Circular to licensed corporations on liquidity risk management

The purpose of this circular is to provide additional guidance to licensed corporations (“LCs”) on establishing and maintaining prudential risk management practices for client money, liquidity and the concentration risks of funding sources within group-affiliated entities.

Hong Kong is an international financial center and Asia trading hub, and as such the securities market is vulnerable to large fluctuations in global market conditions. A sharp swing in market sentiment may cause a widespread liquidity crunch. To ensure financial stability, preventive measures should be implemented to address these risks as far as possible.

The Securities and Futures Commission (“SFC”) remains focused on whether LCs have rigorously evaluated their liquidity needs and developed contingency plans to weather market-wide or idiosyncratic stress. LCs are expected to proactively manage liquidity risks, including concentration limits for counterparties^[1]. In addition, General Principle 8 and paragraph 11 of the Code of Conduct^[2] require LCs to ensure that client assets are adequately safeguarded. Additional risk management should be considered with respect to the deposit locations of client money and sources of funding.

To better safeguard client assets, many regulators globally have tightened the requirements for client money protection. For example, some regulators require financial institutions to report the amount of client money deposited with different entities, and some require that the amount of client money deposited with an individual financial institution be less than a certain portion of total client money or that cash deposits held with any particular bank be limited to the net capital value of the firm’s normal day-to-day operating balances.

Results of fact-finding exercise

The SFC recently conducted a fact-finding exercise^[3] on selected LCs with group-affiliated entities. Two major risk areas were: (i) protection of client money kept with affiliated banks, and (ii) reliance on funding from affiliated group entities.

This circular sets out the SFC’s regulatory concerns and the measures it expects of LCs. Examples of good practices are provided.

1.  Safeguard client money

LCs should keep client money in segregated accounts at all times. However, client money maintained at the LC’s affiliated financial institutions (“FIs”) may be subject to the discretion of the affiliated banking group when any one or more of the connected FIs encounter financial difficulties. Placing and segregating client money with non-affiliated FIs would better safeguard client money.   

In the fact-finding exercise, we noted cases where LCs predominantly deposited client money at affiliated FIs in Hong Kong.

To ensure client assets are adequately safeguarded, the SFC would like to remind LCs to establish, maintain and adhere to prudential risk management practices to safeguard client money, and in particular to set and enforce concentration limits for affiliated FIs.  

LCs should safeguard client money by:

• setting out effective policies and procedures to manage concentration exposure to an affiliated banking group or connected FIs;
  
  
• regularly reviewing concentration exposure to an affiliated banking group and connected FIs; and
  
  
• determining appropriate arrangements and procedures, eg, having segregated accounts at non-affiliated FIs, to reduce exposure to an affiliated banking group or connected FIs on an ongoing basis.

To fulfill the expectations in this guidance, LCs may consider similar practices to ensure sufficient diversification of client money for liquidity risk management.

2.  Funding sources

Abrupt changes in market conditions may trigger a crisis which quickly soaks up liquidity and these conditions may last for an extended period of time. An LC would be adversely affected when it relies on a single or limited funding source.

Our fact-finding exercise found that although many of the LCs had at least one credit facility with multiple FIs, some LCs might obtain funding solely or predominantly from group-affiliated entities.

To properly manage the risks associated with the LCs’ businesses^[4] and to ensure the contingent funds available to LCs are adequate to address liquidity shortfalls in a volatile market situation, LCs should not rely on a single source of funding from within their group. LCs should formulate a diversification strategy which provides for more than one source of funding, conduct regular reviews of existing funding sources including external sources and intragroup support and, where appropriate, obtain additional sources of contingent liquidity from non-affiliated FIs.

LCs may consider similar approaches to ensure independent funding sources are available to enhance liquidity under various market conditions.

Should you wish to clarify any aspects of this circular or in case of doubt, please contact the relevant case officers in charge.

Intermediaries Supervision Department
Intermediaries Division
Securities and Futures Commission

End

SFO/IS/049/2017