Computation of liquid capital in Financial Resources Returns: some common mistakes
A licensed firm must at all times maintain the required liquid capital as prescribed in the Securities and Futures (Financial Resources) Rules (Financial Resources Rules). Liquid capital is the excess of “liquid assets” over “ranking liabilities”, both of which are defined in the Financial Resources Rules. In this compliance hints section, we have summarized some of the common mistakes we have observed when reviewing licensed firms’ draft financial returns:
1. Incorrect haircut percentages applied to proprietary positions. Some firms that have proprietary positions in securities fail to include appropriate haircut percentages to their proprietary positions in the liquid capital computation. Different haircut percentages need to be applied to different types of securities and some investments cannot be included as liquid assets at all.
2. Accounts receivable arising from non-regulated business included as liquid assets. Accounts receivable arising from a licensed firm’s regulated activities that meet specific requirements under the Financial Resources Rules can be counted as liquid assets. However, some firms incorrectly include accounts receivable that arise from non-regulated activities as liquid assets.
3. Concentrated proprietary positions not included as ranking liabilities. Some licensed firms that have proprietary positions exceeding regulatory thresholds do not include the specified percentages under the Financial Resources Rules as ranking liabilities.
4. Net positions in foreign currencies not included as ranking liabilities. Some licensed firms that have net positions in foreign currencies do not include the specified percentage under the Financial Resources Rues as ranking liabilities.
5. Incorrect set-off of assets against liabilities. The Financial Resources Rules provide that the assets and liabilities of a licensed firm must be treated separately on a gross basis and must not be set off against each other. However, some firms incorrectly set off certain assets against liabilities.
Deficiencies identified in the SFC’s and HKMA’s thematic review of the distribution of non-exchange traded investment products
On 18 April 2024, the Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA) jointly issued a circular that contained their observations following the thematic review of the distribution of non-exchange traded investment products. The circular highlighted some deficiencies in performing product due diligence, suitability assessment, providing information to clients, and ensuring investment products are in the best interest of the clients. These deficiencies include:
1. Senior management of some firms approved investment products for offering to clients despite omissions and errors during the product due diligence process.
2. Some firms failed to conduct a thorough assessment of the characteristics, nature, and extent of risks associated with each investment product that they offered to clients.
3. Some firms failed to show a proper understanding of the nature and level of risks associated with the structured products they sold to their clients. As a result, they were unable to provide clear explanations about the features and extent of risks involved, which made it difficult for investors to make well-informed investment decisions.
4. Some firms lacked adequate procedures to ensure that product due diligence was conducted continuously or at intervals proportionate to the nature, features, and risks of investment products.
5. Some firms overlooked whether the design of the risk profiling questionnaire questions and its underlying scoring mechanism could produce skewed results toward high-risk tolerance.
6. Some firms did not provide clear guidance to staff on the types and categories of investment products that would add to a client’s concentration level and failed to properly assess the client’s concentration risk.
7. Some firms failed to provide all relevant transaction-related information to their clients, including disclosure of the maximum percentage of monetary benefits that are receivable by them.
Regulators keep a close eye on the distribution of investment products and regularly issue circulars in this regard. Therefore, licensed firms that distribute investment products should focus on the areas covered by these circulars and regularly assess their business to ensure that their operations align with the regulators’ expectations.
