Findings of concurrent SFC-HKMA thematic review of spread charges and other practices

Circular
29 October 2021
Circular to intermediaries
Findings of concurrent SFC-HKMA thematic review of spread charges and other practices

1. This circular shares some key observations noted from a concurrent thematic review
   conducted in 2020/21 by the Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA) (hereafter collectively referred to as the Regulators) of intermediaries’ spread charges and related practices as well as their disclosure of transaction-related information. Treatment and disclosure of price improvements, spread charges and pricing arrangements
2. Conflicts of interest can arise when intermediaries manage trades for clients. Upon
   receipt of a client request to buy or sell an investment product, the intermediary may agree on a limit order price1 and place the client order to the market for execution. Price improvements occur when client orders are executed at better prices than the indicative prices quoted from the available counterparties when the order is taken.
3. The Regulators reviewed selected intermediaries’ treatment of price improvements,
   including whether adequate policies and procedures had been put in place to govern the handling of benefits from price improvements and whether proper disclosure of the treatment of benefits arising from price improvements had been made to clients in cases where the intermediary would retain the benefits partially or in full.
4. The Regulators noted different practices amongst the selected intermediaries: some
   passed all the benefits from price improvements onto their clients, whilst others retained all or part of the benefits. A number of them failed to put in place proper policies and procedures for handling these benefits. The expected regulatory standards are set out below:
    If an intermediary is acting as an agent for its client in a transaction, it should not retain the benefits from price improvements.  If an intermediary is acting as a principal in a back-to-back transaction2 , the intermediary could retain the benefits, but it should disclose or agree this arrangement with its clients (see paragraph 8(e)).
5. In respect of spread charges and pricing arrangements, intermediaries may provide
   standard fee schedules to their clients, or enter into bilateral pricing agreements with them, and communicate the fees and charges to the clients prior to or at the point of the transaction. The Regulators reviewed the selected intermediaries’ practices to ascertain 1 The limit order price is usually set with reference to the best indicative price quote obtained by the intermediary from the available counterparties when the order is taken and the intended spread to be charged to the client. 2 Paragraph 8.3(a)(ii) of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct).

whether the spreads or fees charged conformed with the standard fee schedules or pricing arrangements as disclosed to or agreed with the clients. It was noted that some intermediaries:
 failed to put in place adequate controls and monitoring to ensure that the spreads or fees charged adhered to the fee schedules or bilateral pricing agreements agreed with the clients; or  did not have clear and detailed guidance governing the establishment of bilateral pricing agreements. Disclosure of transaction-related information
6. The Regulators also reviewed intermediaries’ compliance with the regulatory
requirements in relation to the disclosure of trading capacity, benefits and other transaction-related information as set out in paragraphs 8.3, 8.3A and 10.2 of the Code of Conduct.
7. The Regulators identified some instances of non-compliance with the transaction-related
disclosure requirements and expect intermediaries to take measures to ensure compliance. The intermediaries concerned were required to undertake remedial action to address the issues identified. Key observations are set out in Annex 1 (for licensed corporations) and Annex 2 (for registered institutions). Expected standards of conduct
8. Intermediaries are expected to, amongst other things:
(a) put in place proper policies, procedures and controls to govern the handling of post￾trade spread amendments, price improvements, pricing arrangements (including but not limited to the establishment and approval of bilateral pricing agreements) and the disclosures required under paragraph 8.3A of the Code of Conduct; (b) ensure that staff members understand the capacity in which the intermediary is acting in a transaction and that this is properly disclosed to clients; (c) ensure that any bilateral pricing arrangements are agreed with clients in writing; (d) disclose the monetary3 and non-monetary benefits to clients in writing prior to or at the point of entering into the transaction – it will not suffice to meet the disclosure requirement under paragraph 8.3(a) of the Code of Conduct if an intermediary simply informs clients that the monetary benefits receivable from a product issuer for distributing an investment product or trading profits to be made from a back-to-back transaction are set out in a standard fee schedule4 previously provided to the client 3 Intermediaries should make a specific disclosure of the monetary benefits or trading profit in the form of a percentage ceiling of the investment amount rounded up to the nearest whole percentage point or the dollar equivalent, prior to or at the point of entering into a transaction. 4 Also applicable to bilateral pricing arrangements.

and asks the client to refer to it without making specific disclosure of the monetary benefits or trading profits prior to or at the point of entering into a transaction; (e) for back-to-back transactions where the intermediary acts as a principal, disclose to (which can be a one-off disclosure) or agree with clients prior to or at the point of the transaction in writing5 :
o it will not retain the benefits from price improvements; or o it will retain the benefits from price improvements and;

• whether the benefits from price improvements would be fully or partially
  retained by the intermediary6
  ; and
• whether the intermediary would retain any amount of monetary benefits
  from price improvements in excess of the amount disclosed to clients prior to or at the point of entering into the transaction (Changes); (f) if the intermediary retained monetary benefits which exceeded that disclosed to the client as a result of price improvements, disclose the actual amount of the Changes or the actual amount of the monetary benefit of the transaction to the client on a post transaction basis in writing as soon as possible5 ; (g) clearly communicate internal policies and regulatory requirements to staff and provide them with appropriate training; (h) implement pre-trade preventive controls and/ or post-trade detective controls to prevent or detect any deviations from the intermediary’s policies and procedures; (i) put in place an adequate reporting mechanism to ensure that any material breaches or deficiencies relating to pricing arrangements are brought to senior management’s attention in a timely manner; and (j) maintain proper records (including but not limited to provisions of the bilateral pricing arrangements) to demonstrate compliance with the requirements.

9. Senior management of intermediaries are reminded that they bear primary responsibility
   for ensuring appropriate standards of conduct and adherence to proper policies and procedures. They should review their systems, controls and procedures, having regard to the expected standards set out in this circular, and ensure compliance with the regulatory requirements under the Code of Conduct. 5 Intermediaries are expected to take actions to comply with the disclosure standards as soon as possible, but no later than six months from the date of this circular if major system or operational changes are needed. 6 This is pursuant to General Principle 1 (honesty and fairness) and General Principle 6 (conflicts of interest) of the Code of Conduct.

10. Should you have any questions regarding the contents of this circular, please contact Ms
    Kammy Kwok on 2231 1455 or your case officer at the Intermediaries Supervision Department, Intermediaries Division of the SFC or Ms Eloise Pun at the Banking Conduct Department of the HKMA on 2878 1903. Intermediaries Supervision Department Intermediaries Division Securities and Futures Commission Banking Conduct Department Hong Kong Monetary Authority Enclosure End HKMA/B1/15C SFO/IS/030/2021

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Ann
A
Annex 1
Key observations by the Securities and Futures Commission This annex shares the key observations from the thematic review conducted by the Securities and Futures Commission (SFC) of spread charges and other practices of licensed corporations (LCs). The thematic review covered selected LCs’ policies, systems, controls and management supervision for the distribution of non-exchange-traded investment products (such as bonds and structured products). Some issues, control deficiencies and examples of good practices observed during the thematic review are set out below. A. Internal control and management supervision over order handling and spread charges Deficiencies and non-compliance

1. An LC represented that it would not retain any benefits from price improvements.
   However, it did not have written policies to clearly communicate this practice to its staff or any pre-trade controls or post-trade surveillance reviews for checking whether benefits were passed on to the clients. During our sample review, we noted an instance where the benefit of price improvement was not fully passed on to the LC’s client. This deviated from the representation made by the firm.
2. Another LC represented that it could retain partially, or in full, the benefits from price
   improvement so long as the final spread charges were within the percentage ceiling of the spread charges agreed with or disclosed to the clients. However, the LC did not provide any guidance on the factors for client-facing staff1 to consider to determine whether the benefits could be retained partially or in full. Also, during our thematic review, we noted some instances where the LC did not inform its clients that it might retain the benefits from price improvements.

Examples of good practices
We noted that an LC required its staff to pass all benefits from price improvements on to clients and adopted various measures to ensure that its staff comply with the firm’s policy:

• the policy was communicated to all staff via the firm’s intranet, training sessions
  and compliance reminders to staff;

• client-facing staff were required to advise the central dealing desk of the intended
  spread on each transaction to be executed for clients. If the central dealing desk executed the client order at a better price, all the benefits will be passed on to the client without changing the intended spread indicated by the client-facing staff. The LC also enhanced its internal pricing system so that bond spreads could not be changed after trades were executed with counterparties; and 1 Client-facing staff were allowed to determine the spread to be charged on each transaction executed for clients, subject to the firm’s internal limits.

• the firm’s independent control function performed regular monitoring reviews to
  identify errors, omissions and other deficiencies in order handling and spread charges (eg, charging a client a fee over the thresholds stated in the firm’s policies) and disclosures of transaction-related information to clients. B. Disclosure of transaction-related information Deficiencies and non-compliance (a) Trading capacity

1. We noted that an LC failed to disclose the capacity in which it acted for its clients prior
   to or at the point of entering into transactions in fixed income securities and structured products. When we interviewed the LC’s staff members2 , they were not able to say whether the firm acted as a principal or an agent in the sampled transactions involving third-party issued structured products (eg, equity-linked notes). After numerous enquiries, the LC represented that it acted as an agent in distributing such products to its clients and received commissions from the product issuers. (b) Affiliations with product issuers and independence
2. Some LCs which transacted in non-exchange-traded products (eg, bonds and funds)
   issued by its group affiliates failed to disclose their affiliation with product issuers, whether or not they were independent and the bases for such determination as required under the Code of Conduct prior to or at the point of entering into transactions with their clients. (c) Monetary benefits
3. An LC made a uniform disclosure of the maximum percentage of trading profits from
   back-to-back fixed income securities transactions3 by disseminating the fee schedule to clients at the account opening stage and annually. It failed to make specific disclosures on a transaction basis.
4. In one case, an LC failed to disclose the existence, nature and the maximum
   percentage of trailer fees receivable for transactions in funds. We noted in another case that an LC disclosed the trailer fees receivable from fund houses to its clients in an email prior to or at the point of entering into a transaction. However, the LC only provided a uniform disclosure of the maximum percentage of the trailer fees receivable based on all the funds on its distribution list. It failed to make specific disclosures of the maximum percentage of the trailer fees receivable for particular funds on a transaction basis.

2 Including staff from client-facing, product dealing and compliance functions. 3 For example, an LC made a disclosure of 5% (rounded to the nearest whole percentage point) whereas it might receive a trading profit of 2.5%, 3.5% or 4.5% as allowed by the LC’s internal pricing policy.

Examples of good practices

1. In disclosing its trading capacity, an LC made a one-off disclosure in client
   agreements. In addition, it disclosed how its affiliate was involved in a transaction by stating that the firm will typically act as an agent to arrange an affiliate to act as a principal for primary offerings and secondary market transactions of fixed-income securities and structured products.
2. In a pre-trade document provided to clients on a transaction basis, the LC also
   disclosed the monetary benefits receivable by the firm and its affiliate as a percentage ceiling of the investment amount for particular types of products under primary offering or secondary market trading.

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Annex 2
Key observations by the Hong Kong Monetary Authority This annex shares key observations in relation to the thematic review of spread charges and other practices 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 clients of non-exchange-traded investment products (such as bonds and structured products). Some control deficiencies and issues as well as examples of good practices revealed from the thematic review are set out below. A. Internal control and management supervision over order handling and spread charges Deficiencies and issues Price improvement

1. Some RIs generally provided an indicative all-in price to the clients during order
   taking. In cases where price improvements occurred, the RIs represented that they could retain partially, or in full, the benefits of price improvements so long as the final spread charges were within the percentage ceiling of spread charges agreed with or disclosed to the clients. However, the RIs did not establish policies and procedures, controls and monitoring for management supervision or internal guidance to staff (e.g. on how the benefits arising from price improvements would be allocated and disclosed to clients).
2. An RI required its staff to indicate the intended spread in the system prior to trade,
   and such intended spread would be used for detecting any post-trade spread amendment. From the sample review, instances were noted where the staff member did not determine the actual intended spread prior to the trade, but only input a ball-park figure as the intended spread into the system for trade execution. The practice defeated the purpose of the intended spread information input into the system as audit trails for monitoring post-trade spread amendment. Spread charges and pricing arrangements
3. Some RIs charged clients a spread higher than that disclosed to the clients in the
   standard fee schedules and/ or bilateral pricing agreements for transactions of bonds and structured products. The RIs did not put in place adequate controls and monitoring to ensure that the maximum limits of spread as set out in the standard fee schedules and the terms of the bilateral pricing agreements were properly adhered to.
4. Some RIs did not have clear and detailed guidance governing the establishment of
   bilateral pricing agreements for ensuring adequate disclosure of relevant material information was provided to clients (e.g. disclosure about the nature, scope of fees and terms of the agreements).

Examples of good practices
Price improvement
1. We noted that an RI required its staff to indicate the intended spread in the order
management system prior to trade (for system-supported products) as audit trails and any subsequent changes in spread or other trade amendment were recorded in the system for monitoring purpose.
2. Some RIs established a dedicated committee or forum specifically to handle and
provide management oversight on pricing and disclosure related matters. The dedicated committee or forum brought to senior management’s attention any pricing related issues, and ensured the identified risks were mitigated in a timely manner. Spread charges and pricing arrangements
3. An RI not only put in place pre-trade system controls (e.g. hard block on the
maximum limit of spread) to prevent overcharging clients against the standard fee schedules and bilateral pricing agreements, but also conducted regular post-trade pricing review to identify any overcharging. B. Disclosure of transaction-related information Deficiencies and issues Monetary benefits
1. Some RIs made a uniform disclosure of the maximum percentage of monetary
benefits received or receivable from transactions of bonds and structured products by disseminating the standard fee schedules to clients at the account opening stage, on a regular basis or upon subsequent updates. However, we observed that:

• Those RIs failed to disclose to their clients the monetary benefits received or
  receivable by the RIs on a transaction basis prior to or at the point of trade in some instances.
• An RI merely made a uniform disclosure of the maximum percentage of
  monetary benefits to clients, but not a specific disclosure of the percentage ceiling (rounded up to the nearest whole percentage point) on a transaction basis as required under paragraph 8.3 of the Code of Conduct.
  2. An RI received a recurring fee, as monetary benefits, from the product issuer based
  on the nominal amount of structured product and the client’s holding period of the relevant product. Some instances were noted that the client-facing staff merely disclosed to the clients such monetary benefits receivable by the RI as a one-off fee, instead of a recurring fee.