On April 18, 2024, SFC issued a Joint circular to intermediaries: Findings of concurrent SFC-HKMA thematic review of the distribution of non-exchange traded investment products. I prepared a brief summary for Annex 1 of the circular so that you could read it more easily.
Summary of Annex 1
I. Product Due Diligence (PDD)
A. The LCs shall identifying the key terms and features of investment products
which delineate respective characteristics, nature and extent of risks.
B. LCs must consider the market, industry, economic, political, and regulatory factors impacting risk profiles.
C. Issues identified:
1. Lack of proper verification work and management supervision
The LC’s senior management shall make appropriate enquiries or verification on the investment products.
For example, they misdescribed an accumulator as a coupon-bearing instrument, misdescribed the bid/ask price of a Chapter 37 Bond1 as being determined on an exchange, misstated bonds ranked pari passu with other unsecured unsubordinated debts of the issuers as senior secured”, or misidentified a secured bond as being collateralised by real estate properties of the issuer instead of capital stocks of its subsidiary guarantors with no material operations.
Some LCs did not identify for their clients the special features of bonds, such as variable coupons, bondholder’s put option to demand issuer repurchasing on a specific date, loss absorption or multiple credit support structures.
Proper guidance shall be provided:
An LC having required its staff during PDD to consider the credit risks of product issuers with reference to their credit rating and credit default swap price did not provide guidance on respective criteria of approval.
some LCs selected high-yield bonds for clients merely because of their discounted price and yield advantage over higher-quality bonds, or an issuer exhibited a better prospect of recovery relative to its peers in the industry. However, when credit events and adverse news were severely affecting the market or industry, the LCs did not assess the risks of bonds arising from the commonly deteriorating credit quality across the industry. Nor was there sufficient analysis to support why the high-yield bonds would be considered suitable for clients looking to make bond investments.
2. Inconsistent Risk Assessment
Guidance should be provided to staff on how the risk rating should be adjusted in light of these factors.
An LC classified funds into high, medium or low risks, but it did not provide guidance to staff on the respective criterion of determination. It was unable to explain the rationale underlying its staff’s assessment for classifying a high-yield bond fund not authorised by the SFC as low risk, as compared to other investment-grade bond funds classified as medium risk.
3. Failure to Consider Structured Product Risks Adequately
a. Some LCs did not fully understand the risks of structured products like accumulators and decumulators.
b. Potential underestimation of losses in structured products.
An LC assigned product risk rating to structured products based on the nature of their underlying asset. It had classified an equity-linked fixed coupon note as high risk, and a foreign exchange target redemption forward contract (“FXTARF”)3 as medium risk. However, the terms and features, pay-out and characteristics of the FX-TARF were akin to accumulators and/or decumulators and investors could incur unlimited losses under the contract. It also contained a leverage feature which would have multiplied any amount of loss significantly.
The LC’s assessment of the FX-TARF being generally suitable for clients willing to accept a moderate level of investment risks despite the heightened volatility from the currency pair, and describing its potential maximum loss as nonprincipal protected, were clearly inadequate and insufficient to reflect the nature and extent of risks of the structured product.
4. Insufficient Ongoing PDD
a. No procedures for continuous PDD or periodic reassessment of product suitability.
II. Suitability Assessment
Issues identified:
1. Inadequate Risk Profiling of Clients
a. Risk profiling questionnaires (RPQs) may produce skewed results towards high risk tolerance.
b. Overemphasis on investment experience rather than capital loss risk tolerance.
2. Inadequate Consideration of Clients' Concentration Risk
a. Lack of clear guidance on what constitutes same-type products for concentration risk assessment.
b. Arbitrary use of net worth values without further inquiry.
III. Information for Clients
Common deficiencies:
1. Disclosure of Trailer Fees
a. Failure to disclose the maximum percentage of monetary benefits received per fund.
2. Representation of Independence
a. Misrepresentation of LCs as independent when receiving fees and commissions.
3. Disclosure of Affiliations
a. Inadequate disclosure of affiliations with product issuers.
4. Explanation of PI Status Risks
a. Use of proforma notices that may confuse clients regarding the application of Code of Conduct provisions.
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