INTRODUCTION

This paper outlines the key features of the proposed regulatory regime on securities margin financing activities and informs Members of the progress in the preparation for legislation.

DETAILS

Background

2. Over the last few years, there had been a marked increase in retail participation in the securities market and a substantial rise in margin trading through largely unregulated finance companies. Many of these companies failed to undertake prudent risk management measures, leading to over-lending to margin clients and other non-securities related borrowers and over-exposure to specific stock collateral and individual borrowers. This aroused the concern of the regulators and a series of inspections were carried out in late spring 1997 on these unregulated finance companies by the Securities and Futures Commission ("SFC") and the Stock Exchange of Hong Kong ("SEHK").

3. To ensure that these finance companies were not over-extending themselves in their credit provision, the regulators conducted another round of inspection in October 1997 which resulted in more prudent management of risks by these companies and contributed to a great extent to their ability to withstand the sharp market fall that happened in the latter half of that month. In addition, an industry-wide survey was conducted in late 1997 to help identify any other potential problems and to assess any systemic risk which might have arisen from the concentration in margin clients and stock collateral.

4. As a policy response, an inter-agency working group ¹ ("the Working Group") was established in December 1997 under Financial Services Bureau to study the issue of regulating the share margin financing activities carried out by finance companies associated with stockbrokers in particular. The C.A. Pacific incident added impetus and urgency to the deliberations of the Working Group.

5. The Working Group completed its study and put forward its recommendations for public consultation in early May 1998 in the form of a Consultation Paper. Copies of the Consultation Paper have been circulated to Members earlier. In addition, SFC and SEHK had also jointly organised a series of seminars for the industry to explain the Working Group's proposal and received feedback from the market participants. The two-month public consultation period ended on 8 July 1998 and comments from a total of 88 parties were received. While the respondents were generally in support of the proposed regulatory regime, they also expressed various views and comments on individual recommendations contained in the Consultation Paper. The Working Group has thoroughly and carefully considered the comments received and finalised the proposed regulatory regime as detailed in the Annex. The paragraphs below outline the key features of the proposed regulatory regime.

Key Features of the Finalised Regulatory Regime

6. The proposed regulatory regime aims to increase protection for investors through prudential regulation of the securities margin finance operators while maintaining their commercial viability to meet local market needs. It focuses on four main aspects -

1. registration under the Securities Ordinance;(b) prudential rules on financial resources;
   
   

2. enhanced protection for clients' assets; and

3. standards for business practices.

(a)Registration under Securities Ordinance

7. The proposed regulatory regime will bring the securities margin finance activities and their operators clearly into the purview of the Securities Ordinance ("SO") and thereby subject them to the regulation by the SFC. A new class of registrants, known as securities margin finance providers ("SMFPs"), will be introduced under the SO for these companies. At the same time, the SMFPs will be exempted from certain licensing and operational requirements under the Money Lenders Ordinance (Cap.163) to avoid duplication of regulation.

8. Existing securities dealers (including SEHK members) may continue to provide securities margin financing to their clients but such business will be subject to the same level of regulation as SMFPs.

(b)Financial Resources Rules ("FRRs")

9. The current FRRs came into force in December 1993 as a subsidiary legislation under the Securities and Futures Commission Ordinance (Cap.24). They set the minimum prudential standards on the financial resources of market intermediaries including securities dealers, investment advisers etc. and form an important part of intermediary regulation in Hong Kong, in line with the practise with other advanced financial markets. The proposed regulatory regime will extend the rules to SMFPs and strengthen them to reflect the nature of the securities margin financing activities. The more important elements of these rules include -

• Sole business requirement. SMFPs will be restricted to securities margin financing businesses;

• Minimum paid-up capital. A minimum paid-up capital of $10 million is required for SMFPs;

• Minimum liquid capital. SMFPs will be required to maintain at all times liquid capital not less than $3 million or 5% of their total liabilities, whichever is the higher.

• Value of stocks held as collateral to be discounted (or known as "haircut"). To allow for price fluctuations due to market volatilities, the value of stocks held by SMFPs as collateral against margin loans extended to clients are discounted when calculating asset values for FRR purposes.

• Concentrated risk adjustments. In calculating asset values for FRR purposes, assets arising from over-exposure to individual clients or stock collateral beyond specified thresholds will be discounted. For example, loan receivable from any individual client in excess of 10% of the total loan portfolio and excessive collateral in the form of any single stocks beyond certain thresholds in relation to the total stock collateral portfolio will be subject to additional haircuts in the calculation of the SMFPs' liquid assets.

• Reporting requirements. SMFPs are required to disclose their top margin clients, summary of bank lines and their utilisation to the SEHK and SFC on a regular basis.

(c)Protection of clients' Assets

10. Certain measures are proposed to enhance protection for clients' assets. For example,

• securities dealers will have to have clients' written authorisation to use stocks entrusted to them by their clients to support their margin financing activities. Such authorisation will have to be renewed on an annual basis and will be withdrawable by clients with five days' advance notice. Even with authorisation, the permitted uses of clients' stocks will still be confined to specific purposes.

• such authorisation must be prepared in plain language in both Chinese and English, with clear risk disclosure provisions.

• cash and margin accounts must be clearly segregated.

(d)Standards of Business Practices

11. Code of Business Standards will be introduced for SMFPs to lay out the standards of business practices expected by regulators, including margin call policies, cash flow management and sufficient disclosure to clients on account status.

Encumbrance of Stock Collateral

12. The proposed regulatory regime will continue to permit the current practice of "pooling" of clients' assets. The Working Group fully appreciates the controversy relating to "pooling", as demonstrated in the immensely divergent views received from the public consultation. Before putting the proposal for consultation, the Working Group had considered in detail the matter and come up with the view that disallowing pooling might in effect render the margin financing operations as practised in Hong Kong commercially non-viable, which is not the policy objective that the government has set for the regulation. As pointed out in the Consultation Paper, the Working Group believes that the proposed regulatory regime as a whole would help ensure the capital adequacy of these companies and render better protection to margin clients. The Working Group therefore recommends that pooling of client assets may continue to be allowed insofar as clients are adequately informed of the risks involved.

Legislative Table and Implementation

13. The Department of Justice has been instructed to draft the relevant legislation to give effect to the necessary amendments to the SO as well as the FRRs. It is expected that the bill will be introduced in February 1999.

14. Subject to and following the legislative amendments, existing securities dealers and non-registered entities will have 30 days to indicate to the SFC an interest to provide securities margin financing and, for non-securities dealers, to apply for necessary registration as SMFPs. Registered securities dealers will have six months to bring themselves into conformity with the certain requirements under the new FRRs including minimum paid-up capital and liability test requirements. Non-securities dealers are required to fully comply with the regulation once their licence as SMFPs is granted by SFC.

15. The Administration intends to bring the new regulatory regime into force by mid 1999 at the latest.

CONCLUSION

16. In finalising the proposed regulatory regime for securities margin financing activities, the Working Group has taken into account the concerns expressed by the industry and the public, and tried to strike a careful balance between market integrity and investor protection on the one hand and market viability on the other. It is believed that the proposed regime, if implemented, should greatly reduce the possible systemic risk of the market, render better protection to the investors while also allowing securities margin financing business to continue to be operated under prudential conditions in the market.


Financial Services Bureau
4 December 1998

Annex

Summary of the Working Group's Consideration on the
Comments Received from the Public Consultation on the
Proposed Regulation on Securities Margin Financing

Proposed Changes in Securities Ordinance (para. 37 - 49 of the Consultation Paper)

• In the Consultation Paper, it was proposed that the Securities Ordinance ("SO", Cap. 333) be amended to extend the definition of "securities dealers" to cover share margin finance providers. Of the respondents who expressed views in this regard, most are in support of the proposal to bring share margin financing under the ambit of the securities legislation whereas some of them stress that the proposed definition should be carefully drafted to avoid catching conduct not ordinarily regarded as share margin financing.

• The Working Group agrees that the proposed definition should be clear and the legislation should be easy to follow. In the course of drafting the proposed legislation, the SFC had re-examined the effectiveness of extending the definition of "securities dealers" to capture "securities margin finance providers" but eventually came to the view that it might provoke confusion and distort the existing regulatory regime applying to securities dealers by stretching the definition of "dealer" and "dealing in securities" beyond recognition. As an alternative, the SFC suggested the introduction of a new class of registrants, referred to as "securities margin finance providers". Under the proposal, "securities margin finance provider" means a person who carries on a business of providing securities margin financing in respect of securities listed in Hong Kong . Whereas licensed securities dealers including SEHK members would continue to be allowed to provide margin financing to their clients as under the existing legislation, they would be subject to the same set of regulatory standards as licensed securities margin finance providers but without the need to obtain a separate licence.

• There are several advantages of introducing a new category of registrants. First, given the fact that the conditions of registration and conduct of business of conventional securities dealing and securities margin financing are quite different, it would be more appropriate from the regulatory point of view to segregate securities margin finance providers from the conventional securities dealers. Secondly, it will facilitate the ease of providing a separate Code of Conduct, separate Financial Resources Rules ("FRR") and Conduct of Business Guidelines or other applicable subsidiary legislation and facilitate the imposition of a sole business requirement and the necessity for margin finance providers to be limited companies.

• Having considered the forthmentioned advantages , the Working Group agreed to adopt the new approach, i.e. to introduce a new class of registrants to be known as "securities margin finance providers". While this approach is different from that envisaged in the Consultation Paper, the legal advice to the Working Group suggests that the new approach would not bring about any significant changes to the regulatory regime.

Proposed Changes in Money Lenders Ordinance (para. 50 of the Consultation Paper)

• It was suggested in the Consultation Paper that a loan made by a dealer (i.e. the securities margin finance provider as defined in the above section) for the purpose of securities margin financing be exempted from the Money Lenders Ordinance ("MLO", Cap. 163). Notwithstanding the general exemption, they will still be prohibited from charging their clients excessive interest rates as provided for under section 24(1) of the MLO.

Financial Resources Rules

Sole Business (para. 56 - 62 of the Consultation Paper)

• There were divergent views as to whether companies providing share margin financing should be allowed to engage in other business operations including other money lending activities. While some respondents supported the proposal, others argued that multiple businesses under appropriate and prudent management could in fact diversify market, operational and financial risks. It was also suggested that large institutions should be exempted from the requirement. As explained in the Consultation Paper, the Working Group had thoroughly considered the matter against the background that had led to the collapse of the C. A. Pacific Group and came to the view that a sole business requirement would be essential in eliminating the undue exposure of the registrants to non-securities risks and enhancing proper regulation by SFC. The Working Group remains of the view that a sole business requirement is essential to reduce non-securities exposure of the registrants and to render higher protection for their clients.

• Some respondents also suggested that the definition of "sole business" be relaxed and the definition of "securities margin financing" be extended to cover also the financing activities in futures and leveraged forex contracts and bullion trading. The Working Group had studied the proposal but considered that the nature of these financing activities was in fact very different from that relating to securities margin trading and was not directly relevant to the concerns that led to the proposed regulation. Furthermore, the mingling of other investment products in the business of a securities margin finance provider could result in higher risks and therefore should not be allowed.

Minimum Paid-up Capital (para. 63 - 64 of the Consultation Paper)

• The capital requirement should be adequate to reflect the risk associated with securities margin financing activities. In the Consultation Paper, the Working Group proposed a minimum paid-up capital of HK$10 million for those providing securities margin financing, whether they are securities dealers or securities margin finance providers . The imposition of a minimum paid-up capital requirement is widely supported by the public but there are very different views on the level of the capital requirement, ranging from $5 million to as high as $50 million. The Working Group had re-assessed the adequacy of the level and concluded that minimum paid-up capital level of $10 million is appropriate. Separately, following the consultation on a general review of the Financial Resources Rules ("FRRs") in March 1997, it is also proposed that a minimum capital requirement of HK$5 million be introduced in the same exercise for securities dealers not engaging in share margin financing business.

5% Liabilities Test (para. 65 - 69 of the Consultation Paper)

• Given the past experience of SFC that the 5% liabilities test had provided adequate protection for the market even during the most volatile period in the recent financial turmoil, it was proposed in the Consultation Paper that the 5% total liabilities test be retained. In addition, as recommended by the SFC in the context of its review on the FRR in March 1997, the Consultation Paper proposed that the level of total liabilities test should be reduced to 4% for portfolios between $300 million and $1,500 million and 3% for portfolios exceeding $1,500 million.

• A number of submissions however opposed to the progressive reduction of the percentage and suggested to set the 5% test across the board. On the contrary, there was also one suggestion of setting the level at 3% across the board. The SFC reconsidered the matter in light of the events in the market over the past 24 months and has modified its recommendation that the 5% liability test should remain unchanged across the board. The requirement will be for minimum liquid assets of $3 million or 5% of liabilities, whichever is the higher.

Accounting for Margin Loans (para. 70 of the Consultation Paper)

• It was suggested in the Consultation Paper that the existing practice of requiring a securities dealer to include in the liquid assets either the loan amount outstanding or the discounted collateral value on a client-by-client basis, whichever is the lower, be retained. The Working Group has received no objection to this recommendation.

Haircut Deduction (para. 71 of the Consultation Paper)

• The existing FRR requires that the value of stocks held by registrants should be discounted (the so-called "haircut") in the computation of their liquid assets to account for market volatilities and higher haircut percentages have been adopted for stocks which are less liquid. It was proposed in the Consultation Paper that stocks listed on the SEHK be classified into three categories which attract different haircuts as follows -

  Category of stock	Haircut ratio
  HSI constituent stocks	10%
  HS100 constituent stocks or those eligible for a derivative warrant issue	15%
  All other stocks	25%

  
  

• Whilst the respondents support the rationale of differentiating the haircut ratios on shares of different liquidity, there were divergent views as to the categorisation of stocks and the haircut percentages. Some suggested simplifying the calculation at 20% across the board and others suggested categorising stocks simply in terms of their market capitalisation. There was also a suggestion of raising the haircut ratio for the most illiquid stocks to as high as 100%.

• In light of the comments received, the Working Group re-examined the issue and agreed that the categorisation of stocks should be clear and easy to follow. In this respect, the Working Group came to a view that the category of "stocks eligible for a derivative warrant issue" might give rise to unnecessary ambiguity and should be removed from the categorisation. With respect to the suggestion that the stocks should be categorised on the basis of their market values, it is important to keep in mind that the haircuts are applied to share prices that are marked to market on a daily basis. As such, the Working Group concluded that stocks should be categorised on the basis of whether they are constituents of the HSI or HS100 index. This is in line with the rationale that the Hang Seng family of indexes are compiled basically on the basis of the market value of the respective constituent stocks and their inclusion in an index is likely to be broadly indicative of liquidity.

• For the sake of better risk management of the securities margin finance providers or securities dealers, the Working Group believed that higher haircuts should be applied to illiquid stocks and therefore ruled out the suggestion of setting a fixed haircut across the board. Meanwhile, it has been suggested within the Working Group that the haircut issue be considered in conjunction with the proposal on concentrated risk adjustment to give more flexibility in respect of the overall package of the FRR. Details of the Working Group's deliberation on the concentrated risk adjustment are given in the following section. In brief, the Working Group agrees that the concentrated risk adjustment on stock exposure may be modified to allow flexibility for the registrants provided that the haircut ratios are raised to compensate for the risks involved. The final proposal on haircut deduction is as follows -

  Category of stock	Haircut ratio
  HSI constituent stocks	15%
  HS100 constituent stocks	20%
  All other stocks	30%

Concentrated Risk Adjustment (para. 72 - 73 of the Consultation Paper)

• To address the problem of over-exposure to individual stock collateral or individual clients, it was proposed in the Consultation Paper to include in ranking liabilities any excess of the value of any individual stock or stocks or related companies over 10% of the total value of stock collateral, and any excess of a single margin client receivable over 10% of total margin client receivable whereas the adjustment is also applicable to loans made to related margin clients. The proposal turned out to be rather controversial. While the industry supported the concept of concentrated risk adjustment, they were generally of the view that the proposed requirements were too stringent.

• Concerning the risk adjustment for concentrated stock exposure, most respondents considered that the quality of stock collateral should be taken into account and different thresholds should be applied to different categories of stocks as defined under haircut deduction. Generally, respondents proposed raising the threshold from 10% to 25-30% for blue chips, and to 15-25% for HS100 stocks and stocks eligible for derivative warrant issue, whereas the threshold for the remaining stocks would remain unchanged at 10%. As to client exposure, some respondents proposed raising the threshold to 20% and some to as high as 30-50%. It was also pointed out in some submissions that the ranking liabilities due to concentration risk adjustment should be confined to the total amount of the loan portfolio so that double counting of adjustment and negative asset value of client portfolio would not happen.

• The Working Group considered that some of these concerns were valid. In fact, if the threshold is to apply across the board, it may in effect encourage the registrants to secure part of their exposure against stocks which are themselves very volatile, contrary to the objective of prudential regulation. To address the concerns, it is now proposed that different concentration thresholds be applied to different categories of stocks as in the case of the preliminary haircut applied to asset values. Under this proposal, a concentration threshold of 20% will apply to the blue chips (HSI constituent shares), 15% to HS100 constituent stocks and 10% to the rest. Furthermore, it is also proposed that the concentration threshold will be applied at the company level instead of the client level.

• The revised proposal should have sufficiently addressed the concerns of the respondents. It provides more flexibility for the registrants in their business on the one hand without undue compromise on the prudential regulation.

• As to client exposure, the Working Group took that view that if a higher threshold was to be allowed, the loan portfolio of the securities margin finance provider could be seriously disturbed on the withdrawal of large clients. To encourage dilution of client exposure of the registrants, the Working Group concluded that the 10% threshold should be maintained. The client risk concentration rules also pick up exposures to corporate groups and closely related individuals.

Encumbrance of Stock Collateral (para. 74 - 76 of the Consultation Paper)

• A number of respondents submitted comments in this regard. Whilst there was suggestion that pooling of client assets would expose investor to undue risk that should not be allowed at all, some proposed that pooling should be restricted to financing the client's own overdraft balances only. Before putting the proposal for consultation, the Working Group had considered in detail the matter and concluded that disallowing pooling might in effect render the margin financing operations as practised in Hong Kong commercially non-viable, which is not the policy objective that the government has set for the regulation. As commented in the Consultation Paper, the Working Group believes that the proposed regulatory regime, under which securities margin finance providers are subject to more stringent FRR and other requirements including a higher minimum paid-up capital requirement, a requirement to account for margin loans on a client by client basis, a requirement to hold liquid assets not less than 5% of liabilities, higher haircut deductions and tighter reporting requirement as well as sole business restriction, would help ensure the capital adequacy of these companies and render better protection to the margin clients. The Working Group therefore believes that pooling of client assets may continue to be allowed insofar as clients are adequately informed of the risks involved, as intended by the information disclosure requirements set out herein below.

Trade Date or Settlement Accounting (para. 77 - 78 of the Consultation Paper)

• As explained in the Consultation Paper, the existing FRRs are silent as to whether transactions other than proprietary investment should be accounted on a trade date basis or on a settlement date basis. For clarity and consistency sake, the Working Group proposed stipulating the trade date basis for accounting of all assets and liabilities, whether on or off balance sheet. In addition, to bring it in line with the market norm, it was proposed that a grace period be given and the margin clients should be allowed to provide collateral on the settlement day.

• During the consultation, there was suggestion that allowing margin clients to provide collateral on settlement day (i.e. T+2) would expose margin financing operators to market risk and client credit risks between T and T+2. To reduce the risks involved, some submissions suggested that collateral should be provided on trade day instead of settlement day. On the other hand, there was argument that margin clients may not borrow money every time when they place a purchase order which renders the trade date accounting inappropriate. On similar grounds, there was a proposal that settlement date accounting should be stipulated. The Working Group had considered the comments and was of the view that there were pros and cons either way. On balance, it considers that the possible credit risks involved in allowing the collection of collateral by settlement day could be addressed by the margin lending policies of individual registrants in the light of the credit risks of individual clients. It therefore does not recommend any changes to the original proposal of settlement day accounting.

Reporting Requirements (para. 79 - 80 of the Consultation Paper)

• Securities margin finance providers or securities dealers are required under the proposed regulatory regime to disclose their top 20 margin clients and summary of existing bank lines and their utilisation to the SFC. They are also required to alert the SFC if potential financial shortfall is anticipated. A number of submissions opposed the requirement of disclosing the top 20 margin clients positions on grounds of commercial secrecy and clients' privacy. Others argued that the requirement would be administratively burdensome and difficult to observe. The Working Group believed that sufficient disclosure on the operation of the margin financing operators, in particular their exposure, would be essential in ensuring the compliance with the regulatory requirements and in enabling potential risks to be identified early. It was therefore recommended that the requirements be maintained. It is also worth noting that the SFC as the market regulator is obliged under section 59 of the SFC Ordinance to keep the commercial and personal information obtained in the performance of its functions strictly confidential, which should adequately address the concerns about commercial and personal secrecy. Separately, respondents were supportive to the proposed disclosure requirement of utilisation of bank credit facilities.

Protection of Client Assets

Use of clients' Assets (para. 82 - 84 of the Consultation Paper)

• In order to render better protection of clients' securities, it was proposed in the Consultation Paper that the authorisation under s.81 of the Securities Ordinance on the use of clients' securities be confined to certain means including to deposit as security for any loans or advances made to the registrant; to borrow or lend to fulfil obligations between SEHK Members; or to deposit as collateral with the Hong Kong Securities Clearing Company and the SEHK Options Clearing House for fulfilment of obligations of licensed securities dealers. Of the respondents who addressed this issue, most of them supported the notion that the power of use of client assets should be limited though there was argument that the stricter regulations on the use of client assets might result in a great discrepancy between the permitted treatment of client assets by exempt dealers and licensed dealers. The Working Group believed that since pooling would continue to be permitted under the proposed regulatory regime, safeguards are necessary to limit the use of clients' securities for the sake of better investor protection.

• As to the s.81 authorisation ², it was suggested by a number of respondents that a nil reply from client should be considered as a confirmation of renewal of the margin financing facility and the authorisation. As the s.81 authorisation waives an important obligation for the dealers in the proper safeguard of clients' assets entrusted to them, from the point of view of better protection for investors' interest, it is considered that an explicit consent from a client should be required for the renewal of the authorisation. The Working Group did not propose any change to the proposal as set out in the Consultation Paper.

Information Disclosure (para. 85 - 86 of the Consultation Paper)

• To ensure that investors are aware of the potential risks involved in the conduct of securities margin finance activities, it has been proposed that the s.81 authorisation letter should be prepared in both English and Chinese and in plain language. There should be proper risk disclosure provisions as well as express provision which allows the withdrawal of the authorisation by clients by giving 5 business days' notice provided that they do not have any outstanding loans payable to the securities margin finance providers or securities dealers.

• There was a suggestion from the respondents that a standard bilingual margin agreement should be drafted by the regulators for market usage or as reference and the SFC has been invited to take note of the suggestion. In respect of the proposal to allow clients to withdraw their s.81 authorisation upon 5 days notice, it was suggested that written advice should be given to securities margin finance providers or securities dealers. However, some respondents were of the view that this requirement was undesirable as securities margin finance providers or dealers might not have sufficient time to put other arrangements in place upon such short notice from clients. While this is a matter of internal risk control of the margin financing operators, the Working Group in the interest of the investors, remained that clients should be entitled to withdraw their s.81 authorisation by giving 5 business days notice in writing.

Segregation of Accounts (para. 87 - 88 of the Consultation Paper)

• As set out in the Consultation Paper, to improve protection of securities belonging to clients who only operate a cash account and who have not signed any s.81 authorisation, their securities should always be segregated from securities deposited by margin clients, clients who have signed the s.81 authorisation. The Working group did not propose any change to the proposal.

Code of Business Standards (para. 89 - 94 of the Consultation Paper)

• Many of the comments received suggested that the "Code of Business Standards" should be replaced with a "Guideline" or "Preferable Practices" and securities margin finance providers should be expected to satisfy them on a "best effort" basis. SFC is of the view that the practice of setting out the regulator's expectation of the best practice required of registrants by means of Code of Business Standards is not new and there is no reason to abandon this approach in favour of "Guideline" or "Preferable Practices", which might confuse the industry as to what is expected of them.

Risk Management - Opening of New Accounts (para. 89 of the Consultation Paper)

• As suggested in the Consultation Paper, securities margin finance providers and securities dealers should be encouraged to use their best efforts to verify the financial capacity of their clients when accepting new accounts.

Margin Lending Policy (para. 90 of the Consultation Paper)

• From the perspective of prudent risk management, it is important that securities margin finance providers and securities dealers have in place proper and adequate internal controls to avoid a building up of excessive exposure to individual stock collateral or margin clients and to ensure the financial health of the company. Most of the respondents supported the proposal but suggested that flexibility should be allowed if the margin financing operators have sufficient capital. This however should not be a concern because under the proposed regulation, securities margin finance providers or dealers are in fact free to provide credit facilities to clients, although such business may attract for them unfavourable FRR charges if these loans are backed by their own capital.

• As regards the limits of exposure to individual stock collateral or individual clients, the comments received in response to the proposals on concentrated risk adjustment above are relevant. That apart, it was proposed that a guideline on margin lending policy and procedures could be issued to set out the minimum standards expected to be observed. The guidelines may address credit approval process, credit monitoring process, margin calls, client cash and securities withdrawal, and intra-day trading. There was also suggestion that the companies should have independent credit and audit departments to evaluate the creditworthiness of clients and conduct periodic review of loan files. The regulators have been invited to take into consideration of the above proposals/comments when developing the relevant code.

Margin Call Policy (para. 91 of the Consultation Paper)

• Similarly, the proposal of putting in place suitable margin call policy is to ensure better internal control by securities margin finance providers in their exposure to their margin clients. The Working Group did not propose any further change to it.

Cashflow Management (para. 92 of the Consultation Paper)

• As suggested in the Consultation Paper, licensed securities dealers or securities margin finance providers should be required to perform a periodic review of available banking facilities and assess their adequacy taking into consideration any outstanding client requests for return of their assets and their implications.

Contract Notes and Statement of Accounts (para. 93 - 94 of the Consultation Paper)

• As part of the efforts to ensure adequate risk disclosure, it has been proposed that contract notes should disclose the status of the account and statements of accounts should include the information as to whether an authorisation letter under s.81(3) of the SO has been signed by the clients, and if so, the expiry date. A number of respondents suggested that it would be unnecessary to have the warning message in the statements as clients had already been informed of the nature of a margin account and the risks involved whereas some others proposed that the message should be made on account basis rather than on transaction basis. In view of the fact that some clients might have signed both cash and margin client agreements, the Working Group recommended that the warning message should appear on the monthly statement of accounts and the contract notes should state clearly the status of the account (i.e. whether that particular transaction is effected through the cash or margin account).

Compensation Arrangements (para. 95 - 96 of the Consultation Paper)

• The issue of a compensation scheme for securities margin financing activities is a difficult one and requires a balance to be struck between business viability on one hand and possible consequences in the absence of such scheme during the interim period on the other. During the public consultation, some respondents suggested that SEHK members who also provide securities margin finance service should be covered by a separate scheme other than the present Unified Exchange Compensation Fund and the Broker's Fidelity Insurance Scheme. There was also a suggestion that if the securities margin finance providers have difficulties in soliciting insurance coverage as the Working Group has envisaged, the government should provide assistance for these companies to obtain the coverage or they should be exempted from the requirement.

• The Working Group appreciated that it might be difficult for this small class of registrants to establish a compensation fund and equally difficult for them to secure insurance coverage. The SFC is currently consulting the public on the revised industry compensation arrangements. Parallel assessment is being undertaken on the feasibility of extending the proposed new scheme which includes a re-insurance component to securities margin finance providers. In the event that insurance is not readily available to securities margin finance providers, the SFC would consider accepting a suitable performance bond to be held against claims for compensation.

Transitional Arrangements (para. 97 - 98 of the Consultation Paper)

• As suggested in the Consultation Paper, existing finance companies would be given 30 days from the coming into effect of the relevant legislation to lodge their applications and should comply with the new FRR requirements as and when the licence is granted. As for existing securities dealers who wish to provide securities margin financing, they should notify the SFC of their intention within that 30 day period. They would be given six months of grace period during which they can compute their FRR position without adjusting for the 5% liability test and the minimum paid-up capital requirement due to securities margin financing as well as deductions, if any, in margin client receivable in accordance with the new FRR requirement.

• There were views that existing finance companies should be given three months as opposed to the 30 days to lodge their application for a licence and similarly securities dealers be given the same amount of time to indicate their intention. It was also suggested that the transitional period should be extended to nine months or one year during which existing finance companies should also be saved for the new FRR requirements.

• The Working Group believed that existing finance companies and securities dealers should be able to make their business decision within 30 days after the enactment of the relevant legislation given the prior consultation and the legislative lead time during which the serious business operators would have already been assessing their commercial prospect and viability. The Working Group therefore did not consider that a longer application period would be necessary. As regards the transitional period, the Working Group remained of the view that existing finance companies are effectively unregulated and should be required to comply with the new regulatory requirements as early as possible for the sake of better investor protection. In addition, a longer transitional period will also inevitably lead to more market uncertainty and possibly confusion to investors which should be avoided as far as possible.

Investor Education (para. 99 - 100 of the Consultation Paper)

• In addition to the proposals raised in the Consultation Paper, some respondents suggested that SFC and SEHK should run free seminars for investors to explain the risks associated with securities margin financing, the substance of the protective measures now proposed and the limitations on the protection that the regulatory framework could provide. The SFC and SEHK have been invited to keep the proposals in view when drawing up their future investor education programme.

Other Suggestions

• One respondent specifically suggested that the Securities (Disclosure of Interest) Ordinance should be amended to require banks and brokerage firms to disclose pledges by major shareholders of a corporate in order to allow existing and potential lenders to better assess their credit risks. The Working Group has referred the suggestion to SFC for its consideration in the context of its review of the Securities (Disclosure of Interest) Ordinance now underway.

• There was also a suggestion that the details of the exemption power of the SFC under the proposed regime such as the exemption area, application procedures, judgement criteria, period of exemption to be granted and cost associated should also be made known to the public. As a standing practice, the SFC considers applications for exemptions in a wide range of circumstances, including the compliance with the Code on Unit Trusts, the Takeovers Code and the FRR themselves. The procedure for exemption is straight forward, which requires a written application with reasons and carries certain schedule fees. For check and balance, the decisions of SFC are subject to judicial review.

Financial Services Bureau
4 December 1998

1. The Working Group comprised representatives of the FSB, the Hong Kong Monetary Authority, the SFC, the SEHK, the Companies Registry and the Department of Justice.

2.Section 81(3) of the Securities Ordinance prohibits dealers from using clients' shares to secure loans unless they have the specific written authority from the clients.