Description Both RIs and LCs are subject to capital and prudential requirements.
Capital and prudential requirements for RIs are dealt with in the BCP Assessment; and thus have not been assessed separately under this assessment. However, the BCP Assessment concluded that the HKMA has adopted the various components of Basel 2, 2.5 and 3 on or ahead of schedule. It has taken a more conservative approach for certain items recognized as regulatory capital than is required by the Basel standards. The HKMA applies both the three Basel ratios (common equity tier 1, tier 1 and total capital) as well as a trigger for each of these ratios on an individual AI basis, taking into consideration the unique characteristics of each institution. Supervisory staff regularly assesses AIs’ capital management and planning and uses stress testing to assess the adequacy of capital. Additional information on the capital adequacy for banks can be found in the BCP Assessment.
Equally the assessment concluded that the HKMA has wide powers of information gathering which it uses effectively. The authority receives standard prudential data from firms as well as much management information and supplementary data from surveys and ad hoc data as necessary. Equally, when new returns are required (such as the new return with respect to exposures to Mainland considerable care is taken in identifying comprehensive and granular data points to be reported in order to facilitate thorough analysis. The practice of
commissioning annual reports into the accuracy of returns and the potential to commission reports when needed from the external auditor on the underlying control systems for the preparation of information that is submitted to the HKMA provides a further level of control. Capital requirement - LCs
LCs must to meet minimum capital requirements stipulated by the FRR at all times while licensed by the SFC. The minimum capital requirements include a liquid capital requirement and a paid-up share capital requirement. The FRR rules are a form of a net capital rule. LCs that are subsidiaries of banks are subject to the FRR on a solo basis.
Most LCs are subject to a requirement to maintain a minimum paid up share capital (section 5 of the FRR). However, section 5 FRR exempts a number of types of licensees:
a. an approved introducing agent (as defined in 58(4) of the FRR) who is not a LC licensed for Type 3 regulated activity (leveraged foreign exchange trading); b. a trader (a licensee that is a securities or futures dealer who deals only for its own
account and does not hold client assets or handle client order - section 2 of the FRR); c. a futures non-clearing dealer (an exchange participant of a recognized futures market
but not a clearing participant of a recognized clearing house – section 2 of the FRR); d. a LC licensed for Type 4 (advising on securities), Type 5 (advising on futures contracts),
Type 9 (asset management) or Type 10 (providing credit rating services) regulated activity that is subject to a condition that they do not hold client assets;
e. a LC licensed for Type 6 (advising on corporate finance) that is subject to conditions that they do not hold client assets and they do not act as a sponsor for a listed corporation.
LCs are subject to minimum paid up share capital requirements that vary according to activity or activities for which they are licensed. If an LC is licensed for more than one activity, the minimum amount is the higher or highest amount applying to an activity for which it is licensed.
The minimum amounts are set out in Table 1 of Schedule 1 of the FRR: Table 1 in Schedule 1 to the FRR (paid-up share capital requirements)
Regulated activity Minimum amount of
paid-up share capital (HK$)
Type 1 (Dealing in securities) -
(a) where the licensed corporation in question provides
securities margin financing $10,000,000
(b) in any other case $5,000,000
Type 2 (Dealing in futures contracts) $5,000,000 Type 3 (Leveraged foreign exchange trading) -
(a) where the licensed corporation in question is an
approved introducing agent $5,000,000
(b) in any other case $30,000,000
Type 4 (Advising on securities) $5,000,000
Type 5 (Advising on futures contracts) $5,000,000 Type 6 (Advising on corporate finance) -
(a) where the LC in question is not subject to the no
sponsor work licensing condition $10,000,000
(b) in any other case $5,000,000
Type 7 (Providing ATS) $5,000,000
Type 8 (Securities margin financing) $10,000,000
Type 9 (Asset management) $5,000,000
AIs are also subject to minimum capital requirements. For banks, the minimum paid up share capital and share premium account is HK$300 million; lesser amounts are prescribed for restricted license banks and deposit taking companies.
Liquid capital requirements
Section 6(1) of the FRR requires all LCs to maintain liquid capital which is not less than its required liquid capital. Its required liquid capital is the higher of:
a. the required liquid capital requirements specified for each category of regulated activity in Table 2 in Schedule 1 of the FRR. If an LC is licensed for more than one activity, the minimum amount is the higher or highest amount applying to an activity for which it is licensed; and
b. its variable required liquid capital. By section 2 of the FRR:
a. “liquid capital” means the amount by which liquid assets exceed ranking liabilities; b. “liquid assets” in relation to a LC, means the aggregate of the amounts required to be
included in liquid assets under the provisions of Division 3 of Part 4 of the FRR; c. “ranking liabilities” means the aggregate of the amounts required to be included in its
ranking liabilities under the provisions of Division 4 of Part 4 of the FRR. These are all balance sheet liabilities, in some cases subject to add-ons (for example, 200 percent of the market value of written put options, section 40(12)).
LCs are required to calculate their liquid assets and ranking liabilities according to the detailed provisions of the FRR.
Table 2 in Schedule 1 to the FRR (Required liquid capital requirements)
Regulated activity Minimum amount of
required liquid capital – floor amount
(HK$) Type 1(Dealing in securities)
(a) where the LC in question is an approved
introducing agent or trader $500,000
(b) in any other case $3,000,000
Type 2 (Dealing in futures contracts) (a) where the LC in question is an approved introducing agent, futures non-clearing dealer or trader
$500,000
(b) in any other case $3,000,000
Type 3 (Leveraged foreign exchange trading) (a) where the LC in question is an approved
introducing agent $3,000,000
(b) in any other case $15,000,000
Type 4 (Advising on securities)-
(a) where the LC in question is subject to the
assets)
(b) in any other case $3,000,000
Type 5 (Advising on futures contracts) (a) where the LC in question is subject to the
specified licensing condition $100,000
(b) in any other case $3,000,000
Type 6 (Advising on corporate finance) (a) where the LC in question is subject to the
specified licensing condition $100,000
(b) in any other case $3,000,000
Type 7 (Providing ATS) $3,000,000
Type 8 ( Securities margin financing) $3,000,000 Type 9 (Asset management)
(a) where the LC in question is subject to the
specified licensing condition $100,000
(b) in any other case $3,000,000
Type 10 (Providing credit rating services)
(a) in the case where the LC in question is subject to
the specified licensing condition $100,000
(b) in any other case $3,000,000
The variable required liquid capital (VRLC) of an LC is equal to 5 percent of the aggregate of: a. adjusted liabilities (liabilities less client monies held in segregated accounts and
approved subordinated loans);
b. the aggregate of the initial margin requirements in respect of outstanding futures contracts and outstanding options contracts held on behalf of clients; and
c. the aggregate of the amounts of margin required to be deposited in respect of outstanding futures contracts and outstanding options contracts held on behalf of clients, to the extent that such contracts are not subject to payment of initial margin requirements.
For an LC licensed for Type 3 regulated activity (leveraged foreign exchange trading) an additional amount of 1.5 percent of its aggregate gross foreign currency position must be held.
LCs - risk-sensitivity of capital requirements
The liquid capital requirement aims to address liquidity and solvency risks of LCs by requiring them to maintain adequate liquid assets to meet all liabilities with a safety buffer. The FRR imposes capital charges to address market risk, credit risk, liquidity risk and concentration risk. In addition, the FRR require LCs to maintain a capital buffer (i.e. the required liquid capital) to cover any other risks including operational risks. The required liquid capital (through the calculation of VRLC) of a LC increases with its business size and the LC must maintain more capital as its business expands.
Market risk
held by LCs, for example, investments in shares listed on SEHK are subject to haircuts ranging from 15 percent to 30 percent of the investment’s market value.
.
Credit risk
In the calculation of liquid capital, credit risk is generally addressed by requiring deductions to be made on long outstanding, unsecured or under-secured credit exposures for potential default risks. For example, a LC must not include in its liquid assets any amount receivable from client which has been outstanding for one month or more after the settlement date. (See section 21(1) of the FRR.)
Liquidity risk
Liquidity risk of LCs is addressed by requiring them to maintain adequate liquid assets to meet all liabilities with a buffer to ensure their solvency. Illiquid assets such as fixed assets, illiquid bonds, time deposits with maturity of more than 6 months, assets denominated in a foreign currency which is subject to exchange control etc. are excluded from liquid assets. (Division 3 Part 4 of the FRR).
Concentration risk
Concentrated securities margin loans and concentrated proprietary positions are subject to additional capital charges under the FRR.
When the amount receivable from a margin client or total amount receivable from a group of related margin clients exceeds 10 percent of the aggregate of amounts receivable from all margin clients, the LC is subject to a capital charge to cover the concentration risk. The concentration risk charge equals the amount by which the margin loan due from the margin client (or total margin loan due from the group of related margin clients) exceeds 10 percent of the aggregate margin loans due from all margin clients.(See section 42(1) of the FRR.) A concentration risk charge is imposed on proprietary positions if the net market value of proprietary positions in any line of securities or investments specified in FRR equals 25 percent or more of an LC’s required liquid capital. The concentration risk charge is 5 percent of the net market value of the concentrated proprietary positions concerned if the net market value is 25 percent or more of the LC’s required liquid capital. This increases to 10 percent if the
concentration is 51 percent or more of the LC’s required liquid capital. (See section 44 of the FRR).
Record keeping and reporting Record keeping
An intermediary must keep such accounting, trading and other records in relation to its regulated activities as are sufficient to explain, and reflect the financial position and operation of, the firm’s businesses and enable profit and loss accounts and balance sheets that give a true and fair view of its financial affairs to be prepared from time to time (section 3(1)(a) of the KRR )
Specifically, section 146(4) of the SFO and section 3(1)(a)(vii) of the KRR requires LCs to keep such records as are sufficient to enable them to readily establish whether they have complied with the FRR.
Reporting
LCs are subject to regular reporting requirements as well as ad hoc reporting requirements to report to or notify the SFC in respect of their capital positions.
Pursuant to section 56 of the FRR, LCs must submit financial returns containing a balance sheet, a computation of liquid capital and other financial data to the SFC on a monthly basis within 3 weeks from the end of the reporting period. LCs that do not hold client assets need only report on a six monthly basis. The format of the financial returns is specified by the SFC under section 402 of the SFO. LCs are required to report any required liquid capital deficit in the return.
An LC is required to notify the SFC in writing if its liquid capital falls below 120 percent of its required liquid capital (section 55(1)(a) of the FRR). LCs usually maintain a liquid capital above this reporting threshold in order to avoid triggering the notification requirement.
If a LC becomes aware of its inability to maintain, or to ascertain whether it maintains, financial resources as required by the FRR, it is required , to give written notice, as soon as reasonably practicable, to the SFC (section 146(1) of the SFO.) It must also notify the SFC of its inability to comply with, or to ascertain whether it complies with, any other requirements of the FRR (see section 146(3)).
Independent audit
LCs are required to submit annual audited accounts together with a computation of liquid capital and an auditor’s report on these documents to the SFC (section 156 of the SFO and section 4 of the Securities and Futures (Accounts and Audit) Rules). Section 4(1)(g) of the Account and Audit Rules requires the auditor to express an opinion on compliance with the FRR rules. The SFC follows up any issue raised or qualified opinion expressed by the external auditor of a LC.
Monitoring by regulator
The SFC analyses all financial returns submitted by LCs with the assistance of computerized tools. The computer system performs various analyses to help identify any significant deterioration in liquid capital of LCs. These include monthly analyses to identify significant changes in an LC’s liquid capital, and to monitor the profitability of the LC.
The SFC also performs stress testing periodically based on the information reported by LCs. Risky LCs identified will be subject to close monitoring and may be subject to more stringent reporting requirements, such as to submit regular updates of its financial positions.
Regulator’s powers of intervention
By section 57 of the FRR, an LC must comply with any request by the SFC to provide it within information, including any record or document that the SFC specifies relating to the financial resources or trading activities of the LC.
If the SFC becomes aware (whether by notice from an LC or otherwise) that an LC cannot comply with FRR requirements, the SFC can permit the LC to continue operating but subject to conditions specified by the SFC (section 146(2) of the SFO and section 146(5)(b)). It can also, under sections 204 to 206 of the SFO, restrict an LC’s business or require property to be dealt with in a specified fashion if the preconditions under section 207 are met (these include that any property connected with the business which constitutes a regulated activity for which it is licensed, might be dissipated, transferred or otherwise dealt with in a manner prejudicial to the interest of any of its clients or creditors). The SFC has used these powers to deal with failures to comply with FRR requirements.
Risks from outside the regulated entity
All non-trade related receivables from affiliated companies are excluded from liquid assets of the LC. This is equivalent to a 100 percent deduction from the LC’s liquid capital. All liabilities due to affiliated companies are included in the LC’s ranking liabilities. In this way, the LCs are required to provide capital against all non-trade related exposures to affiliates. Assets and liabilities arising from business transactions with affiliated companies which fall within the regulated activities conducted by the LC are treated in the same way as transactions with third party customers and counterparties.
The FRR applies to LCs on a solo basis only. However, an LC must include in its ranking liabilities any amount by which the total liabilities of a subsidiary exceed the assets of that subsidiary (section 52(1)(b) of the FRR).
Assessment Fully implemented
Comments Intermediaries are subject to minimum and ongoing capital requirements. Ongoing capital requirements of licensed intermediaries are based on a net capital rule that has imbedded charges for market risk, credit risk and concentration risk, while a minimum buffer is used to address other risks (mainly operational risk). Licensed intermediaries must submit regular financial returns.
Principle 31. Market intermediaries should be required to establish an internal function that delivers