Securities & Futures Commission of Hong Kong

Fund Manager Code of Conduct

A. General

Q1:

A number of requirements under the FMCC are specified to be applicable to a Fund Manager that is responsible for the overall operation of a fund.  In this connection, what is the meaning of a Fund Manager that is responsible for the overall operation of a fund?

A:

The FMCC applies to all licensed or registered persons acting as Fund Managers, including, as appropriate, their representatives. Certain requirements (as specifically set out in the FMCC), however, are only applicable to a Fund Manager that is responsible for the overall operation of a fund. 

The SFC notes that despite the governing body of a fund (for example, the board of directors (BOD) for a fund adopting a corporate structure or the trustee for a fund in a unit trust form) may be the legal party responsible for formally making decisions relating to the fund (such as appointing the custodian or deciding on major issues such as how pricing errors and fair valuations should be handled), the fund manager may still in substance be the party responsible for the overall operation of a fund.

For SFC-authorized funds primarily regulated in overseas jurisdictions, the overseas management company is often also the fund manager that is responsible for the overall operation of the fund.

To determine whether a fund manager is the party responsible for the overall operation of a fund, a fact-based review is necessary to ascertain whether in substance it is responsible for the day-to-day operation and management of the fund.

The following are non-exhaustive lists of examples of when a fund manager may or may not be considered to be responsible for the overall operation of a fund:

Non-exhaustive list of examples of when the fund manager IS considered to be responsible for the overall operation of the fund

  • Where the senior management or shareholders of a fund manager constitute a majority of the BOD of the fund.
  • Where the representatives of the fund manager or its subsidiaries constitute a majority of the BOD of the fund.
  • Where the fund is in the form of a limited partnership and the fund manager is the general partner, and the general partner has the responsibility in law to serve as the governing body of the fund.
  • Where the fund manager is responsible for day-to-day management of the fund despite having to seek the agreement of the trustee on significant matters.

Non-exhaustive list of examples of when the fund manager IS NOT considered to be responsible for the overall operation of the fund

  • A Hong Kong fund manager appointed by an overseas management company as sub-manager to manage a fund or an allocated portion of the fund.
  • Senior management of Hong Kong fund manager’s overseas affiliate sits on the BOD of the fund while the Hong Kong fund manager acts as sub-manager.

The above examples are non-exhaustive and for illustration only.  Fund Managers should understand its operations and ensure compliance with the relevant FMCC requirements.

A Fund Manager should use due skill, care and diligence to comply with the requirements in the FMCC to the extent that is within its control.

For the avoidance of doubt, certain generally-applicable FMCC requirements, such as organisation and management structure, staff ethics, record keeping and conflicts of interest requirements, should be complied with by all Fund Managers.


B. Securities Lending, Repo and Reverse Repo transactions

Q2:

A Fund Manager should have collateral valuation and management policy, haircut policy, and cash collateral reinvestment policy in place to manage the counterparty risk of the fund it manages.  The policy should cover the methodology to calculate haircuts on collateral received in connection with securities lending, repo and reverse repo transactions of its funds, whether on a transaction level basis or at the collateral portfolio level. 

In this connection, what should a Fund Manager consider when designing the (i) methodology to calculate haircuts and (ii) cash collateral reinvestment policy in respect of securities lending, repo and reverse repo transactions?

A:

A Fund Manager is expected to exercise professional judgement and give due consideration to the specific nature of each fund it manages when designing the haircut methodology and cash collateral reinvestment policy, taking into account the Financial Stability Board’s (FSB) recommendations1

Fund Managers should consider and assess the acceptability of collateral when formulating their collateral and haircut policy.

In particular, Fund Managers should note the following FSB recommendations in this connection:

(i) Haircut methodology

The haircut methodology of a Fund Manager should be designed on the basis that haircuts are set to cover the maximum expected decline in the market price of the collateral asset (over a conservative liquidation horizon) before a transaction can be closed out. 

The maximum price decline used to determine the applicable haircut should be calculated using a long time series of price data that covers at least one stress period.  If such historical data is either unavailable or unreliable, then stress simulations or data for other similar asset types as a proxy (including at least one stress period and with prudent adjustments made as appropriate) should be used.  The assumed liquidation horizon should be conservative, reflect the expected liquidity or illiquidity of the asset in stressed market conditions, and depend on the relevant market characteristics (such as trading volumes and market depth) and other special characteristics of the collateral. 

Haircuts should cover different risk considerations where relevant, including market risk, counterparty credit risk and foreign exchange risk. Additional factors to be considered in setting the appropriate haircut should include:

  1. specific characteristics of the collateral; and
  2. the correlation between securities accepted as collateral and the lent securities.

(ii) Cash Collateral Reinvestment Policy

In addition to the specific requirements set out in the FMCC that a Fund Manager should consider when designing its cash collateral reinvestment policy, the following requirements could also be considered:

  1. setting a maximum remaining term to maturity for any single investment in which the cash collateral is reinvested which could vary by asset class based on the liquidity of the instruments; and
  2. setting concentration limits in respect of exposure to individual securities, issuers, guarantors, security types and counterparties.

 

1 Please refer to the FSB reports, Strengthening Oversight and Regulation of Shadow Banking: Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, 29 August 2013, and Transforming Shadow Banking into Resilient Market-based Finance: Regulatory framework for haircuts on non-centrally cleared securities financing transactions, 12 November 2015.

Q3:

Can non-cash collateral received under securities lending arrangements be re-hypothecated?

A:

In respect of SFC-authorized funds, non-cash collateral should not generally be re-hypothecated. Fund Managers should comply with the relevant requirements under the UT Code and the SFC Products Handbook as updated from time to time. 

In respect of non-SFC-authorized funds, as the SFC does not regulate such funds, accordingly the SFC does not regulate whether such funds re-hypothecate non-cash collateral received under securities lending arrangements.  However, Fund Managers should put in place and adhere to appropriate risk management policy and comply with other relevant regulatory requirements, including the requirement to disclose re-use and re-hypothecation data to fund investors that is set out in the FMCC.

Q4:

Where a fund has appointed a third-party agent for conducting securities lending, repo and reverse repo transactions on behalf of the fund, is the Fund Manager required to comply with the relevant FMCC requirements in relation to the provision of information on such transactions of the fund to fund investors?

A:

Yes, if it is the Fund Manager that is responsible for the overall operation of the fund and engages in securities lending, repo and reverse repo transactions. In such a case, where a third-party agent is appointed to conduct securities lending, repo and reverse repo transactions on behalf of a fund, the Fund Manager should obtain access to the relevant information from the third-party agent.  For instance, the Fund Manager should ensure that the trustee / BOD of the fund can exercise its power to receive information on such transactions from the agent (for example, by way of its contract with the agent) and pass on the information to the Fund Manager or make the required disclosure to fund investors. 

Where the Fund Manager has delegated reporting matters to another party (eg, the trustee / BOD), it still remains responsible for complying with the reporting requirements in the FMCC.

C. Liquidity Management

Q5:

A set of liquidity management principles for Fund Managers are currently specified in the FMCC. Which of these principles are considered to be applicable to private funds?

A:

While liquidity risk management is a particular concern for open-ended funds, some of the liquidity management principles specified in the FMCC are also relevant to closed-ended funds (for example, sources of liquidity risk may include margin calls or other financing obligations to counterparties on a timely basis). As such, Fund Managers responsible for the overall operation of such funds should consider which principles are relevant. The intensity and frequency in the implementation of the liquidity management principles should be appropriate to the nature, liquidity profile and asset-liability management of each fund.

Q6:

In accordance with the FMCC, a Fund Manager is required to conduct regular assessments of liquidity in different scenarios, including stressed situations, to assess and monitor the liquidity risk of the funds accordingly. Does the Fund Manager have any discretion to decide which fund or account requires regular stress testing? For example, do passive funds require stress testing at all?

A:

A Fund Manager should perform liquidity stress testing on its funds on an ongoing basis to assess the impact of plausible severe adverse changes in market conditions on the liquidity of the funds. The extent or frequency of the testing should be proportionate to the nature and liquidity profile of each fund.  The SFC expects that stress test results should be reviewed by a committee responsible for liquidity risk management and/or senior management to determine whether further actions are warranted.  Even if it is decided that no immediate actions are warranted, the Fund Manager should have in place action plans regarding how it would meet the fund’s liquidity needs should any of the stress scenarios materialise.

D. Fund Portfolio Valuation

Q7:

The FMCC currently requires a Fund Manager that is responsible for the overall operation of a fund or has been delegated responsibility for fund valuation to ensure that, in respect of the fund it manages, appropriate policies and procedures are established so that a proper and independent valuation of the fund assets can be performed and valuation methodologies are consistently applied to the valuation of similar types of fund assets. In meeting this requirement, how can an independent valuation of fund assets be achieved?

A:

The International Organization of Securities Commissions (IOSCO) has published certain principles for the valuation of collective investment schemes2 which requires that, amongst others, the valuation policies and procedures should seek to address conflicts of interest.

The independent valuation of fund assets serves as a mechanism to mitigate a Fund Manager’s conflicts of interest as a fund’s management fees are typically charged based on the fund’s valued asset size.  Accordingly, it is generally considered that independence in the processes adopted for valuation may be achieved by: 

  1. the appointment of a qualified independent third party (being a legal or natural person independent from the fund, the Fund Manager and any other persons with close links to the fund or the Fund Manager) to be involved in the valuation process;
  2. the use of a trustee/custodian, as applicable, to ensure that the Fund Manager carries out the valuation of the fund assets appropriately; 
  3. the separation of the valuation / pricing function from the investment management function to ensure that the persons who are responsible for making investment decisions will not determine the valuations, although they may be able to provide input as appropriate;
  4. review of the valuation by persons who are hierarchically and functionally independent of the investment management function; 

    OR

  5. in case the valuation/pricing is obtained from a third party that itself has a conflict of interest (e.g. being the counterparty, the structurer or the originator), verification of the valuation with an appropriate degree of objectivity by one of the following:
    (i) an appropriate party which is independent from the third party, at an adequate frequency and in such a way that the Fund Manager is able to confirm the valuation;
    (ii) the trustee/custodian of the assets of the fund;
    or
    (iii) a unit within the Fund Manager which is independent from the unit in charge of managing the assets and which is adequately equipped for such a purpose.

2 Please refer to IOSCO’s Principles for the Valuation of Collective Investment Schemes, May 2013.

Q8:

The FMCC currently requires that the fund’s asset valuation policies, procedures and process should be periodically reviewed (at least annually) by a competent and functionally-independent party such as a qualified independent third party or a person performing an independent audit function. The review by such party should include testing the valuation procedures by which fund assets are valued.  

In order to meet these requirements, what are SFC’s expectations regarding the scope of the review by the competent and functionally-independent party?

A:

According to the relevant IOSCO principles in relation to the periodic review of valuation policies and procedures, the scope of the review by the functionally-independent party could include, without limitation, the following assessment criteria: 

  1. whether the valuations are consistent with the designated methodologies;  
  2. whether any pricing overrides and errors are handled in accordance with the policies and procedures; 
  3. whether the fund’s disaster recovery and business continuity policies and procedures are capable of ensuring that the valuation process can be carried out in the event of an emergency or other service disruption; 
  4. consistency of fund’s asset valuation calculations; and 
  5. testing the valuation procedures by which the Fund Manager values its assets.
Q9:

Would an in-house function of the Fund Manager that is independent from the valuation team (e.g. internal audit) be considered a functionally-independent party for the review of fund’s asset valuation process?

A:

It is important that the valuation process should be reviewed by a competent and functionally-independent party. A review of the valuation process by an external auditor would satisfy this requirement. If the valuation process is reviewed by an internal auditor, it should be functionally-independent from the valuation team.

Q10:

Does an audit performed in accordance with International Standard Assurance Engagements (ISAE) No. 3402 meet the FMCC requirements requiring a review of the fund’s asset valuation process?

A:

If the audit performed in accordance with ISAE No. 3402 covers the scope of review in FAQ Q8 above, then it should be able to satisfy the FMCC requirements requiring a review of the fund’s asset valuation process.

E. Disclosure of leverage

Q11:

It is a requirement of the FMCC that a Fund Manager that is responsible for the overall operation of a fund should disclose the expected maximum level of leverage which it may employ on behalf of the fund. 

What are SFC’s expectations on how the expected maximum level of leverage should be calculated?  

A:

The employment of leverage by a fund may, under certain conditions, contribute to the build-up of systemic risk or disorderly markets. As such, regulators internationally have begun to require Fund Managers to provide data on leverage on a regular and ongoing basis.

The SFC recognises that the basis of calculation of leverage may vary from fund to fund depending on its specific nature and there is no general consensus on how leverage should be calculated.  Accordingly, we have not prescribed the calculation methodology for calculating expected maximum level of leverage. A Fund Manager should take into account the investor base when disclosing the calculation methodology such that it is easy for the investors to understand.  The Fund Manager should clearly explain and prominently disclose the basis of calculation of leverage which should be reasonable and prudent.

The minimum disclosure proposed is the disclosure of expected maximum leverage.  Fund Managers can choose to disclose additional information.

F. Side pockets

Q12:

The FMCC requires that a Fund Manager, when setting up side pockets in respect of fund assets it manages, should ensure that it has operational checks and controls for transferring investments in and out of side pockets. In this connection, what is expected of Fund Managers in meeting these requirements?

A:

Due to the nature of the assets in side pockets being illiquid or hard-to-value, it is important for a Fund Manager to have a valuation policy, risk management competency and proper control measures in place to manage side pockets.

In this connection, operational checks and controls for transferring investments in and out of side pockets can be designed by taking into account the following factors:

  1. the need to consult with the fund’s auditor before side pocket creation and when determining the valuation policy;
  2. whether the fund governing body has consented to the circumstances in which side pockets may be used and whether the authority to create side pockets has been disclosed to investors in fund documents;
  3. whether the criteria for side-pocketing individual positions (e.g. materiality of positions, availability of fair value measurement, likely time horizon of investment, nature of exit strategies) are consistent; and
  4. whether side pocketed investments are subject to regular review.
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