Recent Updates to HKSI Paper 3 Version 2.8 Manual – Regulation of Derivatives

The following updates are examinable from March 2024

TOPIC 1 – REGULATORY FRAMEWORK

• HKEx has thirteen divisions, two of which are relevant to this paper:
  • Operations Division
    • Responsible for the trading functions, market surveillance & monitoring functions and clearing and depository functions
  • Equities Division
    • Responsible for sales & marketing functions, equities product development functions and structured product development functions

TOPIC 2 – LICENSING AND REGISTRATION

• Material added relating to Guidelines on Competence:

Competence and Capability

• An intermediary should demonstrate it is competent in accordance with Guidelines on Competence covering its business, corporate governance, internal controls, operational review, risk management and compliance.
• Guidelines indicate areas SFC will consider:
  • Proper organizational structure based on good corporate governance principles, and incorporating clear roles, responsibilities, accountability and reporting lines of its senior management
  • Risk management policies, controls and procedures established as an independent function under competent risk manager or manager-in-charge of a core function of the risk management function
  • Adequate and effective internal control systems with proper internal audit trails and documentation
  • Proper compliance policies and procedures to ensure the compliance with all applicable legal and regulatory requirements as well as own policies and procedures
  • Appropriately qualified employees with supervisory staff having at least three years’ experience and appropriate qualifications
• The guidelines apply to applicants as well as to intermediaries already licensed or registered

• Continuous Professional Training (CPT)
  • A licensed representative or relevant individual must complete 10 CPT hours per calendar year, irrespective of the number or type of regulated activities involved
  • A responsible/executive officer must complete a minimum of 12 CPT hours per calendar year, with the 2 additional hours being related to regulatory compliance
  • Each individual practitioner must complete at least 5 CPT hours per calendar year on topics directly relevant to the regulated activity he/she is involved in. Sponsors must not take less than 2.5 hours of sponsor-related CPT and TC Advisers/TCROs must complete at least 2.5 hours of relevant CPT
  • No less than 2 CPT hours per calendar year must relate to ethics or compliance
  • Each new individual practitioner in Hong Kong must complete 2 CPT hours on ethics within 12 months as a one-off requirement (not applicable to temporary licensees)
  • 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 that do not qualify as CPT:
    • Reading financial journals, newspapers and other technical publications
    • Normal work
    • Activities which do not involve interaction with other individuals
  • Relevant CPT topics for licensees generally:
    • Applicable compliance, legislative and regulatory standards
    • Business conduct and ethical standards
    • Market developments, new financial products and risk management systems
    • Business communication skills and trade practices
    • General principles of law
    • Basic accounting theories
    • Fundamental economic analysis
    • Fintech
    • Environmental, social and governance (ESG)
      • Cybersecurity
      • Information technology
      • Relevant CPT topics for responsible officers, in addition to above:
        • Business management
        • Risk management and control strategies
        • General management and supervisory skills
        • Macro and micro economic analysis
        • Financial reporting and quantitative analysis

TOPIC 3 – CLIENT SECURITIES AND MONEY

• No updates

TOPIC 4 – CONDUCT OF BUSINESS

• Material added relating to Risk Management:RISK MANAGEMENT
  • Persons licensed for Type 2 regulated activity (Dealing in Futures), known as futures brokers, are potentially exposed to significant financial and compliance risks due to:
    • Heightened risks in the commodity futures markets; and
    • Clearing house margin ineffectiveness in extreme market conditions
  • To address the above issues, the SFC has issued the Risk Management Guidelines for Licensed Persons Dealing in Futures Contracts (Risk Management Guidelines)
  • These guidelines apply to any futures dealing activity or asset management activity (excluding dealing in futures solely for the purpose of asset management)
  • A breach of the Risk Management Guidelines is not an offence but could be relevant in court proceedings regarding a futures broker’s fitness and properness

  Risk Management Framework

  • Futures brokers are required to establish an effective risk governance framework to manage risks faced by the broker and its clients
  • The framework should be subject to regular reviews and should be consistent with the broker’s strategic objectives and its financial and management capabilities
  • The framework should also be reviewed when new products/services are introduced or when there are significant changes to relevant laws/regulations
  • Senior management should be responsible for risk management, which should include the following policies and procedures:
    • Identification and assessment of material risks
    • Determination of risk appetites and risk limits
    • Ongoing risk monitoring, controlling and reporting
    • Escalation and resolution procedures for breaches of risk limits and deviations from the policies and procedures; and
    • Stress testing and contingency planning

  Key Areas of Risk Management

  Market Risk

  • Market risk refers to the level of risk of loss from movements in market prices and from changing levels pf price volatility
  • This risk is relevant for futures brokers trading in futures contracts for their own accounts
  • Proprietary futures contract positions should be marked-to-market on a real time basis and end of day valuations should be undertaken by someone independent of front office
  • A market risk measurement system should be used to estimate the impact of market risk on broker proprietary positions

  Risk Limits for Commodity Futures Trading

  • A futures broker should maintain a senior management approved list of commodity futures in which it can deal
  • A futures broker, when physically settling commodity futures, should be sufficiently knowledgeable of the roles of parties involved, related storage and delivery arrangements and related administrative requirements

  Client Credit Risk

  • This is the risk of clients defaulting on obligations under a futures contract
  • A futures broker should establish trading and position limits for clients to mitigate client credit risk
  • Risk limits should take into account:
    • The client’s total or net position in a single futures contract or related futures contracts
    • Total or net margin requirements
    • Any position limits set by a counterparty or under any regulation (counterparty includes any executing agent, clearing agent, exchange or clearing house)
  • The collection of sufficient collateral from a client is key to mitigating client credit risk
  • Margin should meet the required margin for an intended futures trade – a broker may impose a margin requirement higher than the amount set by its counterparty, taking into account the circumstances of the client, the product, market conditions or the broker’s own circumstances
  • Forced liquidation policies and procedures should be established and strictly enforced

  Risks Associated with Concessionary Margining

  • A futures broker may provide concessionary margining where the client is not required to comply with an upfront collateral requirement as per the rules of the exchange or clearing house
  • To provide concessionary margining, the client must meet eligibility criteria
  • Concessionary margining can only be provided if the client has met or not failed to meet margin requirements for at least the preceding year, or at least 3 months if the account has been open for less than a year
  • For such clients, the trading limit should take into account the client’s specific circumstances, including financial situation, settlement history, investment objective and risk appetite
  • Futures brokers providing this service are also subject to a firm-wide quantitative limit applied across all clients – SFC must be notified within one business day of any breach of such limit

  Risk Management Over Executing or Clearing Agents

  • Futures brokers that engage executing or clearing agents should have written policies and procedures in place to ensure proper management of exposure of the firm to the agent
  • If the agent is not a licensed corporation, registered institution, or participant of a recognised exchange company or clearing house, suitable due diligence should be carried out before engaging the agent
  • Arrangements should be made with at least one back-up executing or clearing agent to mitigate any impact of agent unavailability

  Funding Liquidity Risk

  • The risk of a futures broker failing to meet its obligation under a futures contract when it falls due – arises when a client fails to meet its margin call
  • Prudent cash flow management should ensure client money or collateral held is sufficiently liquid
  • Emergency funding plans should be in place in the event of unusual or other circumstances and reliance on a single funding source should be avoided

  Other Considerations

  Material added relating to Risk Management:

  • Futures brokers continue to be subject to the Client Money Rules and the Client Securities Rules, with the Risk Management Guidelines imposing additional requirements to safeguard client assets
  • Key risks of conducting futures transactions outside of Hong Kong should be disclosed in writing and client enquiries should be dealt with in a timely manner
  • Futures brokers should monitor material changes in overseas regulations that may affect its client’s interests
  • Stress testing policies and procedures should be established and approved by senior management. Stress tests should be conducted at least weekly
  • Risk Management Guidelines will become effective on 25 February 2024 and there will be a transitional period of 12 months for interim measures to introduce client risk limits and stress testing

 TOPIC 5 – RECORD KEEPING AND CONTRACTS LIMITS AND REPORTING

Contracts Limits and Reporting

• Prescribed Limits
  • All futures or stock options contracts subject to the reporting requirement are also subject to position limits that are higher than the respective reportable positions. To give three examples:
    • a person holding or controlling a stock futures contract on shares listed on the SEHK will be subject to a reporting obligation once they come to hold 1,000 open contracts for any one contract month, and will be subject to a prescribed position limit of 25,000 net long or short contracts for all contract months combined
    • a person holding or controlling HSI volatility index futures contracts will be subject to a reporting obligation once they come to hold 1,000 open contracts for any one contract month, and will be subject to a prescribed position limit of 10,000 open contracts for any one contract month;
    • a person holding or controlling a stock index futures contract on the HSI will be subject to a reporting level of 500 open contracts multiplied by the ratio of HK$50 per index point for any one contract period and a prescribed limit of 10,000 net long or short position delta limit for all contract periods combined

TOPIC 6 –FUTURES TRADING AND SETTLEMENT

Financial Resources Requirements of HKCC Participants

• General Clearing Participants must maintain liquid capital of not less than required liquid capital (FRR) or HK$100 million plus HK$20 million for each NCP after the 5^th NCP it has a clearing agreement with, whichever is greater

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

• No major updates

TOPIC 8 –OVERVIEW OF MAJOR OVERSEAS FUTURES EXCHANGES AND CLEARING HOUSES

• No major updates