LC Paper No. CB(1)1591/98-99
(These minutes have been
seen by the Administration)

Ref : CB1/PL/FA/1

Legislative Council
Panel on Financial Affairs

Minutes of meeting held on Thursday, 7 January 1999, at 10:45 am in the Chamber of the Legislative Council Building

Members present :

Hon Ambrose LAU Hon-chuen, JP (Chairman)
Hon Eric LI Ka-cheung, JP (Deputy Chairman)
Hon Kenneth TING Woo-shou, JP
Hon James TIEN Pei-chun, JP
Hon David CHU Yu-lin
Hon Cyd HO Sau-lan
Hon Albert HO Chun-yan
Dr Hon David LI Kwok-po, JP
Hon NG Leung-sing
Hon Ronald ARCULLI, JP
Hon CHEUNG Man-kwong
Hon Ambrose CHEUNG Wing-sum, JP
Hon HUI Cheung-ching
Hon Bernard CHAN
Hon SIN Chung-kai
Dr Hon Philip WONG Yu-hong
Hon Jasper TSANG Yok-sing, JP
Hon FUNG Chi-kin

Member attending :

Hon Martin LEE Chu-ming, SC, JP

Members absent :

Hon Margaret NG
Hon James TO Kun-sun
Hon Timothy FOK Tsun-ting, JP

Public officers attending:

Agenda items IV and V

Mrs Rebecca LAI, JP

Deputy Secretary for Financial Services

Agenda item IV

Mr Bryan P K CHAN

Principal Assistant Secretary for Financial Services
(Securities)

Attendance by invitation:

Agenda item IV

Mrs Laura CHA, JP

Deputy Chairman, Securities and Futures Commission

Mr Andrew Procter

Executive Director
(Intermediaries and Investment Products)
Securities and Futures Commission

Clerk in attendance :

Ms Estella CHAN

Chief Assistant Secretary (1)4

Staff in attendance :

Ms Pauline NG

Assistant Secretary General 1

Mr KAU Kin-wah

Assistant Legal Adviser 6

Ms Connie SZETO

Senior Assistant Secretary (1)1

I Confirmation of minutes and matters arising
(LC Paper No. CB(1)700/98-99)

The minutes of the meeting held on 17 September 1998 were confirmed.

II Information paper issued since last meeting
(LC Paper No. CB(1)591/98-99 - Regional Monitor, Issue No.18 (November 1998))

2. Members noted the captioned information paper issued since last meeting.

III Items for discussion at the next meeting
(LC Paper No. CB(1)707/98-99)

3. Members agreed to discuss the following items at the next regular meeting scheduled for Monday, 1 February 1999, at 10:45 am -

1. Concessionary interest rates for certain government loan schemes;

2. Consultation paper on Corporate Rescue and the Protection of Wages on Insolvency Fund; and

3. The Hong Kong Banking Sector Consultancy Study.

IV Proposed regulation on securities margin financing
(LC Paper Nos. CB(1)565, 619 and 652/98-99)

4. The following Members declared their interests related to the subject under discussion -

Name	Interests declared
Dr David LI Kwok-po	directors of banks, securities and finance companies;
Mr Ronald ARCULLI	a non-executive director of SFC;
Mr Bernard CHAN	directors of securities firms and a share margin finance service provider; and
Mr FUNG Chi-kin	a securities dealer

5. At the invitation of the Chairman, the Deputy Secretary for Financial Services `(DS/FS) said that the inter-agency working group (the Working Group) set up in December 1997 to study regulation on securities margin financing put forward its recommendations for public consultation in early May 1998. Views and comments from a total of over 80 parties, which were generally in support of the proposed regulatory regime, had been received by the end of the two-month consultation period. The summary of consideration of these views and comments was given in the Annex to the Administration's information paper. She stressed that the finalized proposal had struck a careful balance between market integrity and investor protection on the one hand and market viability on the other.

6. The Executive Director (Intermediaries and Investment Products), Securities and Futures Commission (ED/IIP(SFC)) took members through the key features of the proposed regulatory regime which focused on four main aspects:

1. imposing registration of 'securities margin finance providers' (SMFPs) under the Securities Ordinance (Cap. 333) thereby subject them to the regulation of SFC. Existing securities dealers might continue to provide the service to their clients but such business would be subject to the same level of regulation as SMFPs;

2. amending the Financial Resources Rules (FRRs) under the Securities and Futures Commission Ordinance (SFCO) (Cap. 24) to bring in sole business requirement, appropriate minimum paid-up and liquid capital requirements, haircut deductions, concentrated risk adjustments as well as additional reporting requirements for SMFPs. All aimed at improving the risk management systems of securities margin finance operators;

3. introducing new measures to enhance protection for clients' assets; and

4. promulgating a Code of Business Standards for SMFPs to lay out the standards of business practices expected by regulators.

7. He further advised that the reform package would be accompanied by appropriate investor education programmes to enhance understanding and awareness of risks associated with securities margin financing activities.

8. Dr David LI Kwok-po conveyed the banking sector's support for the proposed regulatory regime on securities margin financing (SMF) activities which in his views, would further enhance market integrity and contribute to maintaining and enhancing Hong Kong's status as a major international financial centre. He opined that the proposals were appropriate and practical and should be supported by the securities industry and the investing public at large.

9. Noting that under the proposed regulatory regime, SMFPs would be restricted to conduct SMF businesses only, Mr Ronald ARCULLI asked how the proposed sole business requirement could be applied to existing securities dealers and whether there were any measures to ensure their compliance. He also enquired about resources implications on SFC in implementing the proposed regulatory regime.

10. In response, ED/IIP(SFC) explained that the purpose of imposing a sole business requirement was to eliminate undue exposure of SMFPs to non-securities related risks. The essence of the requirement was to disallow mixture of different types of business within the registrant entity rather than to restrict service providers from operating other forms of business. This ring-fencing arrangement would prevent contagion of risks from other businesses operated by the same corporate entity exerting financial pressure on the SMF business. Regarding measures to ensure compliance of service providers, ED/IIP(SFC) advised that apart from routine surveillance actions by SFC, reporting and disclosure requirements on service providers' bank lines and their utilization would provide additional safeguards to facilitate early detection of problem of multiple businesses and enforcement of appropriate disciplinary actions. Nevertheless, SFC envisaged that due to the more stringent FRRs, the existing some 100 finance companies providing SMF services which were associated with securities dealers would likely find it commercially more viable to separate the two businesses. Hence the problem of mixture of businesses would mostly be academic.

11. On the question of resource implications on SFC, ED/IIP(SFC) said that the new regulatory regime would entail additional resource strains on SFC in respect of new duties including registration, inspection, monitoring and taking enforcement actions for non-compliance of various rules and regulations. SFC would also be empowered to appoint external auditors for carrying out detailed inquiries on suspected breaches. SFC had budgeted for the financial need of a modest increase in resources for the division on surveillance and monitoring of SMF activities in the 1999-2000 budget. In fact, SFC had already made internal adjustment in 1998 to deploy considerable resources to work on monitoring of SMF activities.

12. Mr Bernard CHAN referred members to a submission from the industry provided by him on the subject which was tabled at the meeting. (LC Paper No. CB(1)728/98-99 circulated to members after the meeting) Whilst expressing full support for the need to regulate SMF activities, he opined that the proposed regulatory regime was neither suitable nor appropriate in view of the anticipated adverse impact of the stringent regulations on commercial viability of existing service providers. He was concerned that the requirement of the high minimum paid-up and liquid capital and haircut deductions would force existing service providers, especially small to medium sized firms, out of business since they had been suffering from financial problems as a result of the recent economic downturn and might not be able to inject additional capital to meet the new requirements.

13. DS/FS said that it was difficult to accurately quantify the impact of the proposed regulatory regime on existing SMF service providers. However, according to the rough assessment of FSB and SFC, it was expected that no more than 100 existing finance companies would be able or willing to restructure their businesses to meet the new requirements and standards. She recognized that there were concerns among existing service providers about continued viability of business but reiterated that proper balance had to be struck between regulation and the scope of business. Under this broad principle, the proposed regulatory framework was considered prudent and appropriate from the regulator's point of view and it was a commercial decision for the operators whether or not to inject additional capital to comply with the new financial requirements. The Deputy Chairman, Securities and Futures Commission also remarked that while market viability and market development are important, investors' interests should not be compromised. As market environment improved and financial hardship of existing finance companies relieved as indicated in the quarterly surveys conducted by SFC is 1998, SFC believed that market viability would not be seriously affected with the implementation of the new regulatory regime.

14. Considering that an effective regulatory regime for SMFPs should help enhance the risk management of individual finance companies and reduce any systemic risks of the market, Mr FUNG Chi-kin opined that the proposed reform package could not achieve the aims. He criticized that the proposal to require all SMFPs to disclose their top 20 margin clients would be ineffective in controlling risk, administratively burdensome and difficult for service providers to observe. He further suggested the Administration to consider adopting a "risk-based" regulatory approach under which different financial resources and reporting and disclosure requirements were prescribed for SMFPs according to the level and volume of businesses they planned to undertake. Mr James TIEN Pei-chun shared the view that financial resources requirements should commensurate with the scale of SMF business of individual service providers.

15. In reply, ED/IIP(SFC) explained that the new FRR of a minimum paid-up capital of $10 million was considered appropriate as a set up fund for the provision of SMF service and this would be complemented by the minimum liquid capital of at least $3 million or 5% of total liabilities of SMFPs, whichever was the higher, which SMFPs would be required to maintain at all times in accordance with their level of risks involved in running SMF business. Furthermore, application of haircut deductions and concentrated risk adjustments in the calculation of asset values for FRR purposes would provide additional safeguards against risks of price fluctuations in stock collateral and over-exposure to any individual clients or stock collateral. As such, FRR requirements would be consistent with the size of business of SMFPs. As regards the suggestion to prescribe limits on the business volume to be undertaken by SMFPs according to the level of paid-up capital held, ED/IIF(SFC) remarked that this would not be advisable and difficult to pursue as, unlike in the Banking Regulations under the Banking Ordinance (Cap.155), "capital" referred to in FRRs under SFCO was not specified to be held in any form, hence it could be re-invested in forms which might not be readily realisable to cover the risk of SMFPs.

16. On the difficulty for service providers to comply with new reporting requirements, ED/IIP(SFC) explained that the requirement to disclose their top 20 margin clients and summary of existing bank lines and their utilization would facilitate effective supervision by SFC as the information would enable better understanding of the operation of SMFPs, in particular, their exposure and risks involved. SFC did not envisage difficulty for SMFPs to comply with the requirement as existing service providers were providing such information voluntarily on a quarterly basis. DS/FS added that since the information on margin clients was supplied to SFC for regulation purposes and the latter was obliged under the law to keep the commercial and personal information obtained in the performance of its functions strictly confidential, the concern about commercial and personal secrecy should have been adequately addressed.

17. Mr Albert HO chun-yan expressed strong reservation over the proposal permitting the continuation of the current practice of "pooling" of clients' assets for re-pledging to third party banks to secure lines of credit. He pointed out that the practice was inconsistent with the objective of enhancing protection for clients' assets and was against the principle of requiring clear segregation of clients' cash and margin accounts. The mingling of clients' assets was proven to be a problem in the insolvency of the C.A. Pacific Group, giving rise to difficulties in the identification of proprietary interests of individual clients and allocation of balance assets in the compensation process. Moreover, "pooling" always posed risks to margin clients as the funds so obtained were not restricted to finance the client's own account but to finance other margin clients or the finance company's own operation. He was of the view that notwithstanding new measures such as, requirement of clients' written authorization on the use of their stocks for specified purposes and enhanced information disclosure to minimize risk, margin clients were vulnerable to persuasion and they often relied on SMP operators for professional advice and lending. They might be given misrepresented information and induced to sign agreements which they were not fully conversant with. Hence, allowing "pooling" of stock collateral to continue would not contribute to prudential regulation of securities margin financing activities. In this connection, the Chairman opined that the Administration should consider putting in place measures or arrangements to facilitate easy understanding by margin clients of their legal obligations and risks involved in signing margin agreements.

18. In response, ED/IIP(SFC) said that in considering the proposed regulation on SMF activities, the Working Group had drawn reference from other jurisdictions. Whilst it had been found in other markets that securities margin loans were either disallowed, or allowed to be funded out of the service provider's own capital resources or centralized in a limited number of designated service providers, the "pooling" of clients' assets for securing third party credits to finance the business was unique to Hong Kong. The arrangement was not only a common practice among local service providers but also central in their operation. The Working Group recognized that overseas experience/practices had their own merits but none of them fitted the local circumstances. The total banning of "pooling" arrangements might have serious adverse impact on the profitability of service providers. The concern about commercial viability was evidenced in industry-wide surveys and submissions received during the public consultation on the proposed regulatory regime. While noting the risks posed to margin clients, the Working Group considered that "pooling" should only be allowed to continue with adequate safeguards in order to strike an appropriate balance between commercial viability of SMFPs and investor protection. Besides having new FRRs to control risks, proposed measures to enhance protection for clients' assets included requirement on SMFPs to obtain clients' written authorization to use their stocks for specific purposes and clear segregation of cash and margin accounts. Clients' written authorization had to be prepared in plain language in both Chinese and English with clear risk disclosure provisions. It had to be renewed on an annual basis and could be withdrawn by clients with five days' advance notice. Furthermore, the Code of Business Standards to be introduced for SMFPs would specify requirements on service providers in respect of areas including risk management, margin lending policy, margin call policy, cash flow management and disclosure to clients on account status. The Working Group considered that with the proposed regulatory regime in place, coupled with close monitoring and supervision by regulators, risks involved in "pooling" of assets should be contained and regarded as tolerable.

19. DS/FS added that there had been thorough discussions on the issue of "pooling" of clients' assets by the Working Group under which various proposals for different circumstances had been carefully studied and considered. Whilst a number of problems in SMF activities were associated with "pooling" arrangements in the past, the decision to allow the continuation of the practice would strike an appropriate balance between maintaining commercial viability of SMF activities to meet market demand on the one hand and enhancing protection to investors on the other. In order to promote understanding and awareness of risks involved in securities margin financing, DS/FS said that the Working Group also recommended suitable investor education programmes and publicity on the new regulatory regime. Apart from promoting the adoption of standard securities margin contract/agreement and other documents, standardized procedures in dealing with margin accounts would also be specified in the Code of Business Standards. ED/IIP(SFC) supplemented that licensed securities dealers or SMFPs would have to take personal responsibility for failure in explaining margin agreements to clients and there would be requirement for certification to show their compliance in this respect.

20. Mr Albert HO remained concerned about legal problems arising from "pooling", particularly, in the event of insolvency of a SMFP and sought SFC's views in this regard. The Chairman remarked that Mr HO's questions involved complicated legal issues and advised him to pursue the matter with SFC after the meeting. Mr HO agreed.

21. Noting the Administration's intention to bring the new regulatory regime into force by mid 1999 at the latest, Mr FUNG Chi-kin was concerned that this would create additional financial and operational pressure on securities dealers and finance companies who were already heavily burdened with rectification of their systems for year 2000 (Y2K) compliance by mid 1999.

22. DS/FS advised that under the proposed transitional arrangements, existing securities dealers and margin financing service providers would have 30 days to indicate interest to SFC to provide the service. New entrants could also apply for the necessary licence within this period. A six-month period would be allowed for registered securities dealers to bring themselves into conformity with the new FRRs. On the concern about undue pressure on existing service providers having to meet the new SMF regulatory requirements and deal with the Y2K problem at the same time, ED/IIP(FSC) advised that SFC and the exchanges had been discussing with computer system providers to provide necessary software systems to facilitate Y2K compliance of financial institutions. As system providers tackling the Y2K problem also provided necessary system enhancement services required for the new SMF regulatory system, SFC was confident that existing securities dealers would be able to make the necessary changes in their systems within the six-month transitional period. In this connection, DS/FS advised that the first round of large scale external testing for Y2K compliance of securities industry would be conducted in mid-January 1999. Two more rounds had been scheduled for March and June 1999. Financial institutions were expected to be Y2K compliant before mid-1999.

VI Any other business

Proposed creation of directorate posts in the Financial Services Bureau

23. DS/FS informed members that the Administration would submit a proposal to the Establishment Subcommittee (ESC) on 13 January 1999 on the creation of two permanent posts of Administrative Officer Staff Grade B (D3) and C (D2) respectively in the Financial Services Bureau (FSB). Referring to the draft ESC paper tabled at the meeting, DS/FS explained that the proposal would strengthen the directorate structure of FSB to cope with increasingly substantial and complex work in the policy areas of companies and retirement schemes and insurance. She also briefed members on the major on-going programmes and new commitments in respect of the two policy areas to be handled by the new team of staff.

24. Commenting that inadequate staffing support at the directorate level in FSB had caused delays in implementation of some important policy programmes, Mr Eric LI Ka-cheung expressed support for the proposal which would help expediting policy programmes for enhancing Hong Kong's status as a major international financial centre and enabling local economic recovery. However, he cautioned that the right direction for developing policy and legislation should be towards improving the economic and legal environment in Hong Kong for a more open, fair and efficient market rather than over-stressing regulation and penalties on non-complying market participants.

25. DS/FS took note of Mr LI's views and remarked that the Administration recognized the importance of improving existing economic and legal frameworks to facilitate business development and lower business operating costs with a view to enhancing Hong Kong's competitiveness vis---vis neighbouring markets.

26. In reply to Mr Albert HO Chun-yan's enquiry about the development in policy and legislation of insolvency administration, DS/FS advised that the relevant subcommittee of the Law Reform Commission was due to complete its third and final report on the comprehensive review of the winding up provisions in the Companies Ordinance which would give recommendations on the future role and work of the Official Receiver's Office (ORO). The Administration would consider reforms for ORO in the light of the recommendations. As regards whether consultancy would be commissioned to undertake studies in these areas, DS/FS said that since the details had yet to be worked out, it was pre-mature to comment on the need for consultancy studies at the present stage.

27. On Mr Bernard CHAN's comments that officials filling the two directorate posts should be well-versed with the operation of the financial market, DS/FS advised that the Civil Service Bureau (CSB) was responsible for the deployment and management of Administrative Officer Grade Staff. Mr CHAN's view would be conveyed to CSB for consideration.

28. The meeting ended at 12:10 pm.

Legislative Council Secretariat
28 June 1999