Oversight. Consultation Conclusions regarding the Hong Kong Position Limit Regime. April 2017 simmons-simmons.com elexica.com

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1 Oversight April 2017 simmons-simmons.com elexica.com Consultation Conclusions regarding the Hong Kong Position Limit Regime On 21 March 2017, the Hong Kong Securities and Futures Commission (SFC) issued the Consultation Conclusions on Proposed Enhancements to the Position Limit Regime and Associated Amendments to the Securities and Futures (Contracts Limits and Reportable Positions) Rules and the Guidance Note on Position Limits and Large Open Position Reporting Requirement (Consultation Conclusions). The Consultation Conclusions are based on a public consultation which commenced on 20 September 2016 and ended on 21 November 2016 in a consultation paper titled Consultation on Proposed Enhancements to the Position Limit Regime and the Associated Amendments to the Securities and Futures (Contracts Limits and Reportable Positions) Rules and Guidance Note on Position Limits and Large Open Reporting Requirements (Consultation Paper). The current position limit regime is governed by the Securities and Futures (Contracts Limits and Reportable Positions) Rules (CLRP Rules), which is subsidiary legislation under the Securities and Futures Ordinance (SFO). The CLRP Rules set out the relevant position limits for futures and options contracts. The SFC has also published a revised version of Guidance Note on Position Limits and Large Open Position Reporting Requirements (GN). The Consultation Paper proposed the following amendments (Proposals) to the existing regime: raising the cap on the client facilitation excess position limit for Hang Seng Index (HSI) and Hang Seng China Enterprises Index (HHI) futures and options contracts from the current level of 50% to 300% and increasing the net asset value (NAV) requirement from HK$2 billion to HK$5 billion (Client Facilitation Excess Position Limit); incorporating market makers or liquidity providers of exchange traded funds (ETF) into the persons listed under section 4(3) of the CLRP Rules so that they may be authorised by The Stock Exchange of Hong Kong Limited (SEHK) or The Hong Kong Futures Exchange Limited (HKFE) to hold or control excess futures or stock options contracts to hedge the risks arising from their ETF market making or liquidity providing activities (ETF Market Maker Position Limit); allowing exchange participants of the SEHK/HKFE (EP) (or their affiliates) to apply to the SFC for authorisation to hold or control HSI and HHI futures and options contracts in excess of the statutory limit for the purposes of carrying out index arbitrage activities (Index Arbitrage Activity Excess Position Limit); allowing asset managers who meet certain requirements to apply to the SFC for authorisation to hold or control HSI or HHI futures and options contracts in excess of the prescribed limit for fund management purposes (Asset Manager Excess Position Limit); and raising the statutory position limit for stock options from 50,000 contracts to 150,000 contracts (Stock Option Contracts Position Limit). Save lowering the assets under management (AUM) requirement applicable to the Asset Manager Excess Position Limit from HK$100 billion to HK$80 billion, the SFC has determined that its Proposals will proceed without change accordingly. Subject to the legislative process, the SFC expects the revised CLRP Rules to take effect on 1 June 2017.

2 Client Facilitation Excess Position Limit The existing Client Facilitation Excess Position Limit Under the current regime, an EP (or its affiliates) may apply for SFC s approval for an excess position limit for HSI and HHI futures and options for up to 50% of the statutory limit (which can be found in Schedules 1 and 2 of the CLRP Rules) if: there is a relevant business need, which is defined as one that requires the EP to engage in hedging activities to facilitate provision of services to clients (and not for purely proprietary trading purposes); either the EP, any affiliate or their holding company has adequate financial capabilities to cover associated risks i.e. a NAV of not less than HK$2 billion based on the latest reported and audited figures, or a qualifying credit rating; the EP has in place effective internal control and risk management system; and the SFC is satisfied that the excess would not be prejudicial to the interest of the investing public having regard to the prescribed limits and the liquidity of the contracts in question. Upper limit on excess position limit and adequate financial capability requirement In the Consultation Paper, the SFC had stated their observation that the Client Facilitation Excess Position Limit had not been widely used in recent years, as some market participants indicated that the excess limit of 50% is not significant relative to the size of their business. As such, the SFC proposed that the cap on the excess position limit for HSI and HHI futures and options contracts be raised from the current level of 50% to 300%, and the adequate financial capability requirement be tightened from HK$2 billion to HK$5 billion in order to curb with the increased risks. Some market participants and professional associates, however, submitted that an excess limit of 300% should be granted to all successful applicants, or urged the SFC to consider future needs in determining the cap. Regarding the adequate financial capability requirement, some respondent suggested setting a lower minimum financial requirement and increasing it on a case-by-case basis, while some recommended the implementation of a scaled financial requirement. In the Consultation Conclusions, the SFC opined that it is important to consider the actual need of each applicant on a case-by-case basis in determining the level of excess position, and that a 300% cap is sufficient based on the analysis of the HSI and HHI futures and options markets. The SFC also suggested that a minimum NAV requirement of HK$5 billion is appropriate, and concluded that both amendments in relation to the Client Facilitation Excess Position Limit should proceed accordingly. Other public comments The SFC also addressed some additional public comments in the Consultation Conclusions, including: the need for transitional arrangements the SFC commented that transitional arrangements are not needed as all existing applicants are able to meet the new adequate financial capability requirement; clarification of client facilitation and the assessment criteria the SFC stated that the definition of client facilitation is broadly defined and set out in the GN with an example. The revised GN will set out the application process and required documents for each type of excess position limit, and suggested that potential applicants should contact the SFC should they have any relevant questions; and introduction of hedging exemptions the SFC considered that the proposed excess limits will be sufficient to meet the hedging needs of market participants, therefore rejecting the introduction of a blanket hedging exemption at this stage. ETF Market Maker Position Limit Under sections 4(2) and 4(3) of the current CLRP Rules, market makers and liquidity providers registered with the HKFE and the SEHK, and issuers of structured products listed under Chapter 15A of the SEHK s Listing Rules and their related corporations may apply to the SFC or SEHK, as the case may be, for authorisation to hold futures or stock options contracts exceeding the prescribed limit for the purposes of conducting market making or liquidity providing activities, or hedging the related risks. In the Consultation Paper, the SFC proposed to introduce the ETF Market Maker Position Limit by expanding the classes of persons under section 4(3) of the SLRP Rules. 2

3 Citing public support, the SFC intends to also proceed with this proposal. The SFC clarified in the Consultation Conclusions that the proposed ETF Market Maker Excess Position Limit will be applicable mainly to market makers for ETFs tracking the HSI or HHI. Index Arbitrage Activity Excess Position Limit Index arbitrage refers to the purchase (sale) of stock index derivatives products (in particular stock futures) and the sale (purchase) of some or all of the component stocks of the underlying index with an aim to capture the temporary price discrepancy. The Consultation Paper proposed a new section 4D of the CLRP Rules, whereby the SFC may grant to an EP (or its affiliates) an excess position limit of up to 300% of the statutory limit for holding HSI or HHI futures and options if: the excess limit will be used for genuine index arbitrage activities; either the EP, its affiliates or their holding company has adequate financial capabilities (same as the Client Facilitation Excess Position Limit); and the EP has in place effective internal control and risk management. In the Consultation Conclusions, while saying that the SFC will implement the proposal, the SFC addressed the perceived risks of potential misuse or abuse. The SFC recommended an applicant should have a standalone trading desk/book to conduct index arbitrage activities and a Chinese wall (or equivalent internal control measures) between the index arbitrage trading desk and other trading desks. As above, an EP must apply to the SFC. An applicant will also be required to demonstrate the effectiveness of its internal controls and compliance monitoring process to the satisfaction of the SFC. Asset Manager Excess Position Limit Under the present CLRP Rules, if a person holds or controls positions for his own account and also for others, both categories would count towards the person s position limit i.e. an asset manager cannot disaggregate positions held by each of the funds under its management for the purposes of compliance with the CLRP Rules (Aggregation Rule). The Consultation Paper proposed to introduce a new Asset Manager Excess Position Limit, under which the SFC may authorise asset managers to hold or control HSI and HHI futures and option contracts in excess of the statutory limit. The proposed cap will be 300% of the statutory limit. Under the proposal in the Consultation Paper, an eligible asset manager must: be an intermediary licensed or registered by the SFC for Type 9 (asset management) regulated activity under the SFO with a total in AUM of at least HK$100 billion; demonstrate a genuine business need to use these positions to facilitate its asset management activity; and have in place effective internal control procedures and risk management systems to manage associated risks. As with the other excess position limits, an asset manager must apply to the SFC to use the Asset Manager Excess Position Limit. A number of respondents raised concerns about the proposed AUM requirement of HK$100 billion (approximately US$12.8 billion) for being unnecessary and/or too onerous, considering the fact that any futures contracts acquired by an asset manager for the fund being managed would be registered in the name of the fund (or in the joint name of the asset manager and the fund), but not in the name of the asset manager. As such, such futures contracts which belong to the relevant fund should not be affected by any insolvency of the asset manager as the futures contracts are assets of the fund. Therefore there does not appear to be any justification for having such an AUM criterion for an application for the Asset Manager Excess Position Limit. As a compromise, the SFC has now agreed to lower the proposed AUM requirement to HK$80 billion (approximately US$10 billion). The SFC, however, dismissed concerns that many smaller-sized asset managers would not be eligible under the proposed Asset Manager Excess Position Limit, explaining that the current position limits should be sufficient to cater for their needs given the small average fund size relative to the notional value of the statutory position limits. Some respondents also suggested that Aggregation Rule should be abolished, especially when SFC authorised funds are concerned. SFC authorised funds are subject to the regulatory supervision by the SFC. In particular, they are subject to the investment restrictions, including diversification requirements as stipulated in Chapter 7 and/or Chapter 8 of the SFC s Code on Unit Trusts and Mutual Funds (Code). Each of the SFC authorised funds managed by an asset manager is generally treated as separate entity pursuing separate strategy when the investment restrictions under the Code are being applied. It therefore seems illogical to aggregate the positions held by each of the SFC authorised funds an asset manager manages for the purposes of compliance with the CLRP Rules 3

4 when neither Chapter 7 nor Chapter 8 of the Code adopts the aggregation concept generally. However, the SFC did not address this suggestion in the Consultation Conclusions and therefore the Aggregation Rule will continue to apply. Stock Options Contracts Position Limit The present statutory position limit for all stock options contracts is 50,000 open contracts per option class in any one market direction for all expiry months combined. The Consultation Conclusions confirmed to adopt the proposal of amending the CLRP Rules to increase the statutory position limit of stock options contracts from 50,000 contracts to 150,000 contracts. The SFC, however, encouraged licensed corporations to check any lower position limit set by the SEHK in relation to certain stock options contracts. Conclusion With the exception of relaxing the AUM requirement applicable to the Asset Manager Excess Position Limit, the Consultation Conclusions essentially adopted all of the Proposals regarding the position limit regime. As the Proposals will take effect only once negative vetting of the new CLRP Rules has taken place in the Legislative Council, market participants will have time to prepare themselves for the revised CLRP Rules and ensure that they are entitled to hold positions exceeding the statutory limit pursuant to one of the above-mentioned grounds. Fund managers using HSI or HHI futures or options should continue to closely monitor the portfolio of their funds to ensure the aggregated position in HSI or HHI futures or options contracts will not exceed the statutory limit, especially when there is substantial growth of fund size. It is disappointing that despite representations to the contrary the SFC has chosen to restrict the availability of the Asset Manager Excess Position Limited by keeping a very high AUM requirement. Whilst the reduction from HK$100 billion to HK$80 billion in AUM is welcome, there are concerns that the revised CLRP Rules are drafted in such a way so as to limit the SFC s ability to be flexible. A number of asset managers have recently launched leveraged and inverse products listed on the SEHK which use HSI futures contracts. If these products are successful, the statutory contract limit could inhibit their smooth operation. To find out more, contact: Rolfe Hayden T E rolfe.hayden@simmons-simmons.com Gaven Cheong T E gaven.cheong@simmons-simmons.com Eva Chan T E eva.chan@simmons-simmons.com Ivy Yam T E ivy.yam@simmons-simmons.com Esther Lee T E esther.lee@simmons-simmons.com Natalie Kong T E natalie.kong@simmons-simmons.com Stella Wai T E stella.wai@simmons-simmons.com 4

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