The Hong Kong Securities and Futures Commission (SFC) has launched a three-month consultation on proposed amendments to the code on unit trusts and mutual funds (UT Code).
According to SFC, the proposals, which discuss rules surrounding securities lending, seek to modernise the current requirements under the UT Code for public funds, in order to facilitate market development and enhance investor protection.
The existing provision of Chapter 7 of the UT Code (Core Investment Requirements) do not specifically cover securities lending, or repo and reverse repo transactions, however, the SFC has proposed to introduce provisions to govern securities financing transactions, which it said would provide greater flexibility for funds to invest in derivatives.
The SFC explained that funds may only engage in securities financing transactions if it is in the best interests of holders to do so and if the associated risks have been properly addressed.
The SFC’s proposals would introduce explicit provisions in Chapter 7 to permit management companies to engage in securities financing transactions provided that the fund obtains indemnification from the securities lending agent to protect against counterparty default.
Where a fund investing in derivatives exceeds 50 percent exposure, the fund will be governed by and subject to additional requirements under Chapter 8.9.
Such funds will likely be considered as ‘derivative products’, which are subject to enhanced distribution requirements under the code of conduct for persons licensed or registered with the SFC’s code of conduct.
Counterparties in over-the-counter (OTC) derivatives transactions must be substantial financial institutions, whose net exposure complies with the diversification requirements.
SFC stated that if collateral is provided by a OTC derivatives counterparty, the collateral must be subject to a prudent haircut policy and eligible collateral may not include structured products whose payouts rely on embedded derivatives or synthetic instruments.
It also ruled that this also applies to securities issued by special purpose vehicles, special investment vehicles or similar entities, securitised products or unlisted collective investment schemes.
In addition, the fund’s collateral reinvestment policy must prohibit non-cash collateral reinvestment, and limit the reinvestment of cash collateral to short-term deposits, high-quality money market instruments and acceptable regulated money market funds.
The SFC considered whether it would be feasible to require full portfolio transparency for active exchange-traded funds (ETFs), but has chosen not to adopt a full portfolio transparency regime for active ETFs.
It’s reasoning was requiring public disclosure on a daily basis might hinder the growth of active ETFs.
The SFC also said the amount of cash received under a repo transaction is limited to 10 percent of a money market fund’s (MMF) NAV and the aggregate amount of cash provided to the same counterparty in reverse repo transactions may not exceed 15 percent of an MMF’s NAV.
UCITS funds will be required to disclose in the product key facts statements the purposes of, and expected maximum leverage arising from, derivatives investments.
Where a UCITS fund has more than 100 percent of its NAV in derivatives investments, it will be subject to a further minimum initial subscription of $50,000.
SFC concluded: “Fund managers should carefully consider the wide-ranging proposed amendments and be mindful of any relevant future developments. A substantial amount of work and time may be required to update relevant policies and procedures to comply with these amendments.”
“These proposals are intended to create new opportunities and foster financial innovation in the market, and to align the regulatory regime with international standards, [as well as] reflecting market developments and financial innovation, while establishing appropriate safeguards consistent with international standards and practices.”
Image: Shutterstock 