Hong Kong Enhances Protection For ETF Investors
Wednesday, August 31, 2011

Hong Kong’s Securities and Futures Commission (SFC) has announced additional measures to enhance the level of collateral provisions and the transparency of domestic synthetic exchange traded funds (ETFs), in a continuing effort to strengthen protection for investors.

It was disclosed that, as of July 31, 2011, out of a total of 49 synthetic ETFs listed in Hong Kong, 13 of them were domestic synthetic ETFs primarily regulated by the SFC, while the rest were overseas synthetic ETFs cross-listed in Hong Kong. The announced measures will be applied to all synthetic ETFs managed by SFC-licensed managers and primarily regulated by the SFC.

The relevant synthetic ETF managers are now required to top-up the collateral level for each of the domestic synthetic ETFs to achieve at least 100% collateralization. This is designed to ensure there is no uncollateralized counterparty risk exposure arising from the use of financial derivatives to replicate index performance.

They will also need to put in place a prudent haircut policy, particularly where the collateral taken is in the form of equity securities. The market value of such equity collateral must be equivalent to at least 120% of the related gross counterparty risk exposure.

Full collateralization must be achieved by each domestic synthetic ETF as soon as practicable, but no later than October 31, 2011.

"Building on our continuing effort in strengthening protection for investors, we believe the increase in collateral levels will better mitigate the counterparty risks faced by the domestic synthetic ETFs,” the SFC’s Acting Chief Executive Officer, Alexa Lam said. “However, as with any investment products, investors should always exercise caution when making investment decisions, particularly during volatile market situation.”

In addition, to increase transparency, while ETF managers are currently required to make the overall collateralization levels and other information about the collateral available on ETFs’ websites for investors’ reference, domestic synthetic ETF managers will now also be required to publish the latest collateral management policy on the ETFs’ websites on an on-going basis.

The SFC’s announcement followed a series of measures already introduced to enhance investor protection and the transparency of synthetic ETFs.

An ETF is an investment company with shares which trade intraday on stock exchanges at market-determined prices. Investors can buy and sell them in the same way as they currently trade in equities on an exchange. One advantage of the gold ETF is that investors do not have to take physical delivery of the gold itself.

However, ETFs have been increasingly demonized by regulators over the last couple of years in the wake of the financial crisis because they lack transparency, while others have warned that the growing popularity of these instruments with retail investors is depriving companies of much needed equity investment at a time when the global economy remains fragile.

Last year, a report written by Harold Bradley and Robert Litan of the Kauffman Foundation argued that ETFs pose a serious threat to the growth of new companies and stock market stability in the future. ETFs are distorting markets to such an extent, they contended, that they are threatening the growth of new companies by effectively curtailing their access to capital.

In July, the European Securities and Markets Authority published a discussion paper which seeks views on how the regulation of UCITS exchange traded funds can be strengthened to better protect investors.

Having reviewed the current regulatory regime governing UCITS and ETFs, ESMA is of the belief that the existing requirements are not sufficient to take account of the specific features and risks associated with these types of fund.

The paper examines the possible measures that could be introduced to mitigate the risk that particularly complex products, which may be difficult to understand and evaluate, are made available to retail investors. ESMA also cites concerns in the paper about the potential systemic risk caused by these types of fund and their impact on financial stability.