Concurrent SFC-HKMA Thematic Review of the Distribution of Non-Exchange Traded Investment Products

Circular
18 April 2024
Joint circular to intermediaries
Findings of concurrent SFC-HKMA thematic review of the distribution of non-exchange traded investment products

1. During a concurrent thematic review1 of the distribution of non-exchange traded
   investment products by intermediaries, the Securities and Futures Commission (“SFC”) and the Hong Kong Monetary Authority (“HKMA”) identified some issues on intermediaries’ practices in performing product due diligence (“PDD”) and suitability assessment, providing information to clients and ensuring investment products are in the best interests of the clients. The intermediaries concerned were required to undertake remedial action to address the issues identified. Key observations

2. Many intermediaries would assign risk rating to investment products as part of PDD for
   matching with client’s risk tolerance level, either calculated using their internal risk￾scoring mechanisms or based on the nature of underlying investments. The regulators noted that some intermediaries had overlooked certain key features and risk factors in their PDD assessment methodologies which could directly or indirectly impact the risk return profiles and growth prospect of the investment products. In some cases, intermediaries did not consider during the assessments the pay-out and characteristics of a leveraged structured forward contract, credit events relating to the product issuers, heightened market and industry risks, or adverse economic and political environments.

3. These intermediaries could run the risk of making inappropriate recommendations to
   clients if the risk return profiles of the products were not adequately assessed and accurately reflected in the product risk ratings used for the suitability assessment. Under such circumstances, the ability of intermediaries to fully inform clients the nature and extent of risks of the products would also be adversely affected. The risk would be further aggravated if the investment products, such as structured products, have leverage features which could amplify potential losses.

4. Structured products were the most prevalent type of non-exchange traded investment
   products sold by intermediaries. Among the structured products, accumulators and decumulators were the most popular products sold.2 Accumulators and decumulators are derivative products associated with significant investment risks. Investors typically risk a loss up to the notional amount of the contracts, and could only achieve positive returns if the price of the underlying asset moves within the defined range between the strike price and the knock-out price that was set to limit the maximum amount of profit. The loss could be unlimited in some cases, for example, where the investors of decumulators have to bear the loss when the price of the underlying asset goes up. 1 See the Joint circular to intermediaries on Concurrent SFC-HKMA thematic review of the distribution of non-exchange traded investment products issued on 1 March 2022. 2 See the SFC-HKMA Joint Survey on the Sale of Non-exchange Traded Investment Products 2022.

5. Clients would not be able to understand the characteristics of accumulators and
   decumulators should the intermediaries merely hand over the product literature to the client, ask the client to read them, or read them to the client without any explanation. In one case, a salesperson was unable to explain why investors could buy shares at a price lower than the market price with an accumulator contract. He could only read out the value of its “discount” compared to market price, its knock-out clauses and potential losses from the relevant term sheet. It is therefore imperative for intermediaries to develop thorough understanding of structured products during PDD and provide adequate training to staff to ensure that they are fully conversant with the characteristics, nature and extent of risks of the products recommended to clients.

6. Intermediaries are reminded to exercise due skill, care and diligence in selecting
   investment products for different risk categories of clients and arrive at an assessment of the products taking into account information that is appropriate and reasonably available for a fair and balanced assessment. Failure to do so could severely inhibit intermediaries’ ability in helping clients to make an informed investment decision.

7. The regulators also wish to remind all intermediaries of their obligations to, among other
   things –
   (i) give due consideration to all the relevant circumstances specific to a client when assessing the suitability of a product to the client; and (ii) disclose all relevant transaction related information, and ensure that information provided and any representations made are accurate and not misleading.

8. The observations from the concurrent thematic review on licensed corporations are set
   out in Annex 1 and those on registered institutions in Annex 2. Intermediaries are expected to review their policies and procedures to address any issues relevant to their firms with a view to improving compliance, having regard to relevant annexes.

9. Should you have any questions regarding the contents of this circular, please contact Ms
   Nicole Cheung on 2231 1492 or your case officer at the Intermediaries Supervision Department of the SFC or Ms Eloise Pun at the Banking Conduct Department of the HKMA on 2878 1903. Intermediaries Supervision Department Banking Conduct Department Intermediaries Division Hong Kong Monetary Authority Securities and Futures Commission Enclosure End SFO/IS/017/2024 HKMA/B1/15C

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Annex 1
Key observations by the Securities and Futures Commission

1. This annex shares key observations from the thematic review of the distribution of non￾exchange traded investment products conducted by the Securities and Futures
   Commission (“SFC”) on licensed corporations (“LCs”). The thematic review covered selected LCs’ policies, procedures, systems and controls, as well as management supervision of the distribution of structured products (including accumulators and decumulators), corporate bonds and funds. A. Product due diligence (“PDD”)
2. PDD involves intermediaries developing of a thorough understanding of the investment
   products based on their review of relevant product information that is appropriate and reasonably available, and identifying the key terms and features of investment products which delineate respective characteristics, nature and extent of risks. Where relevant, it should also take into account market and industry risks, economic and political environments, regulatory restrictions and any other factors directly or indirectly impacting the risk return profiles and growth prospects of the investment products. (a) Lack of proper verification work and management supervision
3. LCs commonly set out in their policies and procedures a list of factors to be considered
   as part of their due diligence work when selecting investment products for clients. We noted instances where LCs’ senior management failed to make appropriate enquiries or verification on the investment products, and approved them for offering to clients despite omissions and errors during PDD. SFC’s observations (i) Some LCs’ senior management approved substandard PDD documentation which had obvious omissions or contained inaccurate analyses on investment products without verifying respective work. For example, they misdescribed an accumulator as a coupon-bearing instrument, misdescribed the bid/ask price of a Chapter 37 Bond1 as being determined on an exchange, misstated bonds ranked pari passu with other unsecured unsubordinated debts of the issuers as “senior secured”, or misidentified a secured bond as being collateralised by real estate properties of the issuer instead of capital stocks of its subsidiary guarantors with no material operations.

1 Being bond offered for subscription and listed under Chapter 37 of The Rules Governing the Listing of Securities on the Stock Exchange of Hong Kong Limited (“Chapter 37 Bond”), which was not traded on an exchange.

4. LCs failing to afford sufficient review of the investment products for identifying key terms
   and features, including special features, would not be able to duly assess the characteristics, nature and extent of risks of each investment product offered to clients. SFC’s observations (i) Some LCs did not identify for their clients the special features of bonds, such as variable coupons, bondholder’s put option to demand issuer repurchasing on a specific date, loss absorption or multiple credit support structures. Failure to identify and adequately assess these special features which could fundamentally alter the risks and pay-out of the bonds would adversely affect the LCs in helping clients to make an informed investment decision.
5. LCs had sometimes overlooked qualitative factors such as heightened market and
   industry risks, as well as adverse economic and political environments that could also impact the risk return profiles and growth prospect of the investment products. SFC’s observations (i) An LC having required its staff during PDD to consider the credit risks of product issuers with reference to their credit rating and credit default swap price did not provide guidance on respective criteria of approval. (ii) Where high-yield bonds could be more sensitive to economic downturns compared to investment-grade bonds when default risk increases, some LCs selected high-yield bonds for clients merely because of their discounted price and yield advantage over higher-quality bonds, or an issuer exhibited a better prospect of recovery relative to its peers in the industry. However, when credit events and adverse news were severely affecting the market or industry, the LCs did not assess the risks of bonds arising from the commonly deteriorating credit quality across the industry. Nor was there sufficient analysis to support why the high-yield bonds would be considered suitable for clients looking to make bond investments. (b) Inconsistent assessment on product risks
6. Many LCs had assigned risk rating to investment products for matching with the client’s
   risk tolerance level, either calculated using their internal risk-scoring mechanisms or based on the nature of underlying investments. Where staff were allowed to exercise discretion in adjusting the calculated risk-scores or deviate from the LC’s risk assessment methodology, inadequate guidance in this respect would result in inconsistent assessment.

SFC’s observations
(i) An LC assigned product risk ratings to funds primarily based on the nature of underlying assets (e.g. equity funds, high-yield bond funds or investment grade bond funds), their redemption frequency, lock-in period and authorisation status. It further required its staff to consider generally the level of risk of underlying investments, concentration, their use of derivatives and leverage in their assignment of product risk ratings. However, no guidance was provided to staff on how the risk rating should be adjusted in light of these factors. (ii) An LC classified funds into high, medium or low risks, but it did not provide guidance to staff on the respective criterion of determination. It was unable to explain the rationale underlying its staff’s assessment for classifying a high￾yield bond fund not authorised by the SFC as low risk, as compared to other investment-grade bond funds classified as medium risk. (c) Failure to adequately consider the nature and extent of risks of structured products
7. When structured products, particularly accumulators and decumulators, remained the
most prevalent type of products sold by LCs2
, some LCs were not able to demonstrate a good grasp of the terms and features, characteristics of each structured product sold to clients. Some LCs might have underestimated potential losses. LCs failing to thoroughly understand the nature and extent of risks of structured products could severely inhibit their abilities in helping clients with various objectives and horizons to make an informed investment decision.
8. For instance, accumulators incorporate a series of option contracts giving investors the
right to buy the underlying asset at a predetermined strike price that is often set at a discount to the prevailing market price. While investors selling the put option could incur a loss throughout the contract tenor and up to the maximum notional amount, their positive return could only be fully achieved when the price of the underlying asset moves narrowly between the strike price and a knock-out price that was set to limit the maximum amount of investors’ profit. Therefore, accumulators would not offer good value to investors during a volatile market, or for investors looking to maximise their gain from any sharp price changes. SFC’s observations (i) A staff member of an LC who had been selling accumulators to clients was unable to illustrate any understanding that the “discount” in fact represented the premium received by clients from selling a (series of) put option. Neither was he able to explain the deeper the “discount”, the greater the risks. This also led to concerns on whether the staff member could properly explain to clients the characteristics, nature and extent of risks of an accumulator by merely reading

2 See the SFC-HKMA Joint Survey on the Sale of Non-exchange Traded Investment Products 2022.

out from a term sheet the quantum of its potential return, its knock-out clause and the maximum loss from the investment. (ii) An LC assigned product risk rating to structured products based on the nature of their underlying asset. It had classified an equity-linked fixed coupon note as high risk, and a foreign exchange target redemption forward contract (“FX￾TARF”)3 as medium risk. However, the terms and features, pay-out and characteristics of the FX-TARF were akin to accumulators and/or decumulators and investors could incur unlimited losses under the contract. It also contained a leverage feature which would have multiplied any amount of loss significantly. The LC’s assessment of the FX-TARF being generally suitable for clients willing to accept a moderate level of investment risks despite the heightened volatility from the currency pair, and describing its potential maximum loss as non￾principal protected, were clearly inadequate and insufficient to reflect the nature and extent of risks of the structured product. (d) Insufficient ongoing PDD
9. Some LCs maintained a list of approved investment products they could distribute to
clients, but they did not have procedures in place to ensure that PDD was conducted on a continuous basis or at intervals proportionate to the nature, features and risks of investment products to ascertain whether the products remain suitable for their clients. SFC’s observations (i) An LC did not review its previous PDD work when selling investment products to clients in instances where a bond issuer had defaulted repayment on its other bonds, or when the investment manager of a fund was changed. (ii) An LC implemented a new product risk-scoring mechanism only to assess new products but not its existing products. When the existing products remained on the firm’s product shelf, and a certain portion would be adjusted to a higher risk rating if assessed under the new mechanism, failure to assess its existing products would hinder the LC’s suitability assessment when the products it sold to clients were risk-rated with different methodologies producing varying results. (iii) When assigning product risk ratings, some LCs gave significant weighting to the period-to-date return and/or volatility of an investment product, or those of its underlying investment. However, these LCs did not subject a product to review when its return deteriorated, or when volatility heightened during the product tenor. They have failed to ensure that their understanding on the

3 The FX-TARF was a structured forward contract involving a series of forward transactions. The investor’s potential gain was limited by a target profit, but there was no ceiling on potential losses as the investor in unfavourable situation would remain obliged to exchange currencies at the predetermined rates according to a regular schedule during the tenor of the contract. As the FX-TARF also contained a leverage feature, varying notional amounts might be involved magnifying the investor’s risks associated with the contract.

product remained relevant for subsequent suitability assessment, particularly whether the product risk rating continued to reflect the product’s risk return profile during changing conditions. (iv) When the price of a bond dropped beyond a percentage threshold set by an LC for triggering ongoing PDD, its review only focused on the general analysis on market outlook and industry performance, without reassessing the credit quality of the issuer who had been subject to several downgrading actions by credit reference agencies over time. The ongoing PDD work performed was insufficient to illustrate, for instance, in what aspects the specific bond remained suitable for its clients. B. Suitability assessment
10. Suitability assessment is a risk-based process that involves intermediaries matching of
investment products with the personal circumstances and risk tolerance of clients. While many LCs relied on the matching of the product risk rating with their assessment result on a client’s risk profile as their primary consideration, they are reminded to take into account all the relevant circumstances specific to a client, including the client’s financial situation, investment experience, objectives, horizon and concentration risk, when assessing the suitability of a product to the client. (a) Inadequate risk profiling of clients
11. There were different ways for LCs to assess a client’s attitude towards risk for the
purpose of suitability assessments. Where a risk profiling questionnaire (“RPQ”) was used and risk-scores were assigned to the client’s answers to support an assessment, some LCs had overlooked whether the design of the RPQ questions and its underlying scoring mechanism could produce skewed results towards high risk tolerance. SFC’s observations (i) An RPQ used by an LC did not seek to understand from its clients their tolerance of the risk of capital loss. It had instead assigned significant weighting on the client’s investment experience, where the maximum scores assigned to multiple questions relating to the client’s investment experiences would have qualified one as having high risk tolerance. The RPQ would hence produce skewed results on experienced investors; and the LC was unable to justify the disproportionate correlation of one attribute with the client’s risk tolerance. (b) Inadequate consideration of clients’ concentration risk
12. Some LCs did not provide clear guidance to staff on the types and categories of
investment products that would add to a client’s concentration level, nor the nature of assets (e.g. investible, liquid or otherwise) that form the bases of consideration. It calls

into question as to whether an assessment of the client’s concentration risk had been properly and consistently performed. SFC’s observations (i) Some LCs relied on their staff to assess a client’s concentration risk by assessing whether the client’s investments in the same type of product had exceeded a predetermined concentration threshold. However, it was noted that staff had taken different interpretation as to products falling within the same type. Where some staff considered it to include all products within an asset class (e.g. funds), some differentiated them between authorised and unauthorised funds, and some others narrowly differentiated them between fund managers or product issuers. (ii) Where the information about a client’s net worth obtained during account opening may not provide accuracy when used in concentration assessment (e.g. the band range being representative of the client’s net worth was set too wide as answer options on the account opening form), the LC arbitrarily used the maximum value in the band range as the value for the assessment. The LC did not make further enquiry about an appropriate reference to be used. If the mid-point or minimum value in the band range was used, the transaction would be assessed as overly concentrated by the LC.
13. LCs which only focused on the concentration risk of a transaction but neglected
information available to them, including the client’s investments in the account, would not be able to properly assess the overall impact of the transaction on the client’s portfolio. SFC’s observations (i) The staff of an LC assessed a client’s concentration based on a value of the client’s net worth that was 10 times greater than the LC’s record about the client. The LC was unable to demonstrate any clarification made by its staff with the client, nor could the LC ascertain whether the value was representative of the client’s net worth. (ii) An LC did not consider a client’s aggregated exposure on high-risk products, arising from all equity-linked structured products it sold to the client over a short period of time when assessing the client’s concentration risk. (iii) When assessing a client’s concentration risk, some LCs did not consider the client’s exposures on an issuer arising from the client’s holding of high-yield bonds and shares of the issuer, which in aggregate accounted for a very significant portion of the client’s portfolio maintained with the LCs respectively.

14. Many LCs had set concentration thresholds on their clients in respect of the maximum
    proportion of a client’s net worth and/or investment portfolio that may be invested in high￾risk products. While exceeding a particular concentration level may be acceptable so long as the outcome is commensurate with the overall risk profile of the investment portfolio and the client’s other circumstances, some LCs could not justify the set threshold or any exception. SFC’s observations (i) An LC allowed clients of a moderate risk tolerance level to invest up to 80% of the client’s portfolio in investment products classified by the LC as high risk, but the LC could not justify such determination as being commensurate with the clients’ portfolios or the circumstances of all such clients. (ii) An LC allowed its clients during risk profiling to indicate any value between 0% and 50%, or “over 50%” as their acceptable level of concentration. Where clients had indicated to accept a concentration level of over 50%, the LC did not otherwise assess a client’s concentration in high-risk investment products. Neither could it justify in what aspects would an unlimited level of concentration be considered suitable for these clients. Further, clients would be asked to risk￾accept a transaction should it exceed the client’s acceptable level of concentration previously indicated. We were concerned about the LC’s practice to solely rely on a risk acceptance statement made by clients for discharging its suitability obligations.
    C. Information for clients
15. LCs are reminded to deliver all relevant transaction related information4 to a client when
    distributing investment products to the client, prior to or at the point of entering into the transaction. They should act to ensure that any representations made and information provided to the client are accurate and not misleading.
16. Some common deficiencies noted in this respect are highlighted below –
    SFC’s observations
    (i) Many LCs receiving trailer fees from fund managers indirectly through their execution brokers did not disclose the maximum percentage of such monetary benefits receivable per year and per fund on a transaction basis. 5

4 In accordance with paragraph 8.3A of the Code of Conduct Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (“Code of Conduct”). 5 In accordance with the expected standards set out in the answer to question 2 of the Frequently Asked Questions on the Code of Conduct issued on 16 November 2017, and the answer to question 1 of the Frequently Asked Questions on the Code of Conduct issued on 15 June 2018, respectively.

(ii) An LC inaccurately represented itself as being independent when it had in fact received fees and commissions for distributing investment products. Other LCs often did not disclose their affiliation with product issuers, the fact that they were not independent or the bases for such determination.6 (iii) Many LCs explained to clients the risks and consequences of being treated as a Professional Investor (“PI”) with the use of a proforma notice setting out all provisions under paragraph 15.4 and/or paragraph 15.5 of the Code of Conduct the LC could disapply when dealing with PIs. However, the LCs in practice did not disapply the provisions when dealing with clients qualified as PIs. This practice might cause confusion to clients as to whether the Code of Conduct requirements are disapplied by the LCs. 6 In accordance with paragraph 10.2 and Schedule 9 of the Code of Conduct.

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Annex 2
Key observations by the Hong Kong Monetary Authority

1. This annex shares key observations in relation to the thematic review of the distribution of
   non-exchange traded investment products conducted by the Hong Kong Monetary Authority (HKMA) on registered institutions (RIs). The thematic review covered the selected RIs’ policies, systems, controls and management supervision on distribution to customers of non-exchange traded investment products such as funds, bonds and structured products. A. Product due diligence process and assignment of product risk rating (“PRR”) Existing requirements
2. RIs should establish and implement appropriate and effective systems and controls to
   ensure that product due diligence assessment of the investment products should be fair and balanced, taking into account the local circumstances and regulatory requirements, as well as other relevant information that is reasonably available. The mechanism for assessing product risks and assigning PRR to investment products should be reasonable, taking into account all relevant factors. Any special features or complex structure of investment products and the applicable regulatory requirements should be taken into account.
3. The selected RIs generally put in place policies and procedures governing the product
   due diligence process and assignment of PRR. There were some instances that the RIs did not give due consideration to some key features and risk factors during the assignment of PRR to the investment products. HKMA’s observations (i) The PRR model of some RIs did not take into account some key features and risk factors which may directly or indirectly impact the risk return profiles and growth aspects of investments when assigning the PRR to corporate bonds (e.g. salient product risks such as market risks, industry risks, country risks etc.). As a result, some corporate bonds were assigned a PRR which was lower than warranted given the risk factors and complex features, and sold to customers with conservative risk appetite. (ii) When assigning a PRR to structured products, an RI mainly considered the financial features of the products (e.g. market price, payoff, strike price of the underlying assets etc.) without adequate consideration of key risks inherent to structured products (e.g. principal at risk, risk of underlying asset, risk associated with a basket of underlying equities, etc.).

(iii) An RI lowered the PRR of a bond to the lowest risk rating based on the consideration that the bond was close to the maturity date without consideration of the salient product risks (such as market risks, industry risks, default risks, etc.) which might remain despite the shorter time to maturity. B. Suitability assessment Existing requirements
4. RIs are reminded that they should obtain relevant information from customers about their
personal circumstances for assessing suitability of investment products for customers. RIs should have in place adequate systems and controls to conduct a reasonable assessment of customer’s risk tolerance and avoid anomalous profiling results. RIs should act with due skill, care and diligence and seek clarification from the customers on any conflicting information provided.
5. Some RIs adopted risk scoring questionnaire to assess a customer’s risk tolerance level
for the purpose of suitability assessment but they did not implement adequate checking mechanism to ensure the final profiling result could truly reflect the customer’s risk appetite. HKMA’s observations (i) Some RIs did not put in place consistency check between answer of individual questions against the customer’s final risk profile result. It was noted in an instance where a customer’s risk tolerance level could be “very aggressive” despite that a customer’s answers to questions concerning the investment objective and attitude towards risk were relatively conservative. Also, the RIs did not require their staff to make proper enquiries with, or seek clarification from customers about the possible inconsistencies.
C. Best execution
Existing requirements
6. Delivering best execution is fundamental to market integrity and protection of investors
who rely on RIs to act in their best interests during the execution process. RIs should execute customer orders on the best available terms to deliver best execution. RIs should establish proper policies and procedures regarding best execution to cover different types of investment products and which should be reviewed and updated on a regular basis. RIs are expected to have in place arrangements, including controls, monitoring and management supervision, to obtain the best available terms. Arrangements should be subject to periodic review to ensure best execution is achieved consistently.

7. Some deficiencies and issues were revealed in this aspect.
   HKMA’s observations
   (i) Some RIs did not have in place proper policies and procedures about best execution. Deficiencies were identified about the RIs’ performance of ensuring best execution; records keeping; disclosure to customers about best execution arrangement; and inadequate controls and monitoring by relevant functional units.