- The Consumer Council welcomes measures proposed in the above consultation paper by the Securities and Futures Commission (SFC) to mitigate the risks arising from securities margin financing (SMF), which the Council trusts will give better protection to the investing public and promote the healthy growth of the brokerage industry. As a whole, the Council
- ( accepts introducing re-pledging limit on client collateral and increasing the haircut percentages in the Financial Resources Rules (FRR), in order to reduce risks posed to investors from over-borrowing against client collateral by SMF providers; and
- ( strongly urges for complete segregation of collateral of non-borrowing margin clients to provide more effective investor protection as soon as practicable, for reason that even if the re-pledging limit is imposed, it does not stop SMF providers from pooling and re-pledging non-borrowing margin client collateral.
- In respect of the various specific issues posed by the SFC in the consultation paper, the Council's comments are as follows:
Re-pledging Limit
- The Council supports the SFC's proposed measure of introducing a limit on the re-pledging of client collateral to rectify the current deficiency that SMF providers are able to re-pledge client collateral (including those belonging to clients who have no current borrowing from a SMF provider) without restriction.
Q.1 Per-firm re-pledging limit
- The Council is in favour of the Working Group's initial idea of adopting the US model of imposing a re-pledging limit on per-client basis, instead of the current proposal of setting the limit on an aggregate basis (i.e. per-firm re-pledging limit). The latter measure does not address the issue of disparities from pooling and re-pledging of non-borrowing margin client collateral by SMF providers to other clients. On the contrary, segregate client collateral on a client-by-client basis would offer better protection to investors because this has an effect of capping the value of client collateral that can be re-pledged in respect of each client and would limit the amount of collateral that could stand to lose when a SMF provider became insolvent, as noted in the consultation paper.
- Having said that, it is important to also ensure the level of re-pledging limit is not excessive, otherwise the extent of protection from a per-client re-pledging limit would be reduced.
Q.2 Level of re-pledging limit
- In considering the appropriate level of re-pledging limit, the Council is of the view that the amount of loan raised by re-pledging margin client collateral should not exceed (similar approach is adopted in Australia and Singapore) or should be made equal (i.e. 100% as previously considered by the Working Group) to the loan amount extended to client, as opposed to the proposed range of 130% to 150%. From an investor protection perspective, imposing a lower limit, say 100%, that SMF providers can re-pledge client collateral provides a greater level of protection to investors in particular in the absence of prohibition on the pooling and the re-pledging of non-borrowing margin client collateral.
- It is also noted in the consultation paper that only a small number of SMF providers have been excessively re-pledging their client collateral and lending aggressively. The Council therefore expects that a lower re-pledging limit should not have any significant impact on the majority of SMF providers. Should any SMF provider be in difficulty with complying with the re-pledging limit at the initial stage, the SFC should encourage the SMF provider to discuss its difficulty and to arrange for temporary variance treatment.
Q.4 Re-pledging limit in subsidiary legislation
- The Council fully supports that making the re-pledging limit a statutory requirement would ensure better market compliance and enhance investor protection.
FRR Haircut Percentage Rates
Q.6 Adjustment of the haircut rates
- For purpose of better reflecting the quality of an SMF provider's assets that can be accepted as regulatory capital under the FRR, the Council supports that the haircut percentage rates should be brought up-to-date in order to improve their utility as a risk management mechanism.
Q.9 Appropriateness of the haircut rates
- In Table 1 of the consultation paper, it is noted that the proposed new FRR haircut rates have been adjusted upward but are yet more lenient than the average haircut rates adopted by banks/SMF providers. The Council therefore suggests that the new haircut rates should be set in line with the average haircut rates by banks/SMF providers to accurately reflect the risks involved.
Disclosure Requirements
Q.12 Notification requirements to the SFC
- The Council considers it important to make rules which require SMF providers to 'promptly' notify the SFC when they do not meet the prescribed thresholds as a means to increasing the transparency of SMF activities and alerting the SFC to the financial soundness of SMF providers.
Q.13 Disclosure to clients
- Since client collateral is permitted to be re-pledged under the current law if margin clients have given authorization to SMF providers to do so, the Council considers it of utmost importance to enhance investors' awareness of pooling and re-pledging risks at various stages, namely, at pre-contractual, contractual and post-contractual stages.
(i) Disclosure at pre-contractual stage
- The Council understands that clients do have their part to play by reading carefully before signing any margin financing agreement. However, it is not uncommon that clients are asked to sign margin finance agreement regardless of whether or not they intend to trade on margin finance. As a result, for clients who do not intend to and who have not used the margin facilities, their securities may nevertheless be pledged by a SMF provider to banks for loans that the SMF provider uses to advance to other margin clients.
- The Council is of the view that securities firms should, in the first place, disclose to potential clients whether or not the firms re-pledge client collateral and provide clients with pooling risk disclosure statement, before they invite clients to sign any margin financing agreement. These would enable investors to be clearly informed of what they are entering into.
(ii) Disclosure at contractual stage
- At the stage of signing margin financing agreement, the Council believes that there should be a duty on SMF providers to explain to potential clients about the pooling and re-pledging risks associated with giving authorization. In order to ensure clients are aware of the risk warning and will be able to make informed choice, the Council suggests requiring SMF firms to specifically ask clients to opt in by completing a separate form of different color rather than one non-discernible sheet hidden in a stack of documents to be signed by clients. The Council suggests making the aforesaid disclosure mandatory and any violation should attract penalty.
(iii) Disclosure at post-contractual stage
Monthly statement
- The consultation paper proposes to require SMF firms to include in clients' statements of account a statement that the firms have or have not, during the relevant period, re-pledged clients' collateral on an aggregate basis, but not on an individual client basis. The Council is concerned that the proposed message may not help investors become fully aware of the risks to which they are exposed in holding margin accounts particularly if they do not borrow on margin. As a matter of fact, the Council sees little value to be served to clients for inclusion of such a statement.
- Without a proper understanding of the pooling risk associated with giving an authorization, some investors may assume that such an authorization given by them to the firms to re-pledge collateral will only be realized when they have actually utilized the margin facility. If that is the case, investors may interpret the proposed statement as re-iteration of firms' standing policy with respect to re-pledging of client collateral, rather than the sounding of a note of caution for them to act on if necessary. The Council believes that this misconception is particularly likely if the firms have not clearly explained the pooling risks to their clients in the first place.
- Notwithstanding the above, the Council supports the proposal of incorporating a message in the statement to alert investors to the fact that they have authorized the firms to re-pledge their collateral.
Annual reminder
- As regards the obligation to send clients a reminder in the notice of annual renewal of client authorization to the firm to re-pledge client collateral, the Council fully supports the proposal of requiring firms to inform clients that they are always at liberty to shift to a cash account. However, the Council is of the view that the notice should come together with a copy of the risk disclosure statement instead of referring clients to check it out for themselves.
- To better achieve the intended effect of enabling investors to take appropriate steps to protect themselves from the pooling and re-pledging risks, the Council suggests that the notice should include information on the means by which clients may cancel their authorization and shift to trade through a cash account (e.g. days of advance notice required to be given by clients).
- With a view to enhancing investors' awareness of the risks arising from authorizing SMF providers to re-pledge client collateral, the Council supports the SFC proposal that the disclosure should be made in plain, simple language and should be clear. In addition, the Council suggests that the disclosure should prominently show the message about the pooling risks by using larger font size and marking with red color, in both the annual reminder and the monthly statement.
- For the sake of better protection of non-borrowing margin client collateral, the Council suggests the SFC to adopt an alternative approach that may address pooling risks by requiring client activation for the use of margin facility. This would mean that for those clients who have signed margin trading agreement but who have not in fact utilized the margin facility, their securities would not be pooled and re-pledged by firms without account activation by clients. In this way, non-borrowing margin client collateral would not be put in danger through the pooling and re-pledging processes.
Q.14 Transitional period
- The Council strongly suggests that the proposed disclosure requirements should be implemented as soon as practicable.
Ancillary FRR Changes
Q.15 Tighten the FRR provision on cash client receivables
- The Council supports the SFC to enforce prompt settlement and the proposal of tightening the current grace period from 5 business days to 2 business days after the settlement date. This is because with a longer extended settlement period, the firm may be subject to higher market risks which may eventually be detrimental to the interest of clients.
Long-term Solutions
Q.19 Segregation of client collateral
- Both the proposed re-pledging limit and haircut percentage rates are not ultimate solutions so long as client collateral is not segregated on a client-by-client basis, although they can serve as interim measures to alleviate pooling and re-pledging risks. The Council reiterates its preference for segregation of the pooling and re-pledging of non-borrowing margin client collateral which is in practice in other major financial markets. It also appears from the SFC's Retail Investor Survey 2003 that about 44% of respondents indicated support for the idea of banning brokerages from pooling clients' stocks.
- The Council understands that the SFC had conducted a feasibility study of complete segregation of client collateral but concluded that there is currently no market wide infrastructure to support firms to segregate client collateral. However, at the same time it expressed that over 60% of the firms do not re-pledge client collateral. In the best interests of investors and the integrity of the SMF industry, the Council is of the view that the SFC should make public the study results particularly with respect to the costs and benefits involved and the extend of impact to the industry.
- Since the collapse of C.A. Pacific Securities Limited and C.A. Pacific Finance Limited in 1998, the SFC had taken various measures such as gearing ratio adjustment and illiquid collateral haircut, to manage down risks arising from SMF activities. The Council recognizes the efforts taken by the SFC but is very disappointed that after 6 years, segregation of non-borrowing margin client collateral is still only set as a long-term goal. As pointed out in the consultation paper, the liquidation process of the C.A. Pacific is still not completed. The Council is wary of how much longer investors will have to wait. Nowadays, investors not only value professional advice of securities firms but also value how they safe keep client collateral. The Council therefore strongly urges the SFC to set a target date for complete segregation of client collateral, in order to fully address the risks inherent in pooling and re-pledging of client collateral.
Q.20 Regulatory capital requirements
- The Council supports further exploration of the tiering of regulatory capital requirements according to risks of a firm, i.e., the firm should maintain capital commensurate with the risks arising from the business it carries on, rather than risking that of clients.
Conclusion
- To sum up, the Council would like to point out that it understands any proposals for changes would inevitably increase compliance burden on SMF providers. Yet, it is necessary to implement all these changes because Hong Kong does not prohibit pooling and re-pledging of non-borrowing margin client collateral. The Council therefore strongly supports making the changes and setting target dates for their implementation as they are crucial for the interests of the investing public and the reputation of Hong Kong as premier international financial center.
- Furthermore, the Council considers that along with the proposed measures to address risks arising from securities margin financing, investor education is also needed to promote investors' awareness of the potential risks of pooling and re-pledging client collateral. In this respect, the Council, in collaboration with SFC, will continue to play its education role in making investors better aware of the risks involved.
