a standing authority
  • Money held in a segregated account, which is discovered not to be client money, must be moved out of the account within one business day of discovery

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

31. Keeping of Record Rules
  • Records should be kept in Chinese or English, in writing or in any other form that may be convertible into writing
  • The general rule is that all records should be kept for at least 7 years, except for:
    • Daily statements of account – 2 years
    • Records documenting orders – 2 years
    • Copies of contract notes – 2 years

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

32. Daily Statement of Accounts
  • A daily statement must be prepared:
    • By intermediaries providing securities margin finance and their associated entities when client assets are deposited or withdrawn
    • By intermediaries conducting margined transactions, both when the margined transaction is entered into, and when it is closed
  • A daily statement must be issued to the client no later than the end of the second business day after the specified event

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

33. Monthly Statement of Accounts
  • A monthly statement must be prepared by an intermediary for all clients
  • Monthly statements must contain the same information as outlined above for contract notes
  • Information should also include:
    • All contracts entered into for the client during the month
    • Outstanding balances at the beginning and end of the month
    • All open positions held at the end of the month
  • Monthly statements must be issued within 7 business days of the end of each monthly accounting period (10 business days for portfolio asset managers)
  • No statement needed when no activity during the month and no balances at the end of the month
  • An asset manager does not need to prepare monthly statements for authorized CISs that it manages

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

34. Approved Introducing Agent
  • Approved introducing agents introduce securities or futures business to other securities/futures dealers. Not defined in the SFO, but created under the FRR
  • The SFC may approve a licensed corporation as an approved introducing agent if it can satisfy the SFC that it
    • Only receives offers for dealings in securities and passes them on to an exchange participant or another licensed dealer; or
    • Only introduces a client who wishes to trade with an exchange participant or another licensed dealer; and
    • Does not handle client assets and incurs no legal liability in respect of the introduced business
  • The SFC allows approved introducing agents to maintain a lower level of liquid capital and is not required to maintain paid-up capital

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 35. Securities Margin Financing (SMF)
  • SMF is defined as lending money to allow:
    • The acquisition of securities listed on any stock market, whether in HK or elsewhere
    • Where applicable, the continued holding of such securities
  • Exceptions to the definition are lending:
    • For underwriting, sub-underwriting and acquisition under a prospectus
    • By a Type 1 licensee to enable the licensee to engage in SMF for his clients
    • By a CIS to finance investment in the CIS it issues
    • By an AFI to enable its clients to buy/hold securities

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

TOPIC 5 – BUSINESS CONDUCT AND CLIENT RELATIONS

 

 36. GP1 – Honesty and Fairness
  • A licensed/registered person should act honestly, fairly and in the best interests of its clients and the integrity of the market. More specifically:
    • Representations and information to clients should be accurate and not misleading
    • Charges to clients should be fair and reasonable
    • Invitations and advertisements should not contain information that is false, misleading or deceptive; no negative advertising
    • Actions should comply with the Prevention of Bribery Ordinance and any related guidelines issued by the ICAC

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 37. GP2 – Diligence
  • A licensed/registered person should act with due skill, care and diligence, in the best interests of its clients and the integrity of the market. Some practical examples of this are:
    • Client orders should be executed promptly in accordance with clients’ instructions – prompt execution
    • Client orders should be executed on the best available terms – best execution
    • Orders executed for clients should be promptly and fairly allocated to those clients – prompt and fair allocation
    • Advice should be given to clients with due skill, care and diligence
  • Telephone orders should be centrally recorded. Recordings should be kept for at least 6 months

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 38. GP4 – Information about Clients

Client Agreements

  • A written client agreement should be entered into with a client before providing services to the client.
  • The agreement should be in Chinese or English, at the option of the client
  • Attention to relevant risks should be drawn to the client
  • If a face-to-face meeting with the client does not take place, a copy of the agreement should be provided to the client, and steps should be taken to verify the client’s signature

Discretionary Accounts

  • A discretionary account is a client account operated by the licensed/registered person, without the client’s prior approval for each transaction
  • The discretion may be absolute or subject to conditions
  • The Code of Conduct imposes the following on the establishment and operation of discretionary accounts:
    • The client’s authority must be in writing
    • The person authorized to operate the account should be identified
    • The terms of the authority should be explained to the client
    • The authority should be confirmed annually
    • The account should be designated as a discretionary account and be approved by senior management
    • Internal control systems should ensure that the operation of the account is properly supervised

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 39. GP6 – Conflicts of Interest

Handling Client Orders

  • Client orders should be handled fairly and in the order in which they are received
  • Client orders should have priority over orders for the account of the licensed/registered person, or for the account of any employee or agent of the licensed/registered person
  • Where there are aggregated orders for several clients, and the intermediary itself, priority must be given to client orders if all orders cannot be filled
  • The unfair preference of any one client should be avoided
  • When handling client orders, a licensed/registered person will acquire non-public information. This information should not be used to deal:
    • Ahead of transactions pending for other clients (front running)
    • When the release of the information will affect the price

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 40. Fund Manager Code of Conduct
  • Applies to “Fund Managers”, being persons licensed/registered with the SFC whose business involves the management of:
    • Collective Investment Schemes (CIS), whether or not they are SFC authorised
    • Discretionary accounts, whether in the form of an investment mandate or a pre-defined model portfolio (“Discretionary Accounts”)
  • If FMCC is inconsistent with any other legislation, rules, codes or guidelines, the stricter provisions apply
  • Provisions are similar to the general Code of Conduct. Those unique to the FMCC are detailed below
  • A Fund Manager should ensure that client orders are allocated fairly, the allocation intentions are recorded before placing the orders and adhered to, except that any revised allocation should not disadvantage a client (and reasons should be properly documented)
  • Fund managers participating in IPOs are not permitted to make preferential allocations and the reasons for allocations should be documented
  • Any client transactions carried out with a connected person should be at arm’s length, with standard commission rates and on best-execution terms
  • Borrowing/depositing money for a client with a connected person should be at standard interest terms, or better
  • Regarding cross trades:
    • Cross-trades between client accounts should be fairly conducted so that no client is disadvantaged and the clients should be informed
    • Cross-trades between the house account and client accounts should only be done with prior approval of the client
    • Cross-trades between staff personal accounts and client accounts are prohibited
  • House trades are orders for the house account operated for the fund manager itself. The following conditions apply:
    • Priority should be given to client orders
    • House orders should only be aggregated with client orders where it is in the best interests of clients
    • Advance knowledge of recommendations/research reports should not be used to deal until clients have had a reasonable chance to act on the information (no front running)

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

TOPIC 6 – BUSINESS CONDUCT AND CLIENT RELATIONS

 

 41. Internal Control Guidelines
  • Full title: Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the Securities and Futures Commission
  • The ICG identifies eight key areas of business controls:
    • Management and supervision
    • Segregation of duties and functions
    • Personnel and training
    • Information management
    • Compliance
    • Audit
    • Operational controls
    • Risk management
  • SFC recognizes that small entities may not have a complicated system of functional segregation or any compliance/internal audit departments
  • Internal controls refer to the entire system of policies, procedures, checks, controls and division of responsibilities which a licensed/registered person has installed to the run the business
  • A licensed/registered person should use internal controls to provide itself with reasonable assurance that it is able to:
    • Operate its business in an orderly and efficient manner
    • Safeguard the assets of its clients and its own
    • Maintain proper records, and reliable financial and other information that it produces
    • Comply with all applicable laws and regulatory requirements

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 42. Prevention of Money Laundering and Terrorist Financing

Money Laundering: Activities and processes by which property obtained as a result of illegal activities is altered so that it is given the appearance of coming from a legitimate source

  • Five pieces of legislation and one SFC Guideline:
    • Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance (AMLO)
    • Drug Trafficking (Recovery of Proceeds) Ordinance (DTRPO)
    • Organised and Serious Crimes Ordinance (OSCO)
    • United Nations (Anti-terrorism Measures) Ordinance (UNATMO)
    • Weapons of Mass Destruction (Control of Provision of Services) Ordinance (WMD(CPS)O)
    • Guideline on Anti-Money Laundering and counter-Terrorist Financing (GAML)

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 43. Personal Data Privacy Ordinance (PDPO)
  • The PDPO protects the privacy of individuals in relation to personal data
  • The Privacy Commissioner for Personal Data is an independent public officer appointed to enforce and promote compliance with the PDPO
  • Data users must comply with six data protection principles:

Principle 1 – Purpose and manner of collection of personal data

  • Data shall only be collected for a lawful and relevant purpose
  • The purpose of collecting the data should be disclosed

Principle 2 – Accuracy and duration of retention of personal data

  • Personal data should be accurate, up to date and kept no longer than necessary and should be rectified if incorrect

Principle 3 – Use of personal data

  • Without the consent of the subject, the data should not be used for any purpose other than for which it was collected

Principle 4 – Security of personal data

  • All measures should be taken to ensure that personal data are protected against unauthorized access, processing, erasure, etc

Principle 5 – Information to be generally available

  • A data user’s policies and practices relating to the data should be available

Principle 6 – Access to personal data

  • A data subject should be able to get access (at a reasonable fee) to the data held and request corrections to it

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

44. Roles of Senior Management
  • Senior management must provide leadership to drive the promotion of good compliance practices by installing:
    • Good line and reporting structures
    • Clearly defined functions and responsibilities
    • Effective communications
    • Appropriate transparency and disclosure practices
    • Well-defined policies, practices and procedures….in writing
    • Distinctions between supervisory/review functions and operational/line functions

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 45. Corporate Governance
  • Corporate governance is concerned with the system by which companies are directed and controlled to ensure the proper relationship between a company’s management, its board and its shareholders
  • The Organisation for Economic Co-operation and Development (OECD) has issued a set of core principles for corporate governance practices to include:
    • Fairness
    • Transparency
    • Accountability
    • Responsibility
  • An objective of good corporate governance is to avoid management taking improper advantage of its position to the detriment of the company’s interests
  • Corporate governance can be improved through:
    • Installing appropriate checks and balances, such as separating the functions of Chairman and CEO, appointment of non-executive directors, establishment of independent audit committees and setting up of remuneration and benefit committees
    • Increasing transparency and disclosures to shareholders / stakeholders /public
    • Adopting international accounting/auditing standards
    • Installing strong protective structures for minority shareholders, creditors and other lenders
    • Identifying and penalizing corporate wrongdoing
  • Corporate governance deficiencies can lead to insider dealing, fraud and connected transactions which are undervalued

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

TOPIC 7 – PARTICIPATING IN THE HONG KONG EXCHANGES

 

 46. Exchange Participants
  • Those who wish to trade through the SEHK or HKFE, must hold trading rights
  • Only exchange participants can hold trading rights
  • Therefore, before applying for a trading right, an intermediary must register as an exchange participant
  • Exchange Participants are participants of the SEHK; HKFE Participants are participants of HKFE
  • Those wishing to clear trades must become clearing participants of the respective clearing houses
  • From a regulatory point of view, participants must:
    • Be licensed by the SFC for Type 1 or Type 2 regulated activity, as necessary
    • Hold the necessary participantship (SEHK and/or HKFE) for the trading activities they wish to perform

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 47. Short Selling

Under the SFO:

A person shall not sell securities through a recognized stock market unless, at the time he sells them, he or his principal has (or he believes he or his principal has) a presently exercisable and unconditional right to vest the securities in the buyer

  • Securities charged or pledged to secure a loan may still give a person an unconditional right to vest the securities, depending upon details of the charge/pledge
  • Covered short sale: a short sale which satisfies the above general rule
  • Naked short sale: a short sale which does not satisfy the above general rule. Considered an offence
  • It may only be undertaken in securities designated by SEHK, of which there are a large number
  • Exchange Participants must indicate short sell orders when inputting the orders to the trading system
  • Exchange participants must make stock borrowing arrangements for settlement before the short sale
  • A short sale cannot be made below the best current ask price (the tick rule)

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 48. Clearing and Settlement Services
  • The Central Clearing and Settlement System (CCASS) is operated by HKSCC for clearing and settlement of securities transactions on the SEHK
  • HKSCC’s Investor Account Service allows individual and corporate investors to open direct stock accounts in CCASS
  • CCASS stock accounts:
    • 01 account: clearing account where a CCASS Clearing Participant maintains stocks for settlement
    • 02 account: for the handling of stock dividends
    • 03 onwards: safe custody stocks, house investments and securities collateral
  • The clearing and settlement system is as follows:

During Trading Day (T)

  • Trade data automatically transferred from SEHK trading system to CCASS
  • Clearing Participants receive Provisional Clearing Statements through CCASS terminals after 5pm (current day’s SEHK trades) and after 8pm (exercised option trades)
  • Trades reconciled with internal records

(T+1)

  • Final clearing statements available after 2pm
  • Continuous Net Settlement (CNS) system offsets stock transactions in the same security on the same day resulting in a single net stock position for the day
  • Through novation, HKSCC guarantees both sides of the trade

(T+2)

  • SEHK trades settled by electronic debit and credit entries to CCASS CP’s stock accounts

(T+3)

  • Money settlement by CPs through designated banks confirmed in the morning
  • CPs who do not have sufficient stock in their CCASS accounts will be subject to a compulsory buy-in

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

49. Options Trading
  • Licensed/registered persons providing Traded Options services to clients must enter into an options client agreement before engaging in Traded Options business for the clients
  • Only SFC licensed/registered persons may access the trading systems and facilities of the traded market for options in Hong Kong
  • To conduct Traded Options business for clients, an Exchange Participant must register with the SEHK as an Options Exchange Participant (OEP) under one of two categories:
    • Options Trading Exchange Participant (OTEP)
      • must hold system access rights
      • entitled to access the options system
    • Options Broker Exchange Participant (OBEP)
      • not permitted to have system access rights
      • entitled to conduct Traded Options business for the accounts of clients
      • enters into broking client contracts with an OTEP and corresponding client contracts, acting as principal in both cases
    • OTEPs input orders/quotes through the HKATS of HKFE – matched trades are passed to DCASS for processing

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 50. Futures Trading
  • Only licensed/registered persons may have access to HKFE trading systems (directly or indirectly) to carry out the Type 2 activity of dealing in futures contracts
  • There are four categories of HKFE Participant:
Traderentitled to trade in futures contracts and/or options contracts on his own account only
Brokerentitled to trade in futures contracts and/or options contracts on his own account and as agent of an HKFE Participant for the sole purpose of concluding trades on HKFE markets
Futures Commission Merchantentitled to trade in futures contracts and/or options contracts on his own account, for the account of other HKFE Participants and for the account of any other persons
Merchant Traderentitled to trade in futures contracts and/or options contracts only on its own account and only ancillary to its principal business or that of its holding company

 [To access practice questions for this topic, go to Examinator.online – Paper 1]

 

TOPIC 8 – ACCESSING PUBLIC CAPITAL

 

 51. Rules Governing Listings
  • Listing is the process by which an issue of securities is admitted for trading on a stock exchange.
  • The SEHK administers listing matters as part of its responsibility to perform its function of providing a fair, orderly and efficient market for the trading of securities.
  • The Listing Rules are intended to ensure:
    • the suitability of applicants for listing;
    • the fair and orderly issue and marketing of securities;
    • the provision of sufficient, material and timely information by issuers which might concern the investors and the public and affect the prices of listed securities;
    • the fair and equal treatment of shareholders;
    • that the directors act in the interests of the shareholders as a whole, particularly where the public shareholders are a minority; and
    • that all new issues are first issued to existing equity shareholders as rights issues unless they agree otherwise
  • There are also Listing Rules covering listings on GEM, which tend to follow the structure and content of the Main Board rules
  • GEM has been positioned as a “buyers beware” market designed to accommodate companies to which a higher investment risk may be attached

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 52. Listing Procedures for Equity Securities
  • A new applicant must have a trading record of at least three financial years under substantially the same management and ownership
  • The issuer must satisfy at least one of the following three quantitative tests:

Profit Test

  • Profits for the most recent year must not be less than HK$20 million and those of the two preceding years must not be, in aggregate, less than HK$30 million

Market Capitalisation/Revenue/Cash Flow Test

  • The issuer must have:
    • A market capitalization of at least HK$2 billion at time of listing
    • Revenue of at least HK$500 million for the most recent audited financial year
    • Positive cash flow of at least HK$100 million in aggregate for the three preceding financial years

Market Capitalisation/Revenue Test

  • The issuer must have:
    • A market capitalization of at least HK$4 billion at time of listing
    • Revenue of at least HK$500 million for the most recent audited financial year
  • There must be a minimum of 300 shareholders for all three tests
  • At the time of listing, the issuer must have a minimum market capitalisation of HK$500 million, including a public float of at least HK$125 million
  • For GEM listing, the track record must cover at least two years under substantially the same management

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 53. Price Stabilization
  • Price stabilization occurs when issuers or underwriters of newly issued securities may buy or sell the stock to prevent or minimize a decline in the price
  • The SFC considers that it is in the public interest to permit and regulate price stabilizing action connected with public offerings
  • The Securities and Futures (Price Stabilizing) Rules provide a safe harbour for permitted stabilizing activity (otherwise it would be considered stock market manipulation – a form of market misconduct)

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 54. General Principles of the Code on Takeovers and Mergers
  • The Code is based on 10 general principles which are considered to reflect good standards of conduct for persons engaged in takeovers, mergers and repurchases. The principles include provision for:
    • equal treatment of shareholders, the provision of accurate and sufficient information and advice to them;
    • the making of general offers to be made if control of a company changes, is acquired or is consolidated;
    • full and prompt disclosure of information by persons concerned with offers;
    • offerors to ensure when making an offer that they will be able to meet their obligations;
    • rights of control to be exercised in good faith and without oppressing minority and non-controlling shareholders;
    • directors of offeror and offeree companies to provide disinterested advice to their shareholders; and
    • the board of an offeree company in an offer situation not to take any action likely to frustrate the offer without the approval of the shareholders in general meeting

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 55. Mandatory Offers
  • The general principle underlying a mandatory offer is that if the control of a company changes or is acquired or consolidated, a general offer to all other shareholders is normally required
  • A mandatory offer is required to be made when:
    • any person (or two or more persons acting in concert*) acquires, whether by a series of transactions over a period of time or not, 30% or more of the voting rights of a company (trigger); or
    • any person (or two or more persons acting in concert*) who owns between 30% to 50% (inclusive) of the voting rights of a company, acquires at least an extra 2% of the voting rights within a 12 month period (creeper)

*Persons are acting in concert if they, pursuant to an agreement or understanding, actively co-operate to obtain or consolidate control of a company through the acquisition by them of voting rights of the company

  • All mandatory offers must include a cash component and must be at a price not less than the highest price paid by the offeror, or any person acting in concert, within 6 months prior to the start of the offer period

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 56. Definition of CIS
  • The SFO defines a CIS as:
    • An arrangement in respect of a property under which the management of the property is not subject to the day-to-day control of the scheme’s participants, and either:
      • The property is managed as a whole by or for the person operating the arrangement; or
      • The participants’ contributions and accruing profits or income are pooled; and
    • The purpose of the arrangement is to enable the participants to receive profits, income or other payments or returns from the property or dealings relating to it
  • Excluded from the definition are:
    • Arrangements where the participants and the operator of the arrangement belong to the same group of companies
    • Franchise arrangements
    • Arrangements where a solicitor acting in his professional capacity holds money from clients during the course of his work
  • The definition can be extended by the Financial Secretary
  • The intention is to make the definition flexible to ensure any new products are properly regulated

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

TOPIC 9 – MARKET MISCONDUCT AND IMPROPER TRADING PRACTICES

 

 57. Market Misconduct Under the SFO
  • There are six categories of market misconduct:
    • Insider dealing
    • False trading
    • Price rigging
    • Disclosure of information about prohibited transactions
    • Disclosure of false or misleading information inducing transactions
    • Stock market manipulation
  • Legal proceedings against the accused can be criminal in the courts or civil under the Market Misconduct Tribunal (MMT), but not both

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 58. Market Misconduct Tribunal
  • The MMT is chaired by a judge with 2 other members who cannot be public officers. All 3 are appointed by the Chief Executive of HKSAR
  • Can compel and receive evidence relevant to hearings
  • A ‘balance of probabilities’ standard of proof is applied
  • At the conclusion of proceedings, the MMT will issue a public report giving details of the market misconduct and the disciplinary orders handed out
  • Appeals against MMT findings can be made to the Court of Appeal
  • The MMT is subject to judicial review
  • Orders that may be made by MMT against those found to have committed market misconduct include:
    • disqualification for up to 5 years from holding office as director, liquidator, receiver or taking part in the management of a corporation;
    • prohibition on investing or trading in HK markets for up to 5 years (cold shoulder order);
    • prohibition of further market misconduct as specified in the order;
    • payment of profits made or loss avoided, plus compound interest, to the Government;
    • payment of reasonable costs incurred by the Government and the SFC; and
    • disciplinary referral orders recommending that a professional body of which the person is a member should take disciplinary action against him

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

59. Unsolicited Calls (Cold calls)
  • Unsolicited calls include most possible forms of communication made by an intermediary with any person without his express invitation
  • It is an offence to engage in the following acts during an unsolicited call:
    • Offering to make agreements to buy/sell financial products regulated by the SFC
    • Offering SMF
    • Offering to provide profits, income or other returns from dealing in such financial products
  • The provisions are intended to protect the investing public from:
    • Recklessly giving personal details and money to a stranger
    • Believing a person giving financial advice without checking the person’s status or background
    • Buying stock without checking the background of the issuer
    • Opening an account without taking proper precautions
  • Persons exempt from the prohibition:
    • Existing clients
    • Licensed persons
    • Registered institutions
    • PIs
    • Solicitors/accountants acting in their professional capacity
    • Money lenders
  • The prohibition on unsolicited calls does not apply to an agreement to buy or sell securities to/from a person who already holds such securities
  • Unsolicited calls occur when responses are required immediately
  • A person who enters into an agreement as a result of such a call may rescind the agreement by giving written notice within 28 days of entering into the agreement or within 7 days of finding out about the contravention, whichever is the earlier

[To access practice questions for this topic, go to Examinator.online – Paper 1]

 

 60. Improper Practices
  • This section considers some unethical practices and market malpractices which are likely to involve a breach of one or more SFC codes, affecting the fitness and properness of an intermediary to hold a license
  • Some of these practices may also be illegal
    • Boiler room activities
    • Churning
    • Corporate mis-governance
    • Front running
    • Rat trading
    • Unsuitability
    • Unauthorized trades

[To access practice questions for this topic, go to Examinator.online – Paper 1]

The following updates are examinable from 9 June 2021

 

TOPIC 1 – REGULATORY OVERVIEW OF THE HONG KONG FINANCIAL INDUSTRY
  • No updates

 

TOPIC 2 – PRINCIPLES OF RELEVANT HONG KONG LAW AND THE COMPANIES ORDINANCE
  • No updates

 

TOPIC 3 – SECURITIES AND FUTURES ORDINANCE

Material added relating to Open-ended Fund Companies:

  • It is intended that the OFC regime will allow an overseas corporate fund to re-domicile to Hong Kong, enabling the legal entity of the OFC to remain unchanged and all its existing contractual arrangements, resolutions and liabilities not being affected

 

TOPIC 4 – LICENSING AND REGISTRATION, AND SUBSIDIARY LEGISLATION
  • No updates

 

 TOPIC 5 – BUSINESS CONDUCT AND CLIENT RELATIONS

Material added relating to the Code on Open-ended Fund Companies:

  • OFCs allow investment funds in Hong Kong to be established as incorporated companies with limited liability and variable capital as an alternative to the unit trust structure
  • The OFC Code applies to both public and private OFCs and their key operators
  • A public OFC is authorised by the SFC and a private OFC is not a public OFC

REQUIREMENTS APPLICABLE TO ALL OPEN-ENDED FUND COMPANIES (OFCs)

  • Code requirements applicable to all open-ended fund companies cover:
    • General principles
    • Registration and naming
    • Directors
    • Investment manager
    • Custody of OFC assets
    • Administration of the OFC
    • Audit and annual accounts
    • Termination and cancellation of registration

General Principles

  • The OFC Code contains the following seven general principles:
    • Key operators of an OFC shall act honestly, fairly and professionally
    • Key operators shall act with due skill, care and diligence
    • Scheme property of an OFC shall be held by a custodian and properly protected
    • Key operators shall avoid conflicts of interests and where they cannot, there should be disclosure to investors
    • Disclosures should be timely, clear and concise
    • Key operators shall comply with regulatory requirements, co-operate with regulators and promptly inform the SFC of any material breach of the OFC Code
    • Key operators shall ensure compliance with the OFC instrument of incorporation and offering documents

Registration and Naming

  • An OFC registration application must be made to the SFC on the specified form
  • An OFC’s name must not be misleading and must end with “Open-ended Fund company” or “OFC”

Directors

  • OFC appointed directors must be of good repute, appropriately qualified, experienced and proper for the purpose of carrying out OFC
  • An OFC’s name must not be misleading and must end with “Open-ended Fund company” or “OFC”
  • There must be at least one independent director, who is not a director or an employee of the custodian
  • The independent director does not need to be independent of the investment manager
  • Directors must oversee the activities of the investment manager and the custodian

Investment Manager

  • The appointed investment manager must be licensed or registered with the SFC for Type 9 (asset management) regulated activity
  • An OFC may appoint more than one investment manager
  • The investment manager must comply with relevant SFC codes and guidelines:
    • Fund Manager code of Conduct
    • Code of conduct
    • Internal Control Guidelines
    • Guideline on Anti-Money Laundering
  • Sufficient trading, accounting and other records should be kept to reflect financial position and operation
  • Records should be kept in SFC approved premises for at least 7 years
  • The investment manager must act in the best interests of the OFC and investors

Custody of OFC’s Assets

  • An OFC must appoint a custodian to hold in custody the OFC scheme property
  • Eligibility requirements are the same as those of trustees/custodians in Topic 8
  • Custodians of private OFCs may be Type 1 licensed or registered
  • The custodian must keep OFC assets segregated from assets belonging to others
  • Scheme assets may be kept in an omnibus account, subject to adequate safeguards

Administration of the OFC

  • An OFC’s instrument of incorporation must provide for: Procedures for shareholder and director meetings; Share capital structure; and Rights attaching to shares
  • OFC offering documents should indicate how shareholders can obtain information about the OFC

Audit and Annual Accounts

  • An auditor must be appointed that is independent of the investment manager, the custodian and the OFC directors
  • Audited accounts must be disclosed on an annual basis within 4 months of the financial year-end

Termination and Cancellation of Registration

  • When an OFC is voluntarily terminated, its SFC registration will be cancelled, ensuring fair treatment of shareholders
  • OFC liabilities will need to be cleared before proceeds are distributed to shareholders

REQUIREMENTS APPLICABLE ONLY PRIVATE OFCs

There are additional Code requirements for private OFCs covering:

Investment Scope

  • Private OFCs are designed to operate as investment vehicles and so should not operate as corporate entities for general commercial business or trade

Changes to the scheme

  • Any change to the instrument of incorporation must have shareholder approval

Fund operations and Disclosure

  • The instrument of incorporation should clearly set out details of: pricing, dealing, issue and redemption of shares, valuation, distribution policy, use of leverage, fees and charges
  • An OFC must file its offering document with the SFC as soon as practicable
  • Any changes to the offering document must be filed within 7 days of issuing the revised document

Custody Arrangements

  • The custodian may be licenced or registered for Type 1 (Dealing in Securities) regulated activities
  • A Type 1 regulated custodian must comply with the following laws and regulations:
    • SFC Client Securities Rules
    • SFC Client Money Rules
    • SFC Keeping of Records rules
    • SFC Code of conduct
    • SFC Internal Control Guidelines
    • Guidelines on Anti-Money Laundering

 

 TOPIC 6 –BUSINESS OPERATIONS AND PRACTICES

Material added relating to Information Management under the SFC Internal Control Guidelines:

  • Licensed corporations using external electronic data storage providers (EDSPs) must obtain prior SFC approval
  • License corporations using EDSPs should:
    • Conduct proper due diligence on the EDSP’s controls
    • Ensure the EDSP maintains a proper information security policy
    • Ensure there are well-defined responsibilities between the licensed corporation and the EDSP
    • Be aware of concentration risk where an EDSP provides data services to a large number of financial firms

 

TOPIC 7 –PARTICIPATING IN THE HONG KONG EXCHANGES

Material updated relating to stamp duty on stock transactions:

  • 1% on each purchase/sale (increased to 0.13% in the 2012-22 budget)

 

TOPIC 8 –ACCESSING PUBLIC CAPITAL

Material added relating to risks associated with investing in virtual assets:

  • Different levels of regulatory safeguards – not all virtual assets admitted to trade on a licensed platform are subject to the same level of statutory protection

 

TOPIC 9 –MARKET MISCONDUCT AND IMPROPER TRADINGPRACTICES
  • No updates

A regular analysis of HKSI Paper 3 pass rates to help you gauge exam difficulty

 

HKSI Paper 3 – Pass Rates (%)

2020

2021

Change

Comments
January
February
March
April
May
June
July
August
September
October
November
December
75.00
93.33
85.71
75.22
70.83
87.10
85.71
86.36
70.83
87.50
75.00
86.96
83.33
61.54
75.00
75.00
69.23
.
.
.
.
.
.
.
8.33
-31.79
-10.71
-0.22
-1.6
.
.
.
.
.
.
.
.
February pass rate falls significantly
March pass rate falls
.
 .
 .
 .
 .
 .
.
 .
.
  Mean81.6372.82-8.81Average monthly pass rate falls
Standard deviation7.678.060.39Pass rate variability steady

 

A regular analysis of HKSI Paper 9 pass rates to help you gauge exam difficulty

 

HKSI Paper 9 – Pass Rates (%)

2020

2021

Change

Comments
January
February
March
April
May
June
July
August
September
October
November
December
60.00
46.67
57.14
55.16
53.85
70.37
52.63
55.17
70.00
88.00
65.71
42.31
57.14
55.88
62.07
27.03
36.84
.
.
.
.
.
.
.
-2.86
9.21
4.93
-28.13
-17.01
.
.
.
.
.
.
.
.
February pass rate increases significantly
.
April pass rate falls significantly
May pass rate falls significantly
.
.
.
.
.
.
.
  Mean59.7547.79-11.96Average monthly pass rate falls
Standard deviation12.2915.892.78Pass rate variability increases

 

A regular analysis of HKSI Paper 12 pass rates to help you gauge exam difficulty

 

HKSI Paper 12 – Pass Rates (%)

2020

2021

Change

Comments
January
February
March
April
May
June
July
August
September
October
November
December
45.45
55.17
66.67
55.17
66.67
87.18
64.81
52.63
54.55
72.22
72.92
80.65
71.43
70.00
48.57
56.00
61.76
.
.
.
.
.
.
.
25.98
14.83
-18.10
0.83
-4.91
.
.
.
.
.
.
.
January pass rate increases significantly
February pass rate increases significantly
March pass rate falls significantly
.
.
.
.
.
.
.
.
.
  Mean64.5161.55-2.96Average monthly pass rate falls
Standard deviation12.4011.08-2.81Pass rate variability falls

 

A regular analysis of HKSI Paper 2 pass rates to help you gauge exam difficulty

HKSI Paper 2 – Pass Rates (%)

2020

2021

Change

Comments
January
February
March
April
May
June
July
August
September
October
November
December
73.64
68.29
64.71
59.33
54.05
69.11
72.19
70.12
75.89
65.93
67.96
68.46
61.40
63.81
60.53
67.61
66.46
.
.
.
.
.
.
.
-12.24
-4.48
-4.18
8.28
12.41
.
.
.
.
.
.
.
January pass rate falls significantly
February pass rate falls
 March pass rate falls
April pass rate rises
May pass rate rises significantly
.
.
.
 .
 .
.
.
  Mean67.4763.96-3.51Average monthly pass rate falls
Standard deviation6.023.08-2.95Pass rate variability falls