Summary of the Meeting Between HKSFPA and SFC Regarding the Consultation Paper on Proposed Risk Management Guidelines for Licensed Persons Dealing in Futures Contracts
Release Date: 2023-03-27
March 27, 2023
On March 17, 2023, our association was invited by the Securities and Futures Commission (SFC) to participate in a discussion regarding the Consultation Paper on the Proposed Risk Management Guidelines for Licensed Persons Dealing in Futures Contracts (the "New Guidelines"). Unfortunately, the meeting did not suggest any softening of the SFC's stance on the matter. We have summarized three key points from the discussion as follows:
1. Regarding the preferential margin treatment limited to 10% of the higher amount between excess liquid capital or available funds
Our association believes that if the preferential margin treatment under the New Guidelines is restricted to only 10% of excess liquid capital, it will significantly impact the survival of the industry, potentially leading futures brokers to abandon operations in the Hong Kong market. This is mainly due to the new guidelines limiting the margin amount that futures brokers can utilize, thereby affecting their operational scope and margin for error.
(The following examples are simplified interpretations for conceptual understanding and are not precise calculations of the Financial Resources Requirement (FRR).)
According to the current Securities and Futures (Financial Resources) Rules, for licensed entities conducting Type 2 regulated activities (futures trading), the required liquid capital (RLC) is set at HKD 3 million. Additionally, there is a written notification requirement if the liquid capital (LC) falls below 120% of the RLC. Licensed entities must maintain a minimum of HKD 3.6 million to meet basic compliance capital requirements. To avoid confusion, this example will not consider this additional requirement and will only calculate based on the minimum required liquid capital.
Excess liquid capital (ELC) is calculated as liquid capital (LC) minus required liquid capital (RLC), i.e., LC - RLC = ELC, which is the focus here.
For example (all amounts in HKD), if a licensed entity has an LC of 10 million and an RLC of 3 million, its ELC would be 7 million. (This is a simplified numerical illustration for understanding; in actual operations and calculations, licensed entities will consider other risk indicators.)
Previously, the licensed entity could conduct preferential margin trading within the range and margin for error of 7 million. However, the new guidelines limit the preferential margin treatment to 10% of the ELC, meaning the licensed entity can only conduct preferential margin trading within a range of 700,000. To maintain its previous trading range of 7 million, the licensed entity would need to increase its LC from 10 million to 73 million, or significantly reduce its preferential margin trading space or substantially increase its capital (simplified formula reference: ELC / 10% + RLC). From this formula, it is evident that the previously large business scale, under the new measures, would require a disproportionately larger increase in capital and pressure, resulting in a significant imbalance between business operations and risk management, which would affect the operational space of the licensed entity.
| LC | RLC | ELC | 0.1 | under the new measures, new LC requirement emain the same size of preferential margin trading |
scaled up |
| 1,000 | 300 | 700 | 70 | 7,300 | 6.30 |
| 2,000 | 300 | 1,700 | 170 | 17,300 | 7.65 |
| 3,000 | 300 | 2,700 | 270 | 27,300 | 8.10 |
Used in human language to say, in the past, the entirety of the ELC (Excess Liquid Capital) could be used. However, the current situation has changed, with only 10% of the ELC now available for use. To maintain the previous utilization level, an increase in capital is necessary. Given that the original scale was too large, the required multiple of capital increase needs to be greater. This concept can be briefly understood through the diagram provided above.
The new guidelines have bolstered the regulation of risk management, implementing more stringent measures than those in the Singapore market. For instance, in terms of additional margin requirements for clients, Hong Kong deducts the full amount of additional margin from the liquid capital, as well as 5% of the initial margin, regardless of the duration of the additional margin. In contrast, Singapore's approach is more lenient within the first T+2 days, where the deduction from liquid capital is 3% of the maintenance margin. After T+2 days, the deduction becomes the sum of 6% of the maintenance margin and the additional margin amount.
Given that the initial margin is typically 1.2 times the maintenance margin, the deduction from liquid capital in both Hong Kong and Singapore after T+3 days is roughly equivalent. This suggests that the Singapore market offers clients and futures brokers greater risk management relief within the initial T+2 days of an additional margin call.
The licensed companies in the financial sector were initially governed by the Securities and Futures (Financial Resources) Rules (FRR). However, the introduction of additional regulations through new guidelines has resulted in an undoubtedly excessive regulatory framework.
For most futures brokers and generally licensed institutions, the new guidelines have significant implications. To increase their business volume, these entities are required to substantially increase their capital base. Meanwhile, operating costs are continuously rising, and the regulatory authorities are constricting the available operating space. This combination of factors is likely to lead to a significant decline in revenue and profitability, particularly for small and medium-sized futures brokers.
The severe impact on small and medium-sized futures brokers may compel them to abandon their operations in the Hong Kong market or even cease business altogether. Therefore, the regulatory authorities should conduct a comprehensive evaluation of this situation and consider the implications of the current regulatory approach.
2. Stress testing issue
In the meeting, the SFC has suggested that futures brokers should conduct daily stress tests to ensure risk control, but our association believes this is not practical. Because the futures market is relatively stable more than 99% of the time, with price fluctuations generally not exceeding 5%. Therefore, conducting daily stress tests will only consume a lot of manpower, resources and time, increasing the operating costs of futures brokers.
3. Futures brokers need to understand the nature and risks of futures products
SFC emphasizes the critical importance for futures brokers to have a clear understanding of the risks associated with commodities trading, including the potential for physical delivery and system-wide risks. This is exemplified by the recent events in the market, such as the London Metal Exchange (LME) suspending nickel contract trading in March 8, 2022 due to extreme price volatility, and the negative pricing of crude oil futures in April 2020.
In these exceptional circumstances, the local futures brokers have not faced any significant issues, as they have consistently implemented robust internal controls, such as the 50% forced liquidation guideline, and have opted for cash settlement without physical delivery. As a result, when the nickel prices fluctuated dramatically, the clients' grievances were directed towards the exchange's decision to cancel the contract trading, which was a regulatory matter beyond the control of the futures brokers.
Futures brokers are required to provide clients with detailed explanations of the various factors that can impact the prices of futures products. However, the SFC has not provided a definitive answer on whether this level of disclosure is sufficient to meet the relevant regulatory requirements. If deemed inadequate, the introduction of new regulations may serve as a comprehensive solution. In the event of any future emergencies leading to significant price fluctuations in futures products and resulting in client losses, the responsible brokers may be held accountable for the consequences.
In conclusion:
Compared to other prominent financial centers, the Hong Kong futures market faces a distinct disadvantage in the absence of physical delivery. The market's primary focus lies in financial futures and options, particularly index option products, while its development of commodity futures remains relatively lagging.
Given that the current local regulations in Hong Kong are already more stringent than those in Singapore, further regulatory tightening could potentially lead futures brokers to establish their operations in Singapore or other regions. This trend is supported by the observed developments in the China-US derivatives market, where increased competition has driven higher industry concentration, with fewer intermediary institutions and a more pronounced presence of institutional investors.
Data from the US Commodity Futures Trading Commission (CFTC) reveals a 60% reduction in the number of futures commission merchants (FCMs) in the US over the past 15 years, with the top 6 FCMs now accounting for 58% of customer assets. A similar trend is observed in the Hong Kong market, where the number of Type 2 licenses has decreased by one-third during the same period, and the total client asset size is estimated at HK$250 billion.
In contrast, the Chinese mainland futures license count has decreased by only 10% over the past 15 years, with client assets reaching HK$1.65 trillion, a 40-fold increase. This disparity suggests that the Hong Kong futures market may face further industry consolidation, with institutional investors playing an increasingly prominent role.
According to the available data, the number of futures brokers has witnessed a significant decline, dropping from approximately 500 in 2008 to around 300 in 2022. In recent years, while the Chinese mainland has taken steps to liberalize the futures market, most Chinese-funded enterprises have opted to establish their operations in Singapore rather than Hong Kong. This shift can be attributed to the perceived stringency of the Hong Kong market regulations, which are viewed as less conducive to the industry's development. In light of these concerns, our association strongly urges the SFC to undertake a comprehensive and in-depth analysis from multiple perspectives before implementing any new guidelines or regulations governing the futures market.
Responsible for by Mr. Martin Liu, deputy director of the Industrial Relations Department, with the assistance of Mr. Ivan Wong, director, and Mr. Thomas Ip, non-executive deputy director.
Industrial Relations Department
Hong Kong Securities and Futures Professionals Association
Background：
SFC Consultation: Consultation Paper on Proposed Risk Management Guidelines for Licensed Persons Dealing in Futures Contracts (6 January 2023)
Our response to the "SFC Consultation Conclusions on the Guidelines on Risk Management for Futures Trading Activities" published on 25 August 2023 (26 August 2023)
The image shows a photo taken after the meeting with the relevant SFC team members.