LegCo Paper No. CB(1) 2089/95-96(02)

Paper for the Bills Committee
Banking (Amendment) Bill 1996
Proposed Regulatory Framework for Money Brokers

Purpose

In response to comments made by Members, this note -

  1. elaborates further on the weaknesses of the existing self regulatory system for money brokers and the need for a formal regulatory regime;
  2. informs Members of the response of the Hong Kong Foreign Exchange and Deposits Brokers Association (HKFEDBA) and the Hong Kong Association of Banks (HKAB) to the proposed legal framework for money brokers; and
  3. elaborates further on the principles underlying the criteria for approving money brokers as set out in the new Eleventh Schedule.

Weaknesses of the existing self regulatory system for money brokers and need for a formal authorization regime

No fit and proper tests for controllers and directors of money brokers

There are no fit and proper criteria for assessing the fitness and propriety of controllers and directors of money brokers. While the HKAB has the authority under the HKFEDBA’s Memorandum and Articles of Association to approve changes in ownership and directors of HKFEDBA members, HKAB does not have the authority to require prospective shareholders and directors (and they have no obligation) to provide information to enable it to take a view on their fitness and propriety. This was a main concern for HKAB which had led to their request for the introduction of a formal authorization system (see HKAB’s letter at Annex 1).

Inadequate investigatory power against malpractice

The Foreign Exchange and Money Market Practices Committee (MPC) was set up in 1992 to enhance the orderly development of the Hong Kong foreign exchange and money market. It comprises representatives from HKFEDBA and HKAB and has issued a Code of Conduct for money brokers (at Annex 2) in June 1992. As shown in the Code, although the primary role of money brokers is that of a matchmaker and a name-passer, there is a broad range of areas in which malpractices may occur. It is for this reason that the MPC finds it necessary to develop the Code to ensure that the highest standards of integrity and fair dealing will be observed. The Code specifies standards in a wide range of trading practices and conduct including e.g. trading for personal accounts, entertainment and gifts, dealing procedures, settlement procedures, money laundering, etc.

However, the MPC is only an advisory body without any executive powers or statutory authority. It does not have authority to investigate allegations of malpractice or non-compliance with the Code of Conduct. Similarly, HKFEDBA’s ability to investigate into suspected malpractice is limited as it has no authority to examine the financial records of its members.

Inadequate sanctions against malpractice

As the Code does not have statutory backing, MPC, HKAB, and HKFEDBA could be exposed to potential legal liabilities if they publicly reprimand a broker for misconduct. This makes it difficult to conduct disciplinary actions against brokers. For similar reasons, HKAB cannot recommend its members not to deal with a particular broker which has breached the Code of Conduct as this may run the risk of a lawsuit.

Furthermore, given the relatively small number of brokers, it is very difficult to find sufficient number of independent and qualified persons within the industry to arbitrate on disputes or hear complaints against malpractice.

Need for a formal authorization system

In the light of the above, the HKAB and HKFEDBA have suggested that the MA should assume the role of the authorization authority under a formal regulatory regime for money brokers. The HKMA considers that an orderly and efficient interbank foreign exchange and money market is important to Hong Kong as an international financial centre and it is necessary to ensure that the highest standards of integrity and fair dealing are observed by brokers. Accordingly, the HKMA supports a formal authorization regime for money brokers to supplement the existing self regulatory system.

As regards the concern that HKMA is seeking to expand the regulatory net by imposing controls over an industry which apparently does not have any problem, it should be noted that the industry is not free of opportunities for malpractices, which is why a Code of Conduct as set out above was promulgated. It should also be noted that the proposal for a formal regulatory system was initiated by the industry itself in the light of the problem it faces in self-regulation. The HKMA has not sought to expand the regulatory net, but has acceded to an industry request which is conducive to maintaining Hong Kong’s status as an international financial centre. Having said that, as money brokers do not pose major systemic risks or raise deposit protection issues, the scope of the regulatory scheme will be tailored to reflect this.

Response of HKFEDBA and HKAB to the proposed legal framework

Both HKAB and HKFEDBA were consulted in the course of drafting the Bill. Their comments on the Bill and our response are at Annex 3. It should be noted that the issue of whether there should be a formal authorization regime for money brokers was not raised in the comments of both HKAB and HKFEDBA. Almost all of their comments related to the definitions of "money brokers" and "financial instruments" arranged by money brokers. The main purpose of their comments was to ensure that the proposed legal framework adequately covers all money brokers, including electronic brokers. These comments have been appropriately incorporated in revising the draft Bill.

Principles for the approval criteria for money brokers

The authorization criteria set out in the Eleventh Schedule are those which are necessary to ensure that only persons who are fit and proper may be approved as money brokers. The proposed criteria have already been kept to a minimum to take account of the business nature of money brokers, which should not cause systemic risks or raise deposit protection concerns. They should not be too onerous or difficult to fulfil for both existing brokers and new applicants. The principles for the main criteria are described below.

Fitness and properness of controllers and management

The directors, controllers and chief executive of the company must be fit and proper persons. This means that these persons will need to satisfy the MA that they are of good character and reputation and possess sufficient experience, qualifications and knowledge appropriate for their position.

Adequate financial resources

The proposed minimum paid-up capital requirement for money brokers is HK$5 million which is the same as that required for members of HKFEDBA. The aim is to ensure that a money broker has sufficient capital base to meet its running expenses and continue to operate for a reasonable period of time in the event that business volume drops significantly. This is necessary to avoid interruption to the wholesale money market.

The minimum paid-up capital requirement is also in recognition of the fact that although money brokers are generally not subject to the risks of wholesale money market principals, they are still exposed to some residual risks of potential trading loss arising from -

  1. operating expenses (if turnover and therefore income were suddenly to fall sharply);
  2. compensation for errors committed by brokers as a result of which a customer suffers loss (although the risk of such liability may be minimised by having in place adequate systems of internal controls);
  3. customer’s failure to pay commission; and
  4. the open position which money brokers may technically need to take in certain transactions. These involve e.g. Eurobond trading in which one or both counterparties may not wish to reveal identity. In such case, the money broker, in acting as an intermediary, may put through the trade by taking a position as a principal and entering into two back-to-back transactions with the two counterparties. It is therefore technically possible that money brokers may take open positions for a very short time. Such transactions are, however, all made on a matched principal basis, and it is only in the very unlikely event that the principal retracts from the transaction that the broker may incur any actual position.

The HK$5 million threshold is considered reasonable in view of the costs of operating a money broking business in Hong Kong, the possible need to pay compensation for errors and the possible open position that a money broker may need to take on certain occasions. It should also be noted that under paragraph 5 of the Eleventh Schedule of the Bill, the fulfilment of this capital requirement does not preclude the MA from setting further financial resources requirements should that become necessary under particular circumstances.

Adequate accounting systems and systems of controls

As mentioned earlier, adequate and effective systems of controls are necessary to minimise errors and misunderstanding in the trading activities. This is essential in minimising brokers’ exposure to losses arising from payments of compensation to customers due to errors. Further, adequate systems of controls are also necessary to enable management of the brokers to monitor their employees’ compliance with the Code of Conduct, to ensure proper trading practices, and to ensure that proper records are maintained and accurate supervisory information is provided to the MA. Having said that, the MA will only require such accounting and internal control systems which are appropriate to money brokers, taking account of the nature and size of their business.

Business to be conducted with integrity, prudence and competence

The Code of Conduct issued by the MPC sets out the standards, controls and dealing principles which are essential to maintaining the high standards and professionalism of the Hong Kong wholesale money markets. As a minimum to satisfying this criterion, all approved money brokers must satisfy the MA that they, and those they will employ, are able to comply with the Code and will do so at all times.

Hong Kong Monetary Authority
September 1996

Last Updated on 15 December 1998