Martin Wheatley: Cracking the Hong Kong code

Cracking the code

Martin Wheatley
Martin Wheatley, Hong Kong Securities and Futures Commission

What were the rules in Hong Kong for structured products prior to the Lehman Brothers bankruptcy?

Before Lehmans, we didn't really have a category relating to structured products. They had evolved using the Companies Ordinance debenture route in around 2002, when one of the law firms advised that manufacturers create these sorts of products under this regime and this is what the legal structure would be. Like lots of things, structured products evolved using an existing legal framework that wasn't created for them, but which for for a long time was felt to be suitable.

After the Lehman Brothers collapse, we spent a lot of time soul searching. The last two years have been spent doing two things: first is investigating the allegations of misselling, which has been a fairly major exercise involving all the major banks in Hong Kong.

There are some investigations remaining, but the vast majority [of cases] are resolved at the level of our investigation.

The unresolved and quite complex question is still the priority over the underlying collateral: the courts are battling it out as to whether the noteholders or the beneficiaries -- the Lehman estate, effectively - have priority. That issue remains unresolved, and it is a huge question for the International Swaps and Derivatives Association because it challenges the whole basis on which hundreds and thousands of products were structured over the past few years.

All of these notes were collateralised and usually against rated paper, but in most cases that paper is worth money. The contracts that people bought told them that in the event of a bankruptcy they would have priority over that collateral and therefore they would be bankruptcy remote - that was how the products were structured.

The Lehmans liquidators have challenged that and said no, the priority should be the Lehmans liquidators - that is, the Lehmans creditors. So far, the UK court has upheld the Isda contract and the US courts are [looking at] bankruptcy proceedings. Until that gets resolved, the value of the collateral is left sitting there, while the lawyers battle it out.

The other set of issues is, is there policy change that is necessary to ensure that we don't get into a similar situation again? We found that the product documentation was complete - albeit complex - but in such a way that you would not really expect private investors to be able to access and understand the features of a product. Every product usually had two 200-page prospectuses where we could find that the risks were explained. But when the products were sold, the investors either had no access or no appetite to go through complex documentation and simply bought the product on verbal assurances or on a very simple interaction.

We looked at what we needed to change to prevent similar situations happening again and identified two core issues.

The first is how do we get a disclosure document that works for an investor and not one that just works for a lawyer? That's where we came up with our Key Fact Sheet (KFS) requirements of four-page documents that relatively simply explain the features and risks, and so on. That was the disclosure element of the changes.

Second was getting the distribution channel to better meet their requirements under the structured products code of conduct, which are to properly establish the suitability of the product.

Both of these measures have now been implemented and people are operating in accordance with them.

By and large, investors do not read prospectuses. But the KFS document effectively has the same legal standing as the prospectus, so it would carry liability for misstatements. Physically, though, it can be a separate document.

The problem is that if you say that the KFS can be a standalone on which you can rely, the lawyers will start putting more and more into it, saying that if someone is going to rely on it for the sale, then we have to make sure that everything is fully disclosed in that document. Then you suddenly find that your short key facts statement has turned into something remarkably similar to the prospectus.

But most warning statements end up being only copper-plated: "You could lose all your money," for example. You end up with such a bland set of risks that it doesn't explain the relevant or pertinent ones.

Banks have long relied on the so-called ‘safe harbour' exemption to issue smaller-sized structured products without a prospectus. How do you define ‘safe harbour'?

Under the Companies Ordinance, there were safe harbours which I think people were - abusing may be too strong a word - using it to quite a heavy degree, in particular where issues where the denominations were HK$500,000 (€49,000) or above, or issues that were to 50 people or less.

We found that an awful lot of products were finding their way not to professional investors but to private ones - albeit slightly wealthier people - using these exemptions. It meant that the products required no regulatory approval but were still being sold to private investors.

When we removed [these exemptions], the industry came back and said: "We don't mind you removing the half million [Hong Kong dollar] safe harbour if you use the professional investor regime properly." But the way our rules work on the professional investor regime makes it quite difficult for them to comply. We had some quite proscriptive regulations regarding how you establish that someone is a professional investor.

We responded by saying: "That's fine. We are proposing to change our structure - and we are still in the middle of this: when you establish that someone is a professional investor, you can either follow our existing, quite proscriptive approach, or you can follow your own methodology."

So we have left a bit more flexibility, subject to them documenting the basis for their decision. Once they can do that, then if they have got professional investors who they've taken through a process, the sales process is relatively easier and the product range is relatively wider.

The methodology would not be pre-approved. As part of our ongoing inspections, we would go in and ask to see the documentation, so they would have to do it properly.

Does suitability remain a question for the investor?

In the current environment, people are very sensitive, so I suspect they will be quite cautious. They can adopt their own methodology and they will know that we will come and look at it, which itself becomes a check.

Distributors cannot waive the suitability requirement, which is mainly what the ‘professional investor' tag allows you to do: it allows the investor to make up their own mind so [the distributor] is alleviated of the suitability obligation.

But if an investor does not want to be treated like that, you can't force them to be. You still have to go through the process and show that the products are suitable.

How does the SFC define a ‘professional investor'?

The basic test is threefold: the monetary value, which is effectively US$1 million (HK$8 million) [available for a portfolio]; knowledge; and experience of trading previously in the same or similar products.

The problem was, for the HK$8 million, we had all sorts of requirements about how you have to document that, an audited bank statement and so forth. Banks said that creates unnecessary angst, so we said, you work out what methodology you want to use to establish that.

Banks can only rely on the ‘professional investor' tag if you have gone through a process or had something to sign that says: "I acknowledge that I am being treated as a professional investor. I acknowledge and understand the implications of that and that suitability requirements are waived." You can't just treat someone as [a professional investor]. You have to get someone to opt in.

How cohesive are the world's regulators?

Regulators, particularly in today's environment, talk to each other a lot. Where we can borrow good practice and sensible ideas, we will do so.

The SFC is in constant dialogue with China's financial market regulators, who are trying to evolve their structures and ideas very quickly, but they talk to pretty much everybody about how markets are evolving. They will make up their own mind.

The European Union's Key Information Document (Kid) requirements were still evolving when we were drafting the KFS requirements. We talked to the European Commission and made sure that we understood its direction, and we tried to come up with a document that, if not identical, was similar and broadly aligned with EU regulations.

The conduct requirements under the EU's Markets in Financial Instruments Directive (Mifid) are still up in the air and remain uncertain.

In the UK, there is huge uncertainty about the Financial Services Authority's Retail Distribution Review and how that will work in practice.

So while we try to make sure that we are familiar with the likely direction of regulatory changes in other jurisdictions, you can't really be certain of these things. Everything moves at a slightly different pace.

We looked at [the UK Financial Services Authority's new rules on commission for independent financial advisers], but every market is a different stage of evolution and we are not ready to go to that. Maybe that's another stage at some later date. The commission structure is so embedded in the way that people currently operate, that changing it would have been a step too far.

How would you define ‘complexity' as it relates to investment products?

We said, you the banks must determine what you believe is complexity and what you believe is suitable for particular clients. It risks moral hazard for a regulator to step in and say it will take a view on that. In truth, it sort of becomes a cookie-cutter approach where you end up defining that a complex product is only suitable for a sophisticated investor, which is not necessarily the case. It depends on the individual circumstances.

Pure equity is subject to being traded on exchange, having a prospectus approved and having continual updates. The substance of the risk when you buy an equity is the exposure to someone's business model, which evolves and changes over time, as does the company's management team. But the company has a continuous disclosure obligation. With structured products, you are usually exposed to a set of predetermined risks at the start of the product, and those risks are not going to change during the life of the product.

Does the SFC apply one rule across all investments?

We are nowhere on that, effectively because the regulatory structure differs from that in the UK or Europe. We have separate regulators for each segment. If the banking regulator adopts our code to apply to banks when they are creating certain types of interest-rate or currency-linked products, that's their decision. We don't have oversight of that.

Similarly, the Office of the Commissioner of Insurance in Hong Kong (OCI), which ultimately oversees the insurance companies that issue structured products, albeit with an insurance wrapper, makes its own decisions on how to regulate the market. The KFS will apply, but by and large insurance products use something similar to that already - so it's not such a big step.

In terms of the code for the sale and distribution of those insurance products, typically they're mutual funds under an insurance wrapper, so the SFC's documentation standard will apply to them, but their distribution and sale is outside of our scope and is entirely down to the insurance regulator.

Why not incorporate exchange-traded funds into the new regime?

ETFs are interesting because they have evolved from a simple product with continuous price discovery into quite a complex product.

We have been talking to the ETF issuers about product complexity and risk disclosure, and whether these products have adequate disclosure - typically they don't. Not much prominence is given to the swap structure underlying ETFs. So one of the things we are working with the industry on is, how do we get that better disclosed and better available to the people who are investing.

[The result of these discussions] won't be included in the structured products structure that we are looking at. They are still structured as funds and traded, so it's a separate issue, but we are still focused on this question of proper disclosure of risks.

We have been working with the industry and have published on this, and we are working with Hong Kong Exchanges and Clearing about how, when they are traded on the exchange screen, investors are able to differentiate physical from swap-based ETFs.

What did you make of the flash crash, and how would Hong Kong's public markets cope with a simlar event?

We are very aware of the flash crash. It has become very much a current issue for all regulators. The whole focus of regulation has shifted in the past two years. Previously, we worried either about conduct - were you ripping somebody off - or we worried about bankruptcy, prudential oversight, and whether an institution is about to go down.

The view was that competitive market forces would look after the market. What's happened is that this systemic risk was not well understood or well focused on, but that has moved back to centre stage. How do we focus on the health of the system?

While organised public markets came through the credit crisis pretty well, the flash crash has reignited the question of whether regulators are sure we are comfortable enough about public, open markets.

That was an interesting wake-up call where a whole series of interactions caused the integrity of the public market into question. That's why it is not quite a focus for regulators, what were the working components and what rules do we need to have in place to try and protect against something similar happening again.

The US regulatory structure is quite complex because they have so many exchanges and so many rules and different players. It's the interaction of those moving parts that caused the problem.

What was the prompt for doing away with incentives designed to entice investors?

Here were complex, dollar-denominated, first-to-default, credit-linked, collateralised structured products that would have shopping vouchers or flat-screen TVs as an incentive to purchase them. It's just a distraction - there were so many complexities in the product.

People have been quite happy to move away from that, once we have made it clear that the new rule on incentives applies to everybody. Nobody could quite break out of offering incentives - I think industry is quite happy with this change.

Are deposits included in the new rules?

The proposal is that deposits are not [included] and they are left entirely to the banking regulator, but this [issue] is in front of the Legislative Council at the moment and that legislative process may or may not change the proposal.

Will there be a code for professional investors?

No, depending on which product is being distributed. But you do not need to seek approval for products that are being distributed to professional investors. The banks may decide to as good practice, but it is not a regulatory requirement.

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