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STUDY MANUAL FOR

PAPER 2

REGULATION OF SECURITIES

of

the Licensing Examination

for Securities and Futures Intermediaries

Second Edition

First published September 2014

Current Version 2.4 (May 2017)


Published by:

Hong Kong Securities and Investment Institute


Second edition Hong Kong Securities and Investment Institute 2014, 2015, 2017
First edition Hong Kong Securities and Investment Institute 2003, 2004, 2005, 2006

Room 510, 5/F, Wing On Centre, 111 Connaught Road Central, Hong Kong
Website: www.hksi.org
Hotline: (852) 3120-6100
Email: info@hksi.org

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or
transmitted in any form or by any means, electronic, mechanical, photocopying, recording or
otherwise, without the prior permission of the copyright owner.

ISBN: 978-988-97139-2-6

Disclaimer

This manual is for educational purpose only and does not form any legal and/or expert opinion or
advice in whatsoever form by the Hong Kong Securities and Investment Institute (HKSI Institute)
and/or its consultants and shall not be so relied upon. While every effort has been made to ensure its
accuracy, the HKSI Institute and/or its consultants give no warranties and/or representations in
relation to any materials in and/or contents of this manual. Under no circumstances shall the HKSI
Institute or its consultants be liable for any direct or indirect or implied loss or damage caused or
alleged to be caused by reliance on any materials in and/or contents and/or omissions of this manual.
Without prejudice to the generality of the foregoing, the HKSI Institute and/or its consultants shall
have no such liability regarding the fitness for purpose, quality or merchantability of the manual,
whether express or implied, statutory or otherwise.

Paper 2 Version 2.4 ii Hong Kong Securities and Investment Institute


Acknowledgements

The HKSI Institute would like to express our gratitude to the following people for their involvement,
suggestions and support in the development of the second-edition study manual:

Consultants
Mr. Syren JOHNSTONE and Professor. Douglas ARNER, Asian Institute of International Financial
Law (AIIFL), University of Hong Kong.

Working Group Members for Paper 2 Study Manual


Mr. Peter S.Y. YU, Mr. Eric C.H. YIP and Mr. Calvin C.K. TAI.

Board Members 2016-2017


Mr. John MAGUIRE (Chairman for 2017 and 2016), Mr. Joseph CHAN, Mr. David CHAU, Miss
Clara CHIU, Mr. Paul DAY, Prof. Michael FIRTH, Prof. Vincent KWAN, Mr. Christopher LEE, Mr.
Victor LEE, Mr. Craig LINDSAY, Mr. Benson LO, Mr. Louis MAK, Ms. Katherine NG, Mr. Colin
SHAFTESLEY, Mr. Derek SHEK, Mr. Samuel TSANG, Mr. Trini TSANG, Mr. Philip TYE, Miss
Barbara WANG and Ms. Anna WONG.

Examinations Committee Members 2016-2017


Mr. Craig LINDSAY (Chairman for 2017 and 2016), Miss Marcella CHAN, Mr. Michael CHENG,
Ms. Catherine CHEUNG, Mr. Graham COTTINGHAM, Ms. Yvonne HSIN, Mr. Thomas HULME,
Mrs. Christine KOO, Miss Ruth KUNG, Prof. Vincent KWAN, Mr. Felix LAI, Ms. Stephentica LEE,
Mr. Victor LEE, Mr. Jeremy LEIFER, Mr. John MAGUIRE, Mr. Gordon NG, Ms. Molly TAM, Mr.
Allen TZE, Mrs. Judy VAS, Miss Barbara WANG and Prof. Chak WONG.

HKSI Institute Project Team (Development Team, Curriculum & Examinations Department)
Mr. Bernard HO (Director of Curriculum & Examinations), Ms. Katherine CHAN (Senior
Manager), Mr. Trevor CHU (Senior Manager), Mr. Hugo CHU (Manager), Ms. Joan NG (Manager)
and Mr. Sunny SIU.

Paper 2 Version 2.4 iii Hong Kong Securities and Investment Institute
Summary syllabus

Topic 1: Regulatory Framework


1 Introduction
2 Securities and Futures Ordinance (SFO) and relevant regulations
3 Other relevant laws
4 Securities and Futures Commission (SFC)
5 Other relevant regulatory authorities
6 Hong Kong Exchanges and Clearing Limited
7 Overall licensing regime under the SFO
8 Types of regulated activity covered in this manual
9 Requirements for licensing fitness and properness
10 Corporate governance and regulatory supervision
11 Provision of information to the SFC

Topic 2: Requirements of relevant subsidiary legislation


1 Securities and Futures (Financial Resources) Rules
2 Securities and Futures (Client Securities) Rules
3 Securities and Futures (Client Money) Rules
4 Securities and Futures (Contract Notes, Statements of Account and Receipts) Rules
5 Securities and Futures (Keeping of Records) Rules
6 Securities and Futures (Accounts and Audit) Rules
7 Rules relating to compensation and insurance
8 Securities and Futures (OTC Derivative Transactions Reporting and Record Keeping
Obligations) Rules
9 Securities and Futures (OTC Derivative Transactions Clearing and Record Keeping
Obligations and Designation of Central Counterparties) Rules

Topic 3: Management and supervision of securities business


1 Duties and liabilities of responsible officers and executive officers
2 Code of Conduct for Persons Licensed by or Registered with the Securities and Futures
Commission (Code of Conduct)
3 Management, Supervision and Internal Control Guidelines for Persons Licensed by or
Registered with the Securities and Futures Commission
4 Code of Conduct requirements for licensed or registered persons dealing in securities listed or
traded on The Stock Exchange of Hong Kong Limited (SEHK)
5 Prevention of money laundering and terrorist financing

Paper 2 Version 2.4 iv Hong Kong Securities and Investment Institute


Topic 4: Dealing in securities traded on the SEHK
1 Market participants in Hong Kong securities market
2 Participantship and trading right
3 Products traded on the SEHK
4 Trading mechanism and rules
5 Trading halt, suspension, cancellation and withdrawal of listing
6 Clearing and settlement services
7 The SEHK disciplinary procedures
8 Transaction costs

Topic 5: Other securities activities


1 Approved introducing agent
2 Securities margin financing
3 Short selling
4 Securities borrowing and lending
5 Advising on securities
6 Online trading and advising on securities
7 Alternative liquidity pools
8 Automated trading services
9 Offers of securities
10 Cross-border trading

Topic 6: Exchange traded options and over-the-counter (OTC) derivatives


A Exchange traded options
1 Introduction
2 Participant types and access rights
3 Trades monitoring, position limits and reporting requirements
4 Clearing and margin
5 Settlement
B OTC derivatives
6 Licensing
7 Ongoing requirements

Topic 7: Market misconduct and improper trading practices


1 How market misconduct is regulated in Hong Kong
2 Market misconduct
3 Consequences of market misconduct
4 Unsolicited calls

Paper 2 Version 2.4 v Hong Kong Securities and Investment Institute


5 Improper practices
6 SFC Disciplinary Fining Guidelines
7 Enforcement actions

Paper 2 Version 2.4 vi Hong Kong Securities and Investment Institute


About the Licensing Examination for Securities and Futures
Intermediaries

The Licensing Examination for Securities and Futures Intermediaries (LE) has been designed to
accord with the single licensing regime under the Securities and Futures Ordinance. Papers 1 to 12
have been approved by the Academic and Accreditation Advisory Committee of the SFC (AAAC)
as a Recognized Industry Qualification and Local Regulatory Framework Paper for meeting the
competence requirements of the SFC. Papers 15 and 16 have been approved by the AAAC for the
purposes of the examinations under the sponsor eligibility requirements for Type 6 (advising on
corporate finance) individuals wishing to engage in sponsor work as Principals and representatives,
or relevant individuals respectively.

The LE comprises the following fourteen examination papers*:

Paper 1: Fundamentals of Securities and Futures Regulation

Paper 2: Regulation of Securities

Paper 3: Regulation of Derivatives

Paper 4: Regulation of Credit Rating Services

Paper 5: Regulation of Corporate Finance

Paper 6: Regulation of Asset Management

Paper 7: Financial Markets

Paper 8: Securities

Paper 9: Derivatives

Paper 10: Credit Rating Services

Paper 11: Corporate Finance

Paper 12: Asset Management

Paper 15: Sponsors (Principals)

Paper 16: Sponsors (Representatives)

* The LE does not comprise Paper 13 and Paper 14.

Paper 2 Version 2.4 vii Hong Kong Securities and Investment Institute
About this study manual
This second-edition manual has been designed to provide candidates with the information they need
for the examination effective from 6 November 2014. Every effort has been made to ensure it is
accurate at the time of publication.
The manual provides an overview of the Securities and Futures Ordinance and other laws which are
relevant to running a securities business, the regulated activities covered by this manual and the
relevant rules, regulations, codes and guidelines applicable to those activities and the persons
conducting them. It covers discussions regarding securities dealing, securities margin financing,
short selling, securities borrowing and lending, securities advising, online trading and advising on
securities, automated trading services and offers of securities. It follows a topic about exchanged
traded options and over-the-counter derivatives, and finally market misconduct and improper trading
practices and how they are dealt with.
Given that the relevant laws, regulations and requirements covered by the syllabus of the Paper 2
examination may be revised, amended or updated from time to time, no express or implied warranty
is given by the HKSI Institute that the content of this manual is up-to-date or accurately reflects the
current legal and regulatory position. For the avoidance of doubt, this manual does not amount to or
constitute any legal advice given by the HKSI Institute and shall not be so relied upon. You are
reminded to keep abreast of any updates or amendments of the relevant laws, regulations and
requirements by making reference to the relevant legislation published by the relevant authorities.
For the purpose of the examination, however, unless updates on the relevant part of the manual are
provided by the HKSI Institute, examination questions will only be based on materials in the manual
that are still current.
Each topic in the manual consists of an overview, the expected learning outcomes, the study text itself,
revision questions and answers, a brief summary and a checklist.
Note: words carrying a masculine meaning are to be taken to include the feminine, and vice versa.

Learning outcomes
Candidates are advised to use the Learning Outcomes section of each Topic as an indication of the
way in which the topic material is to be studied. It indicates the key areas of knowledge which they
are expected to master and on which examination questions will be based. However, they may be
tested on any aspect of the study manual unless it is specifically ruled out in the manual.

Revision questions and checklists


Revision questions and checklists are included in each topic to help reinforce candidates
understanding of the material.

Module plan
It is estimated that this study manual will require 8-12 hours of study time for each topic, although
candidates may need slightly less or more depending on their work experience and background.

Paper 2 Version 2.4 viii Hong Kong Securities and Investment Institute
Updating this study manual

Updates are produced at appropriate intervals to reflect changes in applicable laws, rules, regulations,
codes and market practices in Hong Kong. Once an update is released, an announcement will be made
on the HKSI Institute website and the latest version of the E-Study Manual will be available for
candidates to download via the HKSI Institute Online Registration and Enrolment System. A list of
major updates made to the last version will also be placed at the end of the E-Study Manual for
candidates reference. Candidates are advised to visit the HKSI Institute website and log on to the
HKSI Institute Online Registration and Enrolment System regularly during their studies to ensure
that they have the latest version of the E-Study Manual prior to taking the examination.

About the Paper 2 examination

Paper 2 is a Recognized Local Regulatory Framework Paper for meeting the SFCs competence
requirements of a responsible officer. The Paper 2 examination consists of 40 multiple-choice
questions to be completed within 60 minutes. The pass mark is 70%.
The study manual and its subsequent updates are the only source of materials for the setting of the
questions, and candidates therefore need to study only the manual and updates to prepare for the
examination. The purpose of the examination is to test candidates understanding of the relevant rules
and regulations governing the activities of dealing in or advising on securities and securities margin
financing in Hong Kong, as well as their general understanding of basic related matters with which
practitioners at a responsible officer level should reasonably be expected to be familiar.
Since the securities industry changes rapidly, the latest regulatory and market information may not be
immediately included in this manual. Unless updates on the relevant information in the manual are
provided by the HKSI Institute, however, examination questions will only be based on the manual
where the information is still current.

Paper 2 Version 2.4 ix Hong Kong Securities and Investment Institute


List of useful websites

Securities and Futures Commission


www.sfc.hk/

International Organization of Securities Commissions


www.iosco.org/

Hong Kong Monetary Authority


www.hkma.gov.hk/

Hong Kong Exchanges and Clearing Limited


www.hkex.com.hk/

Department of Justice, HKSAR Government: Bilingual Laws Information System


www.blis.gov.hk/

Hong Kong Legal Information Institute: Hong Kong Ordinances


www.hklii.hk/eng/hk/legis/ord/

Mandatory Provident Fund Schemes Authority


www.mpfa.org.hk/

Office of the Commissioner of Insurance


www.oci.gov.hk/

Companies Registry
www.cr.gov.hk/

Hong Kong Securities and Investment Institute


www.hksi.org/

Financial Action Task Force


www.fatf-gafi.org/

Joint Financial Intelligence Unit


www.jfiu.gov.hk/

Paper 2 Version 2.4 x Hong Kong Securities and Investment Institute


Licensing Examination for Securities and Futures Intermediaries

Feedback on Study Manual for Paper 2 -


Regulation of Securities

To: Hong Kong Securities and Investment Institute


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Paper 2 Version 2.4 xi Hong Kong Securities and Investment Institute


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Topic 1: Regulatory Framework
Table of contents
Topic overview 1
Learning outcomes 1
1 Introduction 3
Products 3
Services 3
Service providers 4
2 Securities and Futures Ordinance (SFO) and relevant regulations 6
Securities and Futures Ordinance 6
Subsidiary legislation 6
Codes, guidelines and guidance notes 6
3 Other relevant laws 7
New Companies Ordinance and related matters 7
Contract law 16
Law of agency 16
Law of tort 17
Employment law 17
Personal Data (Privacy) Ordinance 17
4 Securities and Futures Commission (SFC) 19
Regulatory functions and structure 19
Directors, committees, tribunals and panels 21
Functions of the SFCs operating units 23
5 Other relevant regulatory authorities 25
Hong Kong Monetary Authority 25
Registrar of Companies 25
Office of the Commissioner of Insurance 26
Mandatory Provident Fund Schemes Authority 26
6 Hong Kong Exchanges and Clearing Limited 28
7 Overall licensing regime under the SFO 29
Key features 29
Regulated activities (RAs) 29
Licensed corporation 30
Registered institution 30
Licensed individual 30
Responsible officer 30
Executive officer and relevant individual 31
Substantial shareholder 31
Solicitors and accountants 32
Exclusions from RAs 32
Temporary licences and provisional licences 33
8 Types of RA covered in this manual 35
Dealing in securities (Type 1 RA) 35
Other securities activities 37
9 Requirements for licensing fitness and properness 39
Fit and proper criteria for licensed representatives and responsible officers (and equivalents
for registered institutions) 39
Fit and proper criteria for corporate applicants and intermediaries (i.e. licensed corporations
and registered institutions) 40
Continuous professional training 41
Licensing Handbook 42
Securities and Futures (Licensing and Registration) (Information) Rules 42
10 Corporate governance and regulatory supervision 44
Introduction 44
The role of senior management 44
Corporate governance 44
Regulatory supervision by the SFC 45
11 Provision of information to the SFC 47
Topic summary 49
Checklist 49
Appendix I 53
Appendix II 55
Topic overview
This Topic provides an overview on the regulatory aspects of the securities industry.
The Topic commences with an introduction to the various financial market regulators, products,
services and providers of services in the Hong Kong financial market.
Next, the Securities and Futures Ordinance (SFO), which constitutes the foundation for the
regulation of the securities and futures industry in Hong Kong, is discussed. The SFO is supplemented
by way of subsidiary legislation, rules and codes to meet the needs of the changing marketplace. An
overview of the relevant subsidiary legislation, codes, guidelines and guidance notes is provided. The
major subsidiary legislation, rules, regulations and codes that should be familiar to responsible
officers of licensed corporations and executive officers of registered institutions who supervise
securities business are further discussed in later topics of this manual.
Certain business laws that affect the industry, including company law, contract law, the law of agency,
the law of tort, employment law and personal data privacy law are then briefly considered.
Following this, we cover the structure and operations of the Securities and Futures Commission
(SFC) and briefly discuss other major Hong Kong regulatory bodies, including the Hong Kong
Monetary Authority (HKMA) and the Mandatory Provident Fund Schemes Authority (MPFA).
The role and main responsibilities of Hong Kong Exchanges and Clearing Limited (HKEX) are
also discussed.
It is important that responsible and executive officers understand the rationale behind the licensing
regime, the requirements that must be met by those who wish to be licensed by or registered with the
SFC and the ongoing obligations for licensed or registered persons. We therefore examine the overall
licensing regime under the SFO and some of its important aspects. Then we introduce the four types
of regulated activity (RA) covered in this manual and discuss in details one of the four: dealing in
securities, and, the requirements of fitness and properness. The definitions of the other three types of
RA which are advising on securities, providing automated trading services (ATS) and securities
margin financing (SMF), will be discussed in Topic 5.
A fundamental aspect of the financial services business, corporate governance and compliance, is
then introduced.
Finally, we summarise certain reporting requirements under the SFO regarding provision of
information to the SFC.

Learning outcomes
At the end of this Topic, candidates should be able to:
(a) know the various financial market regulators in Hong Kong; recall the variety of products and
services that are offered in Hong Kong as an international financial services centre;
(b) explain the background to securities regulation in Hong Kong and the key features of the SFO,
rules, codes and guidelines which comprise the regulatory framework for the industry of dealing
in securities and advising on securities;
(c) demonstrate a basic knowledge of relevant business laws that affect the securities industry,
including company law, contract law, the law of agency, the law of tort, employment law and
personal data privacy law;
(d) be familiar with the objectives, functions, powers, responsibilities and structure of the SFC;
(e) understand the workings of the SFCs operating divisions;
(f) explain the objectives and functions of Hong Kongs financial regulators;
(g) broadly distinguish the roles of the SFC, exchanges and clearing houses;

Paper 2 Version 2.4 1-1 Hong Kong Securities and Investment Institute
(h) be aware of the licensing regime established under the SFO to control and supervise licensed
corporations, registered institutions and their associated entities; the definitions of responsible
officers, executive officers, substantial shareholders, licensed representatives and individuals
registered by the HKMA as performing RAs; and the procedures for granting temporary and
provisional licences;
(i) be aware of the definitions of one type of the RAs relevant to this manual: dealing in securities;
(j) be aware of the ongoing obligations of a licensee, such as the requirements of Fit and Proper
Guidelines, the Guidelines on Competence and the Guidelines on Continuous Professional
Training (CPT);
(k) understand the general good practice of compliance and corporate governance; and
(l) explain the reporting requirements regarding provision of information to the SFC.

Paper 2 Version 2.4 1-2 Hong Kong Securities and Investment Institute
1 Introduction
1.1 The Hong Kong financial system comprises the banking, currency, securities and futures, asset
management, insurance and pensions and mandatory provident fund (MPF) sectors. While
each of these is subject to a specific regulatory regime under different ordinances and
regulatory authorities, investors and market participants increasingly view them as aspects of
a single financial market. Globalisation and advances in technology have enabled investors to
move rapidly from one market to another, arbitraging between markets, products and
transactions.
1.2 The principal regulator of the securities industry in Hong Kong is the SFC, which assumes
responsibility for front-line regulation and discipline of participants trading on the securities
and futures exchanges and also of other securities intermediaries. The regulatory approach
adopted by the SFC is a risk-based one, meaning that regulation is weighted towards the areas
where the SFC perceives the highest risk to lie.
1.3 The various financial market regulators take steps to cooperate and communicate closely with
one another to address any regulatory gaps and to ensure the health of the securities market.
There are regular discussions among Hong Kongs financial regulators: the SFC, HKMA,
Registrar of Companies, Office of the Commissioner of Insurance (see Note below), MPFA.
Memoranda of understanding (MOUs) are in place between the various regulators to specify
their interrelationships and to improve regulatory efficiency and effectiveness, which enable
them to better monitor and address any cross-market risks better and to take prompt and
appropriate action in the public interest or to safeguard the integrity of the markets.
Note: Effective as from 26 June 2017, the independent Insurance Authority replaces the Office
of the Commissioner of Insurance to regulate insurance companies.

Products
1.4 The securities-related products that are traded on the Hong Kong market are basically those
traded on The Stock Exchange of Hong Kong Limited (SEHK). Exchange-traded futures
are traded on Hong Kong Futures Exchange Limited (HKFE), and for examination
preparation purpose, are discussed and covered in a separate study manual. Securities-related
products addressed in the context of the licensing regime by this manual include:
(a) equities;
(b) warrants;
(c) bonds and other debt instruments;
(d) unit trusts/mutual funds;
(e) exchange traded funds;
(f) equity linked instruments; and
(g) options (on securities).
1.5 A more detailed description of the captioned products are presented in Topic 4, Dealing in
securities traded on The Stock Exchange of Hong Kong Limited and Topic 6, Exchange
traded options and over-the-counter derivatives.

Services
1.6 Services covered in this manual, both in this and subsequent topics, are:
(a) buying and selling securities products on behalf of clients, both retail and institutional or
professional;
(b) SMF;

Paper 2 Version 2.4 1-3 Hong Kong Securities and Investment Institute
(c) acting as a securities introducing agent;
(d) engaging in securities borrowing and lending;
(e) holding of client assets;
(f) distributing securities issues;
(g) operating ATS; and
(h) advising other persons on securities.

Service providers
1.7 The principal service providers in the securities investment and advising business are:
(a) intermediaries who are participants of the SEHK;
(b) intermediaries who act for foreign securities companies;
(c) underwriters;
(d) fund and portfolio managers;
(e) approved agents who introduce clients to exchange participants or other brokers but do
not handle client assets;
(f) corporate finance advisers;
(g) advisers to retail investors;
(h) financial planners for collective investment schemes (CISs);
(i) securities analysts;
(j) licensed banks;
(k) trust companies;
(l) securities margin financiers;
(m) support service providers: lawyers, accountants, auditors and valuers;
(n) listed companies;
(o) financial journalists and radio broadcasters;
(p) market operators who provide exchange and/or clearing functions for transactions in
securities, i.e. HKEX, including the SEHK and Hong Kong Securities Clearing Company
Limited;
(q) The Investor Compensation Company Limited (ICC): the ICC is an independent
company recognized by the SFC for dealing with investor compensation matters;
(r) ATS providers: provide by means of electronic facilities, a trading mechanism for
securities and futures contracts other than the operations of a recognized exchange
company or a recognized clearing house (at the moment this would only cover the SEHK,
HKFE and their related clearing houses), for example, trade confirmation and matching
systems provided by brokers;
(s) exchanges from outside Hong Kong: there are dealers in Hong Kong who provide local
investors with access to overseas exchanges;
(t) share registrars (who have formed a Federation of Share Registrars, with the approval of
the SFC) providing share registry services to issuers of listed securities; and
(u) nominee companies that hold client assets of intermediaries.

Paper 2 Version 2.4 1-4 Hong Kong Securities and Investment Institute
Revision question:

Question 1: What is the approach adopted by the SFC for regulating market intermediaries?
Answer 1: Risk-based supervision, which means that regulation is weighted towards the areas
which the SFC perceives to be at the highest risk.

Paper 2 Version 2.4 1-5 Hong Kong Securities and Investment Institute
2 Securities and Futures Ordinance (SFO) and relevant
regulations
Securities and Futures Ordinance
2.1 The legislation is in 17 parts, with 10 schedules (an outline of the SFO appears in Appendix I
of this Topic). It is the principal legislative document governing the securities market in Hong
Kong.

Subsidiary legislation
2.2 In addition to the main body of the SFO, it is necessary to consider the subsidiary legislation
introduced pursuant to the SFO. One of the SFOs strengths lies in the powers given to the
SFC to introduce such subsidiary legislation as a means of implementing the details of the
legal framework. Many of these items of subsidiary legislation are critically important to the
day-to-day operation of intermediaries, as will be observed at various points in this manual. A
list of the subsidiary legislation is provided in Appendix II to this Topic.

Codes, guidelines and guidance notes


2.3 The SFO also empowers the SFC to issue codes, guidelines and guidance notes. These do not
have the force of law and do not override the provisions of any applicable law. However, a
failure to follow the spirit of the codes, guidelines and guidance notes may reflect adversely
on the fitness and properness of licensed or registered persons to continue to be so licensed or
registered. They are discussed in detail in the relevant topics of this manual, and are listed in
Appendix II to this Topic.

Paper 2 Version 2.4 1-6 Hong Kong Securities and Investment Institute
3 Other relevant laws
3.1 We now consider certain business laws that affect the securities industry: company law and,
more briefly, contract law, the law of agency, the law of tort, employment law and personal
data privacy law.

New Companies Ordinance and related matters


3.2 The new Companies Ordinance (NCO) covers all the areas regulated under the old
Companies Ordinances, except the prospectus regime and the winding-up insolvency
provisions which remain regulated under the old Companies Ordinance. A basic knowledge
of company law and companies is becoming increasingly important, particularly as the
regulatory regime for securities and futures is based on the requirement that a licensed
corporation must be a company or a body corporate. The NCO permits the formation of a
company by one or more persons (s. 67, NCO). The NCO also provides that one member
constitutes a quorum for a meeting of a company having only one member.
Note: The NCO referred to in this Topic is the Companies Ordinance which came into force
on 3 March 2014 (i.e. Cap. 622 Laws of Hong Kong). The NCO covers all the areas
regulated under the old Companies Ordinance (i.e. Cap. 32 Laws of Hong Kong),
except the prospectus regime and the winding-up and insolvency provisions. These two
regimes remain under the old Companies Ordinance which has been renamed the
Companies (Winding Up and Miscellaneous Provisions) Ordinance (CWUMPO).

Separate legal entity


3.3 A company is a legal entity distinct from its members. It is a legal person and can make
contracts, take legal action, sue and be sued, own property and commit crimes and torts. It
also has perpetual succession and will only cease to exist if it is dissolved. It can be a limited
company, the normal form of most companies, where the liability of its members is limited.

Private, public and guarantee companies


3.4 Under the NCO, a new category of company is added and now every Hong Kong company
falls into one of 3 categories: private companies, public companies and guarantee companies.

Private company (s. 11, NCO)


3.5 A private company is a company that:
(a) restricts the right to transfer its shares;
(b) may not have more than 50 members (excluding present and past employees who are
members and continue to be members respectively);
(c) may not offer shares (or debentures) to the public; and
(d) is not limited by guarantee.

Public company (s. 12, NCO)


3.6 A public company is one that is not a private company, i.e. does not meet the requirements for
a private company stated above, and is not a guarantee company.

Guarantee company (s. 9, NCO)


3.7 A guarantee company is one that:
(a) does not have a share capital; and

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(b) the liability of its members is limited by the companys articles to the amount that the
members undertake to contribute to the assets of the company in the event of its being
wound up.

Listed company
3.8 A listed company is one that has any of its shares listed on a recognized stock market.

Articles of association
3.9 The articles of association of a company is considered to be the single constitutional document
of the company and form an agreement between the company and its members. The articles
of association prescribe regulations for the internal management and operation of the company.
Note: The memorandum of association is abolished for all companies when the NCO took
effect on 3 March 2014. For existing companies, conditions previously set out in the
memorandum are deemed to be included in the articles of association.
3.10 Model articles of association for private companies, public companies and guarantee
companies are provided in the Companies (Model Articles) Notice. Model articles of private
companies and public companies consist broadly of four parts including matters relating to:
(a) officers, including powers, duties, appointments and disqualifications of directors,
appointments and removal of company secretaries;
(b) members, including meetings and voting procedures;
(c) capital, such as share capital, rights and dealings with shares and dividends; and
(d) miscellaneous provisions such as communications to and by the company and
administrative arrangements.
While companies often adopt one of the model articles, they may prepare their own articles
provided the same is acceptable to the Registrar of Companies.

Meetings and procedures


3.11 Company meetings of shareholders are very important as they provide the only opportunity
for shareholders to exercise any control over the affairs of the company or take part in its
operations.
3.12 A company is required by the NCO to hold an annual general meeting of shareholders (s. 610,
NCO). Companies are permitted to dispense with the requirement to hold annual general
meetings by passing a written resolution or a resolution at a general meeting with unanimous
shareholders consent.
3.13 Other general meetings may be requested by directors, shareholders and the court.

Annual general meeting


3.14 Unless exempted, companies must hold an annual general meeting within six months (for
public companies) or nine months (for private companies or guarantee companies) after the
end of their accounting reference period by reference to which its financial year is determined.
The business of an annual general meeting includes the consideration of the annual accounts,
the declaration of dividends, the election of directors to replace retiring ones, and the
appointment of auditors. The members can question the directors on the annual accounts and
reports, including the directors report, and question the auditors on their report. The usual
audit report does not give much opportunity for questions as it is normally in a standard format
stating that the accounts present a true and fair view of the companys financial position,
unless something is seriously wrong, when the auditors will include a qualification in the
report.

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Resolutions
3.15 Under s. 548, NCO, resolutions may be passed by circularisation and signed by all members
except for:
(a) the removal of auditors before the expiration of their term of office; or
(b) the removal of a director before his term expires.
These must be put to members at a general meeting as ordinary resolutions.
3.16 Statutory rules have been set out by NCO on procedures for proposing and circulating written
resolutions. If the procedures are not followed, the written resolution will not be effective.

Special resolution (s. 564, NCO)


3.17 A special resolution is one passed by at least 75% of members at a general meeting (voting in
person or, where proxies are allowed, by proxy), of which not less than 21 days notice
specifying the intention to pass the resolution has been given. Examples of matters which need
special resolutions are:
(a) reduction of share capital;
(b) winding up of the company voluntarily or by court; and
(c) alteration of objects, articles of association (for companies formed and registered under
the NCO) and conditions in memoranda of association that could have been included in
the articles of association (for existing companies).
A copy of a special resolution must be lodged with the Registrar of Companies within 15 days
of it being passed.

Ordinary resolution (s. 563, NCO)


3.18 An ordinary resolution is a resolution which may be passed by a simple majority of those
present and voting at a meeting of members. Notice must be given.

Powers of shareholders
Powers exercisable by members in general meeting
3.19 These include:
(a) changes to articles of association and company name;
(b) matters relating to buybacks;
(c) issue of shares at a discount;
(d) alteration of capital including reduction;
(e) variation of class rights;
(f) corporate arrangements and reconstructions;
(g) appointment and removal of auditors;
(h) removal of directors;
(i) disposal of company assets;
(j) approval of payments for loss of office; and
(k) winding-up petitions under court order and voluntary winding-up.

Protection of members and minority shareholders


3.20 There are provisions in the NCO and in Companies (Model Articles) Notice which enable a
company to vary the rights of the holders of a class of shares. However, if a variation is being

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processed, the holders of at least 10% of the total voting rights of the shares in that class may
petition the court to have the variation cancelled if it is against their interests. The decision of
the court is final.
3.21 In addition to the above, an individual member may petition the court if the affairs of the
company are being conducted in a manner prejudicial to the interests of the members generally
(see sections 3.23 and 3.24 below for other situations where the interests of members are
protected).

Protection of the interests of minority shareholders


(in relation to internal procedures)
3.22 The court will not generally interfere in internal management matters or where the company
can deal with the matter by calling a meeting. This is the principle of majority power.
3.23 To ensure that this principle is not abused, certain safeguards are provided under the NCO to
protect the interests of minority shareholders:
(a) As seen in section 3.17 above, a special resolution is required for certain matters.
(b) Court sanction is required where the decision of the company will directly affect creditors.
(c) Dissenting members may appeal to the court to have certain resolutions cancelled.
(d) Members with 5% of the paid-up capital which carries voting rights may request the
directors to call a meeting; if the directors will not, the members may do so.
(e) 100 members or 10% of the holders of the issued shares may ask the Financial Secretary
to appoint an investigator into the companys affairs.
(f) A member may apply to the court for an order if he considers that the affairs of the
company are being conducted in a manner prejudicial to the interests of the members
generally or of some part of the members.
(g) A member may petition for a winding up.

Judicial protection of the minority


3.24 In addition to the statutory safeguards above, the court may intervene to allow an individual
member or members to bring an action:
(a) to enforce some personal rights (a personal action);
(b) where a right has been infringed which affects all or a number of members in a similar
way (a joint action); or
(c) on behalf of the company where misconduct has been committed against the company,
for example by a director of the company or a third party (a derivative action).

Directors and officers


Directors
3.25 The NCO merely defines a director as including a person who occupies the position of
director, by whatever name he is called. The NCO itself refers very little to directors but there
is more about them in Companies (Model Articles) Notice. The NCO says that every company
(not being a private company) must have at least two directors (s. 453, NCO) and every private
company must have at least one director (s. 454, NCO). The directors must be appointed by
the members acting in general meeting.
3.26 Every private company (other than one within the same group as a listed company) is required
to have at least one director who is a natural person.

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Shadow directors
3.27 Shadow directors are persons in accordance with whose directions or instructions (excluding
advice given in a professional capacity) the directors, or a majority of the directors, of a body
corporate are accustomed to act.

Officer
3.28 An officer, according to the NCO, includes a director, manager or company secretary.

Qualifications, powers, duties and liabilities of directors


Qualifications of directors
3.29 Persons to be appointed directors must meet the following requirements:
(a) They must be at least 18 years of age.
(b) They must not be undischarged bankrupts.
(c) They must not be disqualified by court order; the four principal grounds for such an order
being:
(i) conviction of an indictable offence for fraud or dishonesty or relating to forming or
operating companies;
(ii) persistent default in relation to the NCO or in acting as a liquidator or receiver;
(iii) fraud in relation to company matters or fraudulent trading; or
(iv) a finding of being unfit during directorship of an insolvent company.
Fraud and the other disqualifications apply to directors and shadow directors (e.g. see section
3.5, Topic 7, which describes disqualification orders made by the Market Misconduct Tribunal
(MMT) preventing persons committing market misconduct from being directors of
companies).

Powers of directors
Directors may override shareholders
3.30 Matters relating to the control of the operation of companies are dealt with in Companies
(Model Articles) Notice or the articles of association of the company, whichever applies. The
general powers to manage the business of a company are vested in the directors. Under
Companies (Model Articles) Notice, they can exercise all the powers of the company except
those otherwise required by the NCO, the articles of association and any directions given by
special resolution.
3.31 Directors in these circumstances are not bound by resolutions passed by members in a general
meeting, nor can the members override future management actions of the directors.
Members in general meeting may only intervene in the management if the directors are:
(a) unwilling to act;
(b) seeking approval to act beyond their powers (the members can approve such acts by
ordinary resolution); or
(c) acting in breach of their fiduciary duties (the members may ratify such breaches in
general meeting).
3.32 Under common law, directors should exercise their powers as a group by having meetings
(board of directors meetings or board meetings) with a proper quorum, passing resolutions
that have to be minuted. This can be avoided as usually the companys articles of association
allow the board to delegate its powers to individual directors, to committees and to the
managing director. Under s. 483, NCO, a written record of a decision made by the sole director
of a private company shall be sufficient evidence of that decision.

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Duties of directors
Fiduciary duties
3.33 The directors have a fiduciary relationship with the company. They must act with the utmost
good faith towards their principal, i.e. the company; and:
(a) act bona fide for the benefit of the company;
(b) exercise their powers for their proper purpose; and
(c) not allow any conflict of interest between their duties as directors and their personal
interests.

In addition, they must act with reasonable care, skill and diligence (s. 465, NCO)
3.34 Section 465, NCO imposes on directors requirement to exercise reasonable care, skill and
diligence. This is not as onerous as the fiduciary duties mentioned above. The NCO provisions
set out a mixed objective and subjective test in the determination of the standard of directors
duty of care, skill and diligence. To determine whether a director of the company has breached
the duty of care, skill and diligence owed by him to the company, his conduct is compared to
the standard that would be exercised by a reasonably diligent person with:
(a) the general knowledge, skill and experience that may reasonably be expected of a person
carrying out the functions carried out by the director in relation to the company (objective
test); and
(b) the general knowledge, skill and experience that the director has (subjective test).

Liabilities of directors
3.35 The above fiduciary and statutory duties imposed on directors represent two sources of
liability for directors. Directors are additionally subject to other, more specific duties imposed
upon them by particular statutory provisions. For example, Twelfth Schedule, the CWUMPO
provides for a fine and/or imprisonment for a director that authorizes the issue of a prospectus
containing an untrue statement. Where a director breaches strict requirements of the NCO,
such as failing to prepare financial statements when required to do so, liability will also arise.
It is therefore important that directors understand both the general and the specific
responsibilities imposed upon them, and how to properly discharge them, in order to fulfill
their roles as directors and to address their exposure to directors' liabilities.
3.36 The company may have the following remedies for a breach of duty by directors:
(a) It may obtain an injunction stopping such action.
(b) If the directors have not disclosed a personal interest in a contract they have made on
behalf of the company, the contract may be cancelled at the option of the company, i.e.
rescission.
(c) All directors who have acted in breach of their duties will be jointly and severally liable
to the company for damages.
(d) If they have wrongfully profited by dealing with the companys property, the directors
must account to the company for such profits.

Relief for directors for a breach


3.37 Any ratification by a company of conduct by a director in relation to negligence, default,
breach of duty or breach of trust in relation to the company must be approved by resolution of
the members of the company disregarding the votes in favour of the resolution by the director,
any entity connected with the director and any person holding shares of the company in trust
for the director or for the connected entity.

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3.38 The court may give relief to a director or directors if they have, in causing the breach, been
shown to have acted honestly and reasonably.

Financial arrangements with directors


Material interest in transactions, arrangements or contracts (s. 536, NCO)
3.39 If a director (or his connected entity) is directly or indirectly interested in a transaction,
arrangement or contract, or a proposed transaction, arrangement or contract with the company
that is significant in relation to the companys business, he must declare to other directors the
nature and extend of that interest (if it is material):
(a) as soon as reasonably practicable for a transaction or arrangement that has been entered;
or
(b) before the company enters into the transaction or arrangement for a proposed transaction
or arrangement.

Directors remuneration
3.40 Authority for payment is provided in the companys articles. The model articles of association
in the Companies (Model Articles) Notice provide that the remuneration of directors is
determined by the company in general meeting. This usually covers directors fees. If a
director holds some other position, such as managing director or executive director, he can
have a service contract.

Loans
3.41 A company cannot directly or indirectly:
(a) make a loan to a director of the company or a body corporate controlled by such a director;
or
(b) enter into a guarantee or provide security for such a loan
without the approval of its members.
3.42 Similarly, a company cannot directly or indirectly make a loan or guarantee to a director of its
holding company or a body corporate controlled by such a director without the approvals of
its members and the holding companies members.
3.43 The prohibition on loans to directors is extended to cover a wider category of persons who are
connected with a director, such as the directors adult child, parent and a cohabitee.
3.44 There are exceptions, such as the following:
(a) a de minimus threshold of 5% of the net assets of the company before a transaction is
subject to the restriction; and
(b) expenditure in connection with defending any proceeding or investigation or regulatory
action for misconduct provided that the directors has to repay the company if he is found
guilty or to have committed the misconduct.

Audits and investigations


3.45 Investigations may be ordered by the Financial Secretary or the company may itself carry out
a private investigation.

Appointment of inspectors by Financial Secretary


3.46 The Financial Secretary is required to appoint inspectors to investigate and report on the
affairs of a company if the court declares that an investigation should be carried out (s. 841,
NCO).
3.47 He may also appoint inspectors if:

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(a) an application is made by the specified number of members;
(b) the company passes a special resolution requesting such appointment;
(c) he suspects fraud in the business or formation of the company, or oppressive conduct, or
an intent to defraud creditors; or
(d) he suspects the persons concerned with the formation or management of the company to
have been guilty of fraud or other misconduct (ss. 840 to 841, NCO).

Duty to assist the inspector (s. 846, NCO)


3.48 All present and past officers and agents of the company, including bankers, solicitors and
auditors, are required to:
(a) produce all books and records that they have (this includes power given to the inspector
to enter premises and conduct searches);
(b) attend before the inspector when required and answer questions (on oath if so required
by him); and
(c) otherwise give him all reasonable assistance.
3.49 They are required to assist the inspector, who can go to court and compel them to do so, if
necessary. The exceptions are solicitors, who cannot be forced to divulge privileged
communications, and bankers, who do not have to provide information other than that relating
to the company under inspection.

Liquidations of companies

Compulsory liquidation
3.50 This is a compulsory winding-up ordered by the court, and the liquidator is appointed by the
court and acts under its control.

Circumstances of winding up by court (s. 177, CWUMPO)


3.51 A company may be wound up by the court if:
(a) it has by special resolution resolved that it shall be wound up by the court;
(b) it does not commence its business within a year from its incorporation; or has suspended
its business for a whole year;
(c) it has no members;
(d) it is unable to pay its debts;
(e) the event occurs on the occurrence of which the memorandum or articles of association
provides that the company is to be dissolved; or
(f) the court is of the opinion that it would be just and equitable to wind up the company.
Examples are where:
(i) the main object of the company has failed;
(ii) the company was formed for a fraudulent purpose; or
(iii) the basis of mutual trust, understanding and confidence on which the company was
formed no longer exists.

Petitioners
3.52 The petitioners may be:
(a) the company;
(b) a creditor;

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(c) a contributory (i.e. every person liable to contribute to the assets of a company in the
event of its being wound up);
(d) the Financial Secretary, if he thinks it desirable in the public interest;
(e) the Registrar of Companies, if the company has breached provisions of the NCO or is
being carried on for an unlawful purpose;
(f) the Official Receiver, where there is already a voluntary winding up (s. 179, CWUMPO);
and
(g) the SFC, if it appears desirable in the public interest (SFO gives authority to the SFC).
3.53 The court may appoint a liquidator, who may be the Official Receiver. The powers of the court
in supervising a compulsory winding-up and the powers of the liquidator are extensive and
will not be considered here. For more information, reference should be made to a textbook on
insolvency practice.

Voluntary liquidation
3.54 A voluntary winding-up may be started by members or creditors. There are fewer formalities
than with a compulsory liquidation and this route is far more popular.
3.55 A voluntary winding-up is started:
(a) when the period fixed for the companys duration as stated in its articles of association
comes to an end;
(b) by the passing of a special resolution for winding up; or
(c) if the directors of a company or, in the case of a company having more than two directors,
the majority of the directors deliver a winding-up statement under s. 228A, CWUMPO
that the company should be wound up after passing a resolution to that effect at a board
meeting. However, prior to no later than 28 days after the delivery of any winding-up
statement to the Registrar of Companies to commence the winding-up, a meeting of the
company must have been summoned and a provisional liquidator must have been
appointed. In the case of a private company having only one director, the sole director
may make the winding-up statement.

Members voluntary winding up (s. 233, CWUMPO)


3.56 This may be undertaken if the directors or, in the case of a company having more than two
directors, the majority of the directors issue a certificate of solvency to the effect that they
have:
(a) made a full enquiry into the affairs of the company; and
(b) formed the opinion that the company will be able to pay its debts within 12 months from
the commencement of the winding-up as specified in the certificate of solvency.
3.57 In the case of a private company having only one director, the sole director may issue a
certificate of solvency.
3.58 The certificate of solvency must be issued within the 5 weeks preceding the resolution and be
delivered to the Registrar of Companies for registration not later than when the copy of the
winding-up resolution is delivered, and must include a statement of the companys assets and
liabilities at the latest practicable date. If this is done, it will be a members voluntary winding-
up; if not, it will be a creditors voluntary winding-up.

Creditors voluntary winding up (ss. 241 to 243, CWUMPO)


3.59 Where a resolution for voluntary winding-up has been proposed, the company must arrange a
meeting of the creditors to be held within 14 days thereafter subject to a minimum notice
period of 7 days. Advertisements must be run in the Gazette and newspapers. A statement of

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the position of the companys affairs will be presented to the meeting, at which a liquidator
and a committee of inspection will be appointed to supervise the process.

Contract law
3.60 A contract is an agreement between two or more persons creating obligations that are
enforceable or otherwise recognisable under law, for example:
(a) the purchase or sale of a security or futures contract;
(b) the acceptance by an investor of an initial public offer of securities made by an issuer;
(c) an undertaking to manage a mutual fund; and
(d) the purchase of a leveraged foreign exchange contract.
These are all forms of contractual arrangements which have special legal obligations under
the law of contract.
3.61 The elements of a legally binding contract are the following:
(a) an intention to create legal obligations;
(b) the existence of offer and acceptance, where acceptance may be implied by conduct;
(c) there is valuable consideration, which can include an agreement not to sue under the
contract; a contract under deed does not need consideration;
(d) the parties must have legal capacity, i.e. they must be at least 18 years of age and have no
mental impairment; thus, if a securities dealer enters into a contract with a minor, the
dealer may be at risk if the minor disclaims his commitments;
(e) a contract may be unenforceable if it has an illegal element, and thus an intermediary may
face legal risk; and
(f) the parties must have given their consent to the contract without any form of pressure; if
a party was forced to enter into the contract under pressure, the contract will be void.

Terms of a contract
3.62 The terms of the contract are important:
(a) They can be expressly agreed or implied (the terms may be implied by court or by
common law).
(b) They can be conditions or warranties; a condition is a term of a contract which is of
considerable importance such that a breach of a condition might lead to repudiation by
the innocent party or a claim for damages; a warranty is a term of lesser importance such
that a breach of a warranty may only lead to a claim for damages by an injured party.
(c) There can be conditions precedent (which must be met) or conditions subsequent which,
if they fail, may lead to repudiation of the contract.

Law of agency
3.63 Agency is a fiduciary relationship (see section 3.66 below) created by express or implied
contract or by law, in which one party, the agent, may act on behalf of another, the principal,
and bind the principal by those of his words or actions that are within the scope of his agency.
3.64 The law of agency has an important impact on financial services. For example, a stockbroker
can be an agent for his client, and an account executive may be considered the agent of his
employer.
3.65 A principal is liable for the acts of his agent as, for example, a firm is liable if an account
executive it employs and has held out to be acting for the firm cheats a client. Equally, a

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director is an agent of the company on whose behalf he signs contracts. The agent is a fiduciary
(see section 3.66 below) and his relationship with his principal is based on absolute trust and
integrity.

Fiduciary relationship
3.66 A fiduciary is a person who owes another person duties of good faith, trust, confidence,
honesty and care. A fiduciary relationship is one in which one person has a duty to act for the
benefit of the other on matters within the scope of their relationship. Examples of fiduciary
relationships are those of stockbroker and client, principal and agent, solicitor and client, and
trustee and beneficiary.

Law of tort
3.67 When parties who have no contractual relationship are in a situation where one party suffers
loss or damage as a result of the act of the other, a wrong or tort may have occurred, and under
civil law a liability may have arisen. There are various branches of the law of tort, of which
the tort of negligence has the most direct application to securities and futures business. The
tort of negligence is one committed as a result of a failure to observe the standard of care
expected under law in a particular case.
3.68 For example, financial advisers may be exposed to actions in tort if they are negligent in giving
advice, but reliance is placed on their advice and losses are incurred. This is a complex area
as there may be contractual as well as tortious relationships in such situations.

Employment law
3.69 Under common law, an employer must provide his employee with remuneration, indemnity
for expenses, losses and liabilities incurred while performing his duties, and a safe working
environment.
3.70 Also, under common law, an employee must demonstrate skills and competence, faithful
service, obedience and confidentiality.
3.71 If the two parties fail to observe these basic elements in the relationship, there can be a breach
of the law as well as of the contractual relationship between them.

Personal Data (Privacy) Ordinance


3.72 The Personal Data (Privacy) Ordinance (PDPO) was established to protect the privacy of
individuals in relation to personal data.
(a) Personal data means any data relating directly or indirectly to a living individual, from
which it is practicable for the identity of the individual to be directly or indirectly
ascertained (and are in a form in which access or processing is practicable).
(b) It applies to any data user who, in relation to personal data, means a person who alone or
jointly, or in common with other persons, controls the collection, holding, processing or
use of the data.
(c) The data users must comply with six data protection principles (see section 3.73 below).
(d) The Privacy Commissioner for Personal Data is an independent public officer appointed
to enforce and promote compliance with the PDPO.

Data protection principles


3.73 The data protection principles are set out in Schedule 1 to the PDPO and may be summarised
as follows:
(a) Principle 1 purpose and manner of collection of personal data

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(i) Personal data shall not be collected unless for a lawful purpose directly related to a
function or activity of the data user, and unless the collection is necessary for or
directly related to that purpose and the data is not excessive for the purpose. The
data shall be collected through lawful and fair means.
(ii) Where the data is collected from the data subject, he should be informed, at the
prescribed times, of the purpose for which the data is to be used, the classes of
persons to whom the data may be transferred and of his rights to access and to request
the correction of the data.
(b) Principle 2 accuracy and duration of retention of personal data
Personal data should be accurate and up-to-date. All practicable steps must be taken to
ensure that personal data is kept no longer than necessary, and personal data should be
rectified if known to be incorrect. Contractual or other means must also be adopted to
prevent any personal data transferred to a data processor from being kept longer than
necessary.
(c) Principle 3 use of personal data
Personal data should not, without the consent of the data subject, be used for a new
purpose.
(d) Principle 4 security of personal data
All practicable measures should be taken to ensure that personal data is protected against
unauthorized or accidental access, processing, erasure, loss or other use.
(e) Principle 5 information to be generally available
All practicable steps shall be taken to ensure that a person can ascertain a data users
policies and practices relating to personal data, and can be informed of the kind of
personal data held and of the main uses of that data.
(f) Principle 6 access to personal data
A data subject shall be entitled to ascertain whether data of which he is the subject is held,
request and receive access to his personal data within a reasonable time at a reasonable
fee and in an intelligible form, and to request corrections to the data, and to be given
reasons for any refusals in relation to the above and to object to the Privacy Commissioner
for Personal Data.

Revision questions:

Question 2: Name three procedures that are provided under the NCO to protect the interests of
minority shareholders of a company.
Answer 2: Any three procedures mentioned in section 3.23.
Question 3: What is the fiduciary relationship between a director and the company?
Answer 3: It means the director must act with the utmost good faith towards the company and:
act bona fide for the benefit of the company;
exercise his powers for their proper purpose; and
not allow any conflict of interest between his duties as a director and his
personal interests.

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4 Securities and Futures Commission (SFC)
Regulatory functions and structure
4.1 The SFC was created by law under the Securities and Futures Commission Ordinance (now
repealed and subsumed in the SFO). It is independent, meaning that it is not part of the
Government machinery of the Civil Service or the ministerial system. Nevertheless, it reports
to and is accountable to the Government.

Regulatory objectives of the SFC


4.2 The objectives of the SFC in relation to the securities and futures industry, as stated in s. 4,
SFO, are to:
(a) maintain and promote the fairness, efficiency, competitiveness, transparency and
orderliness of the industry;
(b) promote understanding by the public of financial services including the operation and
functioning of the industry;
(c) provide protection to the investing public;
(d) minimize crime and misconduct in the industry;
(e) reduce systemic risks in the industry; and
(f) assist the Financial Secretary in maintaining the financial stability of Hong Kong by
taking appropriate steps in relation to the industry.

Functions and powers of the SFC


4.3 The functions and powers of the SFC are wide and are set out in s. 5, SFO. The principal
functions are to:
(a) take such steps as it considers appropriate to meet the objective in section 4.2 (a) above;
(b) supervise, monitor and regulate the activities of:
(i) recognized exchange, recognized clearing houses, recognized exchange controllers
and recognized investor compensation companies or persons carrying on RAs; and
(ii) registered institutions that are regulated or to be regulated by the SFC under any
relevant provisions;
(c) promote, encourage and enforce the proper conduct, competence and integrity of persons
carrying on RAs;
(d) maintain and promote confidence in the securities and futures industry;
(e) cooperate with and provide assistance to other regulators;
(f) secure an appropriate degree of protection for the investing public;
(g) promote, encourage and enforce internal control and risk management systems by
persons carrying on RAs, including registered institutions in the case of any RAs they
conduct; and
(h) suppress illegal, dishonourable and improper practices in the securities and futures
industry.
4.4 Other functions include promoting:
(a) investor education;
(b) investors understanding of investment products;
(c) investors understanding of the importance of making informed investment decisions; and

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(d) investors appreciation of the benefits of purchasing different types of financial services
including investing in financial products through regulated persons.
4.5 The reliance that may be placed by the SFC on the supervision of authorized financial
institutions (AFIs) by the HKMA is summarised in sections 5.2 to 5.4 below.
4.6 The SFC has general duties as stated in s. 6, SFO to:
(a) help maintain Hong Kongs position as an international financial centre;
(b) facilitate innovation in financial products;
(c) avoid restrictions on competition;
(d) act in a transparent manner; and
(e) use its resources efficiently.
4.7 In addition, the SFO provides that it may not delegate certain functions of the SFC to others.
They are detailed in Part 2, Schedule 2, SFO and include powers:
(a) to make subsidiary legislation;
(b) to establish committees under s. 8, SFO;
(c) to withdraw exchange companies;
(d) to appoint external investigators; and
(e) to institute proceedings in the MMT under s. 252(1) of the SFO.

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Directors, committees, tribunals and panels
(See Figure 1 below, an organisational chart of the SFC)

Audit Advisory
Committee Committee
The Board

Budget Regulatory
Committee Committees

Investment
CEO CEOs
Committee
Office1

Remuneration
Executive
Committee Committee

Corporate Investment Supervision


Enforcement Intermediaries
Finance Products of Markets

Intermediaries Corporate
Licensing Legal Services
Supervision Affairs

External Human Information Planning and


Relations Finance Resources Technology Administration

1 CEOs Office includes five units, namely the Commission Secretariat, International Affairs, Mainland Affairs, Press
Office and Risk and Strategy .

Figure 1: SFC Organisational Chart at April 2017. Source: www.sfc.hk

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Directors of the SFC
4.8 The directors of the SFC include the Chairman, the Chief Executive Officer (CEO), and at
least 5 other directors. The majority of SFC directors must be non-executive directors who are
prominent persons from the industry or the legal and accountancy professions, or other leaders
in the securities and futures industry. In April 2017, there were 6 executive directors (including
the CEO) and 8 non-executive directors (including the Chairman). The SFC may in addition
employ such staff as it considers appropriate.
4.9 Each of the 5 executive directors other than the CEO supervises an operating division. The
divisions are Corporate Finance; Enforcement; Investment Products; Supervision of Markets
and Intermediaries. There are also Legal Services Division and Corporate Affairs Division
which are support units. These divisions are supported by various committees responsible for
different aspects of the SFCs internal corporate governance, including among others, audit,
remuneration and budget, all of which have independent members to provide advice.

Advisory Committee
4.10 The Advisory Committee is responsible for advising the SFC on policy matters concerning its
regulatory objectives and functions. It has no executive powers and does not police the SFC
in any way. It is chaired by the SFC Chairman, and comprises the CEO and not more than two
other executive directors appointed by the Chairman, and between 8 and 12 other members
appointed by the Chief Executive of the Hong Kong Special Administrative Region (Hong
Kong SAR) in consultation with the Chairman of the SFC.

Committees, tribunals and panels


4.11 The SFC has established various regulatory committees to which it has delegated some of its
functions, e.g.:
(a) Takeovers and Mergers Panel is responsible for The Codes on Takeovers and Mergers
and Share Buy-backs. Much of the administration of this code is in practice exercised by
the SFC staff, acting as the Takeovers Executive.
(b) Takeovers Appeal Committee hears appeals against the disciplinary rulings of the
Takeovers and Mergers Panel at the request of an aggrieved party for the sole purpose of
determining whether any sanction imposed by the Panel is unfair or excessive.
(c) Products Advisory Committee advises on matters relating to the SFC Handbook for
Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted
Structured Investment Products, the SFC Code on MPF Products and the Code on Pooled
Retirement Funds, including overall market environment, industry practices and novel
product features.
(d) Investor Compensation Fund Committee administers the Investor Compensation
Fund and regulates its procedures in accordance with Part XII of the SFO.
(e) Academic and Accreditation Advisory Committee approves industry-based courses
and examinations for meeting the licensing competence requirements, and recognises
providers of training for the purposes of the CPT requirements.
(f) Share Registrars Disciplinary Committee hears and determines disciplinary matters
relating to share registrars in the first instance.
4.12 The following tribunals and panels are independent of the SFC:
(a) Securities and Futures Appeals Tribunal (SFAT) established by the SFO as an
independent statutory body. Chaired by a High Court judge, the SFAT comprises current
and former judges appointed by the Chief Executive of the HKSAR and two other
members drawn from a panel appointed by the Financial Secretary under delegated

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authority. The function of the SFAT is to hear appeals against the decisions made by the
SFC relating to the licensing or registration of intermediaries and certain other matters.
(b) Leveraged Foreign Exchange Trading Arbitration Panel established under rules
made by the SFC as provided for in s. 118, SFO. An arbitrator will be appointed from the
Leveraged Foreign Exchange Trading Arbitration Panel to hear disputes in accordance
with the Securities and Futures (Leveraged Foreign Exchange Trading) (Arbitration)
Rules.
(c) Process Review Panel an independent body appointed by the Chief Executive of the
Hong Kong SAR to review and monitor the operational processes of the SFC. It reports
to the Financial Secretary and recommends improvements to the SFC.

Functions of the SFCs operating units


4.13 Corporate Finance Division:
(a) administers The Codes on Takeovers and Mergers and Share Buy-backs to afford fair
treatment of shareholders and to provide an orderly framework for takeovers and share
buy-backs transactions in Hong Kong;
(b) supervises the listing-related activities of the SEHK;
(c) reviews and recommends changes to the Rules Governing the Listing of Securities on the
SEHK (Listing Rules);
(d) reviews and authorizes prospectuses and marketing materials for unlisted shares or
debentures; and
(e) administers the dual filing regime under the SFO to enhance the quality of disclosure by
listed companies.
4.14 Enforcement Division:
(a) enforces the SFO;
(b) monitors the trading of Hong Kongs stock and derivative markets and inquires into
irregularities;
(c) disciplines dishonest regulated intermediaries and those who are responsible;
(d) inspects the books and records of listed companies if impropriety is suspected, which
may involve directors, officers or substantial shareholders etc.;
(e) reports suspected market misconduct to the Financial Secretary; and
(f) co-operates with domestic and overseas regulatory bodies in local and overseas
investigations.
4.15 Investment Products Division:
(a) develops regulatory platforms, including those for authorization applications of
investment products, so as to facilitate market growth and product innovation;
(b) regulates and approves investment products that are offered to the public and subject to
the SFO; and
(c) monitors disclosures and ongoing compliance of authorized investment products.
4.16 Supervision of Markets Division:
(a) supervises the conduct, operation and internal systems of the exchanges and clearing
houses;
(b) strengthens Hong Kongs market infrastructure;
(c) authorises ATS providers;

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(d) regulates approved share registers;
(e) supervises and monitors activities of the ICC and manages the investor compensation
fund;
(f) facilitates the development of and encourages participation in Hong Kong markets by
liaising with local and overseas participants; and
(g) conducts market-related research to assist in formulating policies.
4.17 Intermediaries Division:
Intermediaries Division comprises the Licensing Department and Intermediaries Supervision
Department. That Division is primarily responsible for administering licensing requirements
and conducting ongoing supervision of licensed corporations with a focus on their business
conduct and financial soundness.
4.18 Licensing Department:
(a) licenses corporations and individuals seeking to conduct RAs as defined under the SFO;
(b) issues codes and guidelines concerning the competence and suitability of corporations
and individuals to remain licensed;
(c) monitors the on-going compliance of licensing requirements by licensees, substantial
shareholders of listed corporations and directors of licensed corporations and substantial
shareholders;
(d) maintains a public register of licensed persons and registered institutions; and
(e) initiates policies on licensing issues.
4.19 Intermediaries Supervision Department:
(a) supervises the business conduct of licensed corporations and individual licensees on an
ongoing basis, by conducting on-site inspection and off-site monitoring;
(b) monitors the financial integrity of licensed corporations; and
(c) maintains communication with intermediaries and the industry on relevant policy and
regulatory issues.

Revision question:

Question 4: State three regulatory objectives of the SFC in relation to the securities and futures
industry.
Answer 4: Any three mentioned in section 4.2.

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5 Other relevant regulatory authorities
Hong Kong Monetary Authority
5.1 The HKMA is required to maintain currency stability, ensure the safety and stability of the
banking system, and promote the efficiency, integrity and development of the financial system.
It is headed by the Chief Executive, who has several deputies. It manages the Exchange Fund
and the Hong Kong SARs monetary policy and also supervises the banking system.
5.2 The HKMAs linkage with the SFC principally relates to its supervision of banks, the logical
contact being with the Deputy Chief Executive (Banking Supervision). This linkage is
particularly important in view of the increasing volume of securities and securities-related
business conducted by banks in Hong Kong.
5.3 Under the SFO and the Banking Ordinance, AFIs, which are regulated by the HKMA and
include banks, have to be registered with the SFC as registered institutions if they wish to
carry out an SFC-RA. As the frontline regulator of AFIs is the HKMA, the latter takes the
leading role in vetting applications for such registration and in supervising their SFC-RAs,
including carrying out on-site inspections. The HKMA applies all SFC criteria, such as the
fit and proper criteria, in supervising AFIs registered with the SFC.
5.4 The HKMA may refer cases of suspected malpractice by registered institutions in respect of
the SFC-RAs to the SFC, which may directly review those institutions. The SFC may suspend
or revoke the registrations of such institutions, issue public or private reprimands, and impose
fines on both the institutions concerned and the relevant employees engaged by the institutions
in respect of the RAs. The HKMA, on the other hand, may remove the names of relevant
employees, either temporarily or permanently, from the register it maintains under the
Banking Ordinance. Only the persons named in that register may carry out SFC-RAs. Clearly,
the HKMA and the SFC must work closely together in relation to any SFC-RAs that are
carried out by registered institutions. To this end, an MOU has been signed between the two
regulators, setting out their roles and responsibilities so as to minimise overlaps under the
regulatory regime.

Registrar of Companies
5.5 The Registrar of Companies administers and enforces certain aspects of the:
(a) NCO;
(b) CWUMPO;
(c) Limited Partnerships Ordinance;
(d) Trustee Ordinance;
(e) Registered Trustees Incorporation Ordinance;
(f) Money Lenders Ordinance; and
(g) Miscellaneous Incorporation Ordinances.
5.6 The Companies Registry maintains and makes available for public inspection financial and
other returns, charges registered by companies and so on. It will follow up defaults in making
the prescribed returns of the entities covered by these Ordinances and may strike off
companies for failure to make returns or for not carrying on business.
5.7 The Registrar of Companies does not directly regulate companies, limited partnerships,
trustees or money lenders; such functions are assumed by different bodies. As a member of
the Standing Committee on Company Law Reform, the Registrar of Companies takes an
active interest in corporate governance issues and may make recommendations.

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5.8 There are no direct links between the SFC and the Companies Registry in regulatory areas,
although the two agencies maintain an active liaison on issues of common interest.

Office of the Commissioner of Insurance


5.9 The principal functions of the Office of the Commissioner of Insurance, which is headed by
the Commissioner of Insurance as the designated Insurance Authority, are to ensure that the
interests of policy holders are protected and to promote the general stability of the insurance
industry in Hong Kong.
5.10 The Insurance Authority has the following major duties and powers:
(a) the authorization and regulation of insurers;
(b) the regulation of insurance agents, who must be appointed by an insurer and registered
with the Insurance Agents Registration Board, established by The Hong Kong Federation
of Insurers. The agents are not directly authorized or supervised by the Insurance
Authority. Supervision is by the appointing insurers, who are required to comply with the
Code of Practice for the Administration of Insurance Agents issued by The Hong Kong
Federation of Insurers and approved by the Insurance Authority;
(c) the regulation of insurance brokers, who may obtain authorization from the Insurance
Authority or from one of two bodies approved by the Insurance Authority, the Hong Kong
Confederation of Insurance Brokers and the Professional Insurance Brokers Association.
These bodies are charged with the responsibility of ensuring that their members comply
with the statutory requirements and that the interests of policy holders are properly
protected; they also handle complaints; and
(d) the promotion of self-regulation by the industry and the maintenance of close contact
with the industry through a consultative process.
5.11 The Insurance Authority is concerned with the regulation of insurance companies and
insurance intermediaries. To the extent that the latter do not undertake any SFC-RAs or that
insurance products do not fall within the descriptions of products defined by the SFO (but see
section 5.12 below), there is little linkage between the spheres of activity of the Insurance
Authority and the SFC.
5.12 Notwithstanding the above, there are two classes of funds authorized by the SFC which do
have certain linkage with the Insurance Authority: investment-linked assurance schemes and
pooled retirement funds, both of which are marketed by the insurance industry. Authorization
of these has been delegated by the SFC to the Committee on Investment-Linked Assurance
Schemes and Pooled Retirement Funds. The Insurance Authority is represented on this
committee, as insurance companies wishing to promote these schemes will need to be
authorized under the Insurance Companies Ordinance.
Note: The Insurance Companies (Amendment) Ordinance 2015 enacted on 10 July 2015
provides for, amongst others, the establishment of an Independent Insurance Authority
to replace Office of the Commissioner of Insurance by taking over its regulatory
functions. Such replacement effects from 26 June 2017. The Insurance Companies
Ordinance is renamed the Insurance Ordinance on the same date.

Mandatory Provident Fund Schemes Authority


5.13 The MPFA has responsibility for:
(a) registering MPF schemes;
(b) approving pooled investment funds;
(c) overseeing and making rules and guidelines for the administration and management of
registered schemes and pooled investment funds;

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(d) ongoing monitoring of compliance by MPF products with the Mandatory Provident Fund
Schemes Ordinance (MPFSO);
(e) investigating alleged breaches of the provisions of the MPFSO;
(f) approving trustees and regulating the affairs and activities of such approved trustees; and
(g) dealing with complaints about MPF products and approved trustees, and referring them
to the SFC and other regulators for action where necessary.
5.14 MPF schemes refer to compulsory retirement schemes covering a large number of employers,
who must set up plans for employees not already covered by other pension plans.
5.15 MPF schemes available to employees include equity, bond, balanced funds, money-market
and capital preservation funds.
5.16 Certain responsibilities of the MPFA interlink with the particular responsibilities of the SFC:
(a) vetting and authorizing MPF products and related marketing materials in accordance with
the provisions of the SFC Code on MPF Products and the relevant ordinances (including
the SFO);
(b) registering and approving investment managers and continued monitoring of their
conduct in the investment management of MPF products;
(c) supervising the activities of investment advisers and securities dealers providing services
in respect of MPF products;
(d) investigating alleged breaches of the provisions of the SFC Code on MPF Products and
any relevant ordinances, and taking enforcement action; and
(e) dealing with complaints referred to it by the MPFA or the public about MPF products
authorized by the SFC, or the conduct of SFC-licensed persons engaged in the investment
management of these products.
The MPFA and the SFC have MOUs coordinating these responsibilities and to assist each
other in performing their functions efficiently and properly.

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6 Hong Kong Exchanges and Clearing Limited
6.1 HKEX is a listed company on the SEHK. On 6 March 2000, the SEHK, HKFE and the three
associated clearing housesHong Kong Securities Clearing Company Limited, The SEHK
Options Clearing House Limited and HKFE Clearing Corporation Limitedbecame wholly
owned subsidiaries of HKEX.
6.2 HKEX is an exchange controller recognized by the SFC under s. 59, SFO. The SEHK and
HKFE are recognized under s. 19, SFO as exchange companies that may operate a stock
market and a futures market in Hong Kong respectively. The three clearing houses obtain their
recognition under s. 37, SFO. A recognized exchange controller may control a recognized
exchange company or clearing house.
6.3 HKEX is responsible for ensuring an orderly and fair market in securities and futures contracts
traded on or through the SEHK and HKFE, respectively. HKEX is required to ensure that risks
are managed prudently, to act in the interests of the public, having particular regard to the
interests of the investing public, and to ensure that where such interests conflict with any other
interests the former shall prevail. The SEHK is also responsible for administering the Listing
Rules.
6.4 The board of HKEX is a mix of directors appointed by the Government (the majority) and
those elected by the shareholders; the board elects the Chairman and appoints the Chief
Executive. The Chairman of HKEX must be approved by the Chief Executive of the Hong
Kong SAR, while the Chief Executive of HKEX has to be approved by the SFC.
6.5 The SFC supervises and monitors the activities of HKEX, the exchange companies and the
clearing houses, approves their rules and amendments to the rules, approves the fees they
charge, and administers and enforces the applicable legislation. It also carries out regular
reviews of these activities.
6.6 Except in relation to the management of business risk, and the enforcement of their own
listing, trading, clearing and settlement rules, HKEX, the exchanges and the clearing houses
are not responsible for front-line prudential and conduct regulation of market participants,
which is carried out by the SFC.

Revision question:

Question 5: What are the main responsibilities of HKEX?


Answer 5: HKEX is responsible for ensuring an orderly and fair market in securities and futures
contracts traded on or through the SEHK and HKFE, respectively. It is required to
ensure that risks are managed prudently, to act in the interests of the public, having
particular regard to the interests of the investing public, and to ensure that where
such interests conflict with any other interests the former shall prevail. It is not
responsible for front-line prudential and conduct regulation of market participants,
which is carried out by the SFC.

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7 Overall licensing regime under the SFO
Key features
7.1 Part V, SFO provides for the implementation of the licensing regime, including:
(a) the setting up of a single licensing system to cover the ten specified types of RA (see
section 7.4 below) and the licensing of corporations (licensed corporations) to conduct
one or more RAs subject to any conditions the SFC may wish to impose;
(b) allowing licensed persons conducting some RAs to undertake certain others, e.g. a Type
1 licence or registration covers Type 4, Type 6 and Type 9 RAs as well if the conducting
of those activities is wholly incidental to the conducting of the Type 1 RA;
(c) the registration of AFIs to engage in one or more of the ten types of RA (registered
institutions) (see section 7.6 below); however, an AFI carrying out Type 3 or Type 8 RA
is exempted from the registration requirement;
(d) permitting an individual to engage in a RA for a registered institution provided that his
name is entered in the register maintained by the HKMA as engaged by the registered
institution in respect of that RA (see sections 7.13 and 9.21 below);
(e) the cessation of exempt status for the old category of exempt persons after the
commencement of Part V, SFO;
(f) the recognition of excluded activities of certain classes of persons (see section 7.21
below);
(g) the granting of temporary and provisional licences (see sections 7.22 and 7.23 below);
(h) the setting of fit and proper guidelines for licensing and registration purposes;
(i) requiring an individual engaging in a RA for a licensed corporation (as his principal) to
be licensed (licensed representative). A licensed representative will usually be accredited
to one principal, but the SFC may approve his accreditation to more than one licensed
corporation within the same group of companies;
(j) approving persons who, in addition to being licensed as representatives, carry out
supervisory functions for a licensed corporation and are nominated as responsible officers
by that corporation (see section 7.9 below);
(k) requiring a registered institution to comply with the provisions of the Banking Ordinance
in the appointment of at least two executive officers to be responsible for directly
supervising its RAs (see section 7.13 below);
(l) the approval of persons to be substantial shareholders of licensed corporations; and
(m) applying restrictions on the use of certain descriptive titles, such as stockbrokers, by
unlicensed persons (see section 7.24 below).
7.2 Only corporations may become intermediaries. A corporation that obtains a licence will be
regarded as a licensed corporation unless it is an AFI, in which case it will be regarded as a
registered institution. Together they are referred to as intermediaries.
7.3 It is an offence to engage in a RA without being either licensed or registered to do so.

Regulated activities (RAs)


7.4 The ten distinct types of RA (see Schedule 5, SFO) are:
Type 1: dealing in securities;
Type 2: dealing in futures contracts;
Type 3: leveraged foreign exchange trading;

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Type 4: advising on securities;
Type 5: advising on futures contracts;
Type 6: advising on corporate finance;
Type 7: providing ATS;
Type 8: SMF;
Type 9: asset management; and
Type 10: providing credit rating services.

Licensed corporation
7.5 Under the licensing regime, any business carrying on RAs must be a company incorporated
in Hong Kong or an overseas company registered with the Company Registry of Hong Kong.
Individuals, sole proprietorships and partnerships cannot be licensed for this purpose. The
SFC must be satisfied that the corporation meets the fit and proper criteria in respect of the
activities it applies to conduct, the licence may cover the full range of regulated business.

Registered institution
7.6 AFIs (including banks) that are authorized and regulated by the HKMA and conduct SFC RAs
must be registered with the SFC as registered institutions, such status having been set up as
a special category because of the special features of AFIs. They are jointly regulated by the
HKMA and the SFC, with the HKMA being the front-line regulator that will apply all SFC
regulatory criteria, including fitness and properness and business conduct, other than capital
adequacy, the handling of client money and the audit requirements in supervising them. All
references to registration will generally apply to this category as the term licensing will be
used for all businesses and persons directly supervised by the SFC.

Licensed individual
7.7 As mentioned in section 7.1(i) above, an individual engaging in a RA of a licensed corporation
(as his principal) must be licensed with the SFC as a licensed representative. A licensed
representative can be accredited to more than one licensed corporation within the same group
of companies.
7.8 If a licensed representative ceases to be employed by his accredited licensed corporation, the
corporation must notify the SFC within seven business days of the cessation. The licensed
representative is allowed 180 days for transfer of his accreditation to another licensed
corporation, failing which his licence is deemed to have been revoked upon such cessation.

Responsible officer
7.9 A responsible officer is a licensed representative who:
(a) actively participates in or supervises a RA;
(b) is nominated by the licensed corporation as a responsible officer; and
(c) is approved by the SFC as a responsible officer.
7.10 Each licensed corporation is required to:
(a) appoint not less than two responsible officers, at least one of whom must be an executive
director (see Note 1 below) (s. 125, SFO);
(b) ensure that every individual executive director of the licensed corporation is approved as
a responsible officer (s. 125, SFO); and

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(c) ensure that it has, for each RA, at least one responsible officer available at all times to
supervise the business of the RA for which it is licensed, and who is based in Hong Kong
(s. 118(1)(a)(ii), SFO) (see Note 2 below).
Note 1: The SFO defines an executive director, in relation to a licensed corporation, as
one who actively participates in, or is responsible for directly supervising, the business
of a RA for which the corporation is licensed.
Note 2: Although at least one responsible officer who can perform the regulated function in a
sole capacity must be based in Hong Kong, it is not essential that the other responsible
officer is in Hong Kong at all times provided that he can be contacted (preferably by
telephone) whenever necessary, that proper internal controls are in place and that the
period of absence of the responsible officer from Hong Kong is reasonable for the
proper discharge of his duties.
7.11 A licensed corporation which contravenes this provision without reasonable excuse commits
an offence and is liable on conviction to a fine at level 6 and, in the case of a continuing
offence, to a further fine of HK$2,000 for every day during which the offence continues.
7.12 While all executive directors must be responsible officers, a licensed corporation may also
apply for other senior personnel to be so approved. The basic conditions for approval as a
responsible officer are that:
(a) he is a fit and proper person to be so approved; and
(b) he has sufficient authority within the licensed corporation.
Such approval can be subject to reasonable conditions which the SFC may impose on the
corporation and the individuals concerned.

Executive officer and relevant individual


7.13 The equivalents of responsible officers for registered institutions are called executive officers.
There must be at least two of these for each RA conducted by the institution. At all times,
there must be at least one executive officer available to supervise the RA concerned. In
addition, other staff of a registered institution conducting RAs must be on a register
maintained by the HKMA of such persons, but they do not need to be individually licensed by
the HKMA or the SFC. Such staff are the equivalents of the licensed representatives of
licensed corporations.

Substantial shareholder
7.14 The status of substantial shareholder has special relevance to the application of the licensing
regime. A person may not become or continue to be a substantial shareholder of a licensed
corporation without first being approved by the SFC as such (s. 131 and Schedule 1, SFO).
7.15 A substantial shareholder of a corporation is formally defined in Schedule 1, SFO. In simple
terms for the purposes of this manual, it may be taken to refer to a person who alone or together
with his associates:
(a) has an interest of more than 10% of the total number of issued shares of the corporation;
(b) directly or indirectly has more than 10% of the voting power of the corporation at a
general meeting; or
(c) is able to exercise 35% or more of the voting power of another corporation at a general
meeting which in turn has more than 10% of the voting power of the corporation at a
general meeting.
Note: The above definitions in the SFO of responsible officers, executive directors, executive
officers and substantial shareholders are given specific and limited meanings

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applicable to intermediaries and their associated entities. The respective terms may
have other meanings in other situations.
7.16 The substantial shareholder must keep the SFC informed of his contact details and must notify
the SFC of any changes within 14 days.
7.17 A person who becomes a substantial shareholder without first obtaining the permission of the
SFC commits an offence.
7.18 A defence available to this person is that he was not aware, and could not have reasonably
found out, that he had become a substantial shareholder, and that when he did find out he
applied for approval. (The time limit allowed is as soon as reasonably practicable and in any
event within three business days after he became so aware.) Until the shareholder receives
the SFCs approval that he may continue to be a substantial shareholder of a licensed
corporation, he may not exercise any voting powers (s. 131, SFO).
7.19 The SFC has powers under s. 133, SFO to direct the licensed corporation which has a non-
approved substantial shareholder to forbid his participation in management or in voting at
meetings. Where an application to be a substantial shareholder is rejected by the SFC, it may
direct the person to reduce his interest in the licensed corporation.

Solicitors and accountants


7.20 The position regarding solicitors and professional accountants referred to in section 7.21
below is further clarified under Frequently Asked Questions on the SFCs website.

Exclusions from RAs


7.21 There are certain persons some of whose activities might otherwise fit the descriptions of RAs
listed in Part 1, Schedule 5, SFO, but for the fact that these are specifically excluded from the
definitions of RAs given in Part 2 of the Schedule. Such persons will not need licensing in
respect of those activities. They include:
(a) professional accountants, solicitors and counsel conducting Type 4, Type 5, Type 6 or
Type 9 RAs that are wholly incidental to their professions;
(b) trust companies conducting Type 4, Type 5, Type 6 or Type 9 RAs wholly incidental to
the discharge of their trustee duties;
(c) persons licensed or registered to conduct Type 9 RA who carry out Type 1, Type 2, Type
4 or Type 5 RAs solely for the purposes of their Type 9 RA (the wholly incidental
exemption);
(d) persons licensed or registered to conduct Type 1 RA who carry out Type 4, Type 6 or
Type 9 RAs solely for the purposes of their Type 1 RA (the wholly incidental
exemption);
(e) persons licensed or registered to conduct Type 1 RA who may provide financial
accommodation (Type 8 RA) to facilitate acquisitions or holdings of securities by those
persons for clients; and
(f) corporations carrying out Type 4, Type 5, Type 6 or Type 9 RAs solely for their wholly
owned subsidiaries, holding companies holding all their issued shares or other wholly
owned subsidiaries of the holding company.
The above list of activities and persons conducting them comprise only some of the exclusions
from the licensing requirements. For a full list, refer to Schedule 5, SFO.

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Temporary licences and provisional licences
(ss. 117, 120 and 121, SFO)
7.22 The SFC may grant a temporary licence for a period not exceeding three months, subject to
conditions, to a corporation which principally carries on its business overseas, allowing it to
conduct one or more than one RA (other than Type 3, Type 7, Type 8 and Type 9 RAs) in Hong
Kong. Representatives of licensed and temporarily licensed corporations may be given
temporary licences for a period not exceeding three months for the same purpose. The total
period for which temporary licences can be held by the same person may not exceed six
months over a 24-month period.
7.23 Applicants for representative licences may on application be given provisional licences to
cover the period before the decision on a licensing application is finalised by the SFC. The
provisional licences will be revoked upon the approval or refusal by the SFC of the application.
Use of specified titles
7.24 Unlicensed or unregistered persons may not use the titles specified in Schedule 6, SFO. For
example, a person not licensed for Type 1 RA cannot describe himself as a bond broker, bond
dealer, securities dealer, stock dealer or stockbroker (refer to Schedule 6, SFO for a full list).

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Revision questions:

Question 6: What is the basis of the licensing regime?


Answer 6: That it is a single licensing regime.
Question 7: Name the RAs that require a licence from the SFC.
Answer 7: The ten types are:

Type 1: Dealing in securities


Type 2: Dealing in futures contracts
Type 3: Leveraged foreign exchange trading
Type 4: Advising on securities
Type 5: Advising on futures contracts
Type 6: Advising on corporate finance
Type 7: Providing ATS
Type 8: SMF
Type 9: Asset management
Type 10: Providing credit rating services

Question 8: What is the role of a responsible officer?


Answer 8: A responsible officer is a licensed representative who:
actively participates in or supervises a RA;
is nominated by the licensed corporation as a responsible officer; and
is approved by the SFC as a responsible officer.
Question 9: Who may apply for a temporary licence?
Answer 9: Subject to conditions, a corporation which principally carries on its business
overseas may apply to the SFC for a temporary licence for a period not exceeding
three months, allowing it to conduct certain specified SFC-RAs (including Type 1
and Type 4 RAs) in Hong Kong. Representatives of licensed and temporarily
licensed corporations may be given temporary licences for a period not exceeding
three months for the same purpose.

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8 Types of RA covered in this manual
8.1 As mentioned previously, the following are the RAs covered in this study manual:
(a) dealing in securities (Type 1);
(b) advising on securities (Type 4);
(c) providing ATS (Type 7); and
(d) SMF (Type 8).

Dealing in securities (Type 1 RA)


8.2 A person is required to be licensed or registered for Type 1 RA if he carries on a business in
Hong Kong of dealing in securities or holds himself out as carrying on such a business activity.
8.3 Securities are defined in Schedule 1, SFO, to cover a wide range of instruments, including:
(a) shares, stocks, debentures, loan stocks, funds, bonds or notes;
(b) rights, options or interests in the above instruments;
(c) certificates of interest or participation in, or warrants to subscribe for or purchase, the
above instruments;
(d) interests in CISs;
(e) interests, rights or property, whether in the form of instruments or otherwise, commonly
known as securities;
(f) interests, rights or property which are prescribed by the Financial Secretary under s. 392,
SFO as securities; and
(g) structured products that do not fall within (a) to (f) above but are the subject of an offer
to the public which is authorized or required to be authorized under s. 105(1), SFO.
8.4 The above definition of securities specifically includes derivatives such as options (and
implicitly warrants) in respect of the underlying shares, stocks etc..
8.5 Derivatives are defined (for the purposes of market misconduct) in s. 245, Part XIII and s.
285, Part XIV, SFO, in relation to listed securities (whether or not the derivatives themselves
are listed), to mean:
(a) rights, options or interests in, or in respect of, listed securities;
Note: These are also securities per the definition of securities.
(b) contracts for the purposes of making a profit or avoiding a loss, by reference to the price
of listed securities or rights, options or interests in listed securities;
(c) rights, options or interests in respect of (a) or (b); and
(d) instruments or other documents creating, acknowledging or evidencing any of (a) to (c),
including certificates of interest or participation in receipts in respect of, or warrants to
subscribe for or purchase, listed securities or rights, options or interests or contracts.
8.6 Options and warrants are normally considered as derivatives anyway, and it might therefore
seem more logical to study them with other derivatives such as futures. However, warrants
and options on listed securities are traded on the SEHK and will therefore be studied under
the operations of the SEHK. This is one of the anomalies of the Hong Kong market,
contradicting the customary references to the SEHK as the cash market and HKFE as the
derivatives market.
8.7 It is appropriate here to refresh the candidates understanding of the principal and agency
functions of dealing in securities. An important role of a dealer is to bring together those with

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surplus capital to invest and those who need investment capital. This function is exercised via
the primary market, and transactions are carried out through the process of underwriting and
distribution to investors of new issues of securities. Investment dealers assume the function
as principals in this role. When acting as a principal, the dealer owns securities as part of its
own inventory in its buying and selling transactions with investors.
8.8 The second function of a dealer is to facilitate active and liquid secondary markets in the
shares. A dealer may act as principal or agent in this role. When acting as an agent, the dealer
buys and sells shares on behalf of clients and does not own the shares itself at any time during
the transactions. The dealers profit is the brokerage commission charged for each transaction.
On the other hand, a dealer who acts as principal in secondary markets does so by maintaining
an inventory of issued securities. The dealer buys shares in the market, holds them in inventory
for a certain period of time and then sells them. The dealer may also complete a buy and sell
transaction from its own books.
8.9 Type 1 RA, dealing in securities, is defined in Schedule 5, SFO. A person deals in securities
if he makes or offers to make an agreement, or induces or attempts to induce another person
to enter into an agreement:
(a) for acquiring, disposing of, subscribing for or underwriting securities; or
(b) for the purpose of making profits from securities.
8.10 Excepted from the definition are:
(a) a recognized stock exchange, clearing house or authorized ATS;
(b) a person dealing in securities as defined above through a licensed securities dealer or
registered institution (see Note below, which applies only to this category of persons);
(c) a person acting as principal with certain types of professional investors (PIs), or in the
acquisition, disposal, subscription or underwriting of securities;
(d) the issuing of prospectuses and forms of application for shares with prospectuses;
(e) the issuing of an advertisement or invitation authorized by the SFC;
(f) a trust company registered under the Trustee Ordinance acting for a CIS; and
(g) certain Type 4, Type 6 and Type 9 RAs.
Note: Nevertheless, such persons will be regarded as dealing in securities if in return for
remuneration they:
(i) communicate agreements or offers as mentioned above from a third person to a
securities dealer;
(ii) make such an agreement or offer on behalf of a third person with a securities
dealer;
(iii) accept an offer from a third person for a securities dealer; or
(iv) make introductions between a securities dealer and a third person.
8.11 For clarity, dealing in securities for the purposes of the SFC licensing regime will include
dealing in securities traded on the SEHK and other securities, where the activity is conducted
in Hong Kong.

Categories of persons licensed or registered for Type 1 RA


8.12 To conclude this initial definition section, the categories of persons conducting Type 1 RA
include:
(a) a participant of the SEHK, whether it engages in activities on the SEHK or outside it;
(b) another securities dealer carrying out dealing in securities in Hong Kong;

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(c) a licensed representative of the above;
(d) an AFI registered with the SFC for this activity (and its staff who deal with the public and
are on a register maintained by the HKMA as engaged in such activity);
(e) a portfolio manager who is licensed (as a securities dealer) for Type 1 RA; and
(f) a securities introducing agent.
This list is not exhaustive.

Structure of large entities


8.13 Thus, it is common for larger entities to structure themselves to include one or more of the
following entities:
(a) a securities dealing company which transacts the major part of dealing in securities in
Hong Kong and elsewhere for the group (Type 1 licence);
(b) a participant of the SEHK through which securities dealing on the SEHK is channelled
by the first company (Type 1 licence);
(c) an SMF company which lends money for SMF direct to investors (Type 8 licence); the
use of this vehicle is diminishing after the SFC tightened the requirements on SMF;
(d) a finance company which may engage in treasury functions for the group; and
(e) a group holding company.
8.14 The various entities must comply with the regulatory requirements of the SFC regime in
accordance with their licences and with the exchange/clearing house rules according to the
type of participants involved.

Approved introducing agents


8.15 Approved introducing agents form a sub-set of dealers in securities, not defined in the SFO
but created under s. 58(4), Securities and Futures (Financial Resources) Rules (FRR) to
cover introducers of securities business to other securities dealers.

8.16 The SFC may approve a licensed corporation as an approved introducing agent if it can satisfy
the SFC that it only conducts the business of:
(a) receiving from a client offers for dealings in securities and passing on the offers in the
name of the client to an exchange participant, or another licensed dealer; or
(b) introducing a client who wishes to trade in securities to an exchange participant, or
another licensed dealer; and
(c) does not handle client assets and incurs no legal liability in respect of the introduced
business except for its own negligence, wilful default or fraud.
8.17 Capital and other requirements for approved introducing agents are discussed in section 1 of
Topic 5.

Other securities activities


8.18 Discussions about the other 3 RAs relating to securities (i.e. advising on securities, providing
ATS and SMF) are provided in Topic 5. Topic 5 also includes discussions about various forms
of Type 1 RA such as short selling, securities borrowing and lending, online trading and
advising on securities, offers of securities and cross-border trading.

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Revision question:

Question 10: Give three examples of categories of persons licensed or registered for Type 1 RA,
i.e. dealing in securities.
Answer 10: Any three listed in section 8.12.

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9 Requirements for licensing fitness and properness
9.1 Both corporate (including officers e.g. directors, managers etc.) and individual applicants for
licences or registration have to satisfy fitness and properness requirements. There are four
main categories of these fit and proper requirements (s. 129, SFO):
(a) financial status or solvency;
(b) educational or other qualifications or experience (having regard to the nature of the
functions to be performed);
(c) ability to carry on the RA competently, honestly and fairly; and
(d) reputation, character, reliability and financial integrity.
These requirements apply to applicants and to licensed and registered persons on an ongoing
basis. Compliance with the requirements will be monitored by the HKMA in the case of AFIs
and their executive officers and staff, and by the SFC in other cases.
9.2 The onus is on applicants to make the case that they are fit and proper to the satisfaction of
the SFC.

Fit and proper criteria for licensed representatives and responsible


officers (and equivalents for registered institutions)
Financial status or solvency
9.3 An individual applicant should not, in Hong Kong or elsewhere, be an undischarged or
recently discharged bankrupt, be currently involved in bankruptcy or similar proceedings or
have failed to meet any judgment debt.

Competence and capability


9.4 An individual applicant should meet age requirements (i.e. 18 years for representatives or
equivalents) and competence qualifications as listed in the Fit and Proper Guidelines and
amplified in the Guidelines on Competence.

9.5 The competence tests involve experience and educational qualifications.

Character and integrity


9.6 An individual applicant should satisfy the SFC (or the HKMA as appropriate) that he:
(a) is of good character;
(b) has not breached any codes or guidelines promulgated by the SFC or other regulators;
(c) has not been subject to disciplinary action by professional associations;
(d) has not been disqualified by the court from acting as a director, as detailed in the Fit and
Proper Guidelines; and
(e) has not been a director or substantial shareholder of, or been involved in managing, an
insolvent corporation.
An individual applicant whose application is successful should continue to meet the
requirements in sections 9.9 to 9.11 below on an ongoing basis.

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Fit and proper criteria for corporate applicants and intermediaries
(i.e. licensed corporations and registered institutions)
Financial status or solvency
9.7 An intermediary should:
(a) be able to comply with the capital requirements: for licensed corporations the FRR, and
for registered institutions the HKMAs capital adequacy requirements; and
(b) not be subject to insolvency proceedings or have failed to meet a judgment debt.

Competence and capability


9.8 An intermediary is expected to demonstrate that it is competent, in accordance with the
Guidelines on Competence, and to conduct its RA efficiently and effectively. The criteria
include:
(a) proper organizational structure based on good corporate governance principles and
incorporating clear lines of responsibility and authority;
(b) risk management policies, controls and procedures established as an independent
function under a competent risk manager;
(c) effective internal control systems and independent internal audit and compliance
functions staffed by qualified and experienced personnel;
(d) effective information technology support;
(e) appropriately qualified employees with supervisory staff having at least three years
relevant experience and appropriate academic qualifications; and
(f) suitable training policies and programmes.
9.9 The guidelines apply to applicants as well as to intermediaries already licensed or registered,
as long as they retain this status. Competence includes proper business structures, sound
internal control and risk management systems and competent personnel. These are detailed in
Appendix A to the Guidelines on Competence.
9.10 When considering an application from a corporation, the SFC may take into account any
information in its possession, whether or not provided by the applicant (in the case of
applications for registration with the SFC by AFIs, the HKMA takes the main vetting role),
relating to:
(a) any other person who is or is to be employed by, or associated with, the applicant;
(b) any other person who will be acting for or on behalf of the applicant in relation to the RA;
or
(c) where the applicant is a corporation in a group of companies:
(i) any other corporations in the same group of companies; or
(ii) any substantial shareholders or officers of the applicant or any corporation referred
to above (sub-paragraph A of s. 129(2)(b)(iii), SFO).
9.11 The SFC and the HKMA may also have regard to the fitness and properness of related persons
who are not licensed or registered, such as non-executive directors and officers, as well as
substantial shareholders and other controllers of a corporation.

Character and integrity


9.12 A corporate applicant must be reliable and have a good reputation and financial integrity. It
must also meet similar requirements as in section 9.6 above, except for section 9.6(d).

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These requirements will have to be satisfied on an ongoing basis after licensing or registration
has been obtained.
9.13 The SFC carries out vetting tests with the police, the customs and excise authorities and
overseas regulators, if necessary, to satisfy itself as regards criminal and disciplinary records.

Continuous professional training


9.14 The Guidelines on CPT set out the SFCs expectations regarding CPT to foster the fitness and
properness of the licensed or registered persons through periodic training to enhance their
technical skills, professional expertise, ethical standards and regulatory knowledge. These
guidelines will also be applied as appropriate by the HKMA. The objectives of the CPT
programme are to:
(a) maintain and enhance the technical knowledge and professional expertise of individuals
carrying on RAs;
(b) provide investors with the assurance that the licensed or registered individuals they may
deal with have the necessary skills, experience, knowledge and ethical standards to carry
out the RAs in an efficient, effective and fair manner; and
(c) maintain and enhance the international reputation of Hong Kong for high professional
standards.
9.15 The Guidelines on CPT set out the SFCs requirements that, among other things,:
(a) corporations should conduct or arrange CPT programmes best suited for their staff to
enhance their industry knowledge, skills and professionalism; and
(b) individuals should always remain competent in performing RAs by means of ongoing
CPT programmes.
9.16 The SFC requires every individual licensee to undertake a minimum of five CPT hours every
calendar year for each RA, with proportional hours for those who obtained their licences
during the year. The SFC has introduced the concept of licensees falling into different
competence groups, enabling those who carry on more than one RA to be credited with CPT
hours for all RAs within the same competence group. For example, whereas a licensee for
Type 1 and Type 4 RAs would only need to engage in a minimum of five CPT hours, a licensee
for Type 1 and Type 9 RAs would need to engage in a minimum of 10 CPT hours, as the first
two RAs are under the same competence group while the latter two are not. For details, see
paragraph 4.3.3, Guidelines on CPT.
9.17 CPT may be achieved through attending courses, workshops, lectures, seminars, distance
learning with submission of assignments, self-study with independent assessments, industry
research, publications, delivery of speeches and so on. Reading financial journals, newspapers
and other technical publications, and undertaking normal work and activities which do not
involve interaction with other individuals will not count as CPT.
9.18 Paragraphs 7.1 and 7.2, Guidelines on CPT set out the following as relevant topics for CPT
purposes.
(a) For licensees generally:
(i) applicable compliance, legislative and regulatory standards;
(ii) business conduct and ethical standards;
(iii) new financial products in the industry and the associated risk management systems;
(iv) business communication skills and trade practices;
(v) general principles of law;
(vi) computer knowledge;

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(vii) basic accounting theories; and
(viii) fundamental economic analysis; and
(b) For responsible officers, in addition to the above topics:
(i) business management;
(ii) risk management and control strategy;
(iii) general management and supervisory skills;
(iv) macro and micro economic analysis; and
(v) financial reporting and quantitative analysis.
9.19 The Academic and Accreditation Advisory Committee of the SFC has endorsed a list of
recognized institutions for providing CPT.
9.20 Corporations and individuals should keep the training materials and attendance records of
CPT programmes. Individuals taking CPT programmes should keep proof of attendance.
Records should be retained for a minimum of three years.
9.21 As discussed above, the HKMA expects staff of registered institutions responsible for or
conducting RAs to comply with the SFCs Fit and Proper Guidelines, Guidelines on
Competence and Guidelines on CPT requirements, with compliance monitored by the HKMA.
9.22 Failure to have in place appropriate CPT programmes or to maintain CPT records by a
corporation, or failure to comply with the minimum CPT requirements or to keep appropriate
records on the CPT programmes undertaken by an individual will raise serious concerns as to
the fitness and properness of those persons, which may lead to disciplinary proceedings and
to suspension or revocation of their licences. These failure may lead to disciplinary action by
the SFC (against responsible officers and licensed representatives of licensed corporations) or
the HKMA (against executive officers and relevant individuals of registered institutions).

Licensing Handbook
9.23 This handbook gives full details of how to apply for a licence and the various requirements.
It summarizes those relating to licensing matters as set out in the SFO and its subsidiary
legislation such as the Securities and Futures (Licensing and Registration) (Information) Rules
(Information Rules).

Securities and Futures (Licensing and Registration) (Information)


Rules
9.24 The Securities and Futures (Licensing and Registration) (Information) Rules prescribe:
(a) information to be provided with applications to the SFC;
(b) changes to be notified by intermediaries, licensed representatives and substantial
shareholders;
(c) information to be contained in annual returns by licensed persons; and
(d) particulars for entry in the Public Register maintained by the SFC.

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Revision question:

Question 11: What criteria do an applicant for a licence from or registration with the SFC have to
meet?
Answer 11: A corporation or an individual seeking a licence or registration is required to meet
the fitness and properness criteria.

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10 Corporate governance and regulatory supervision
Introduction
10.1 We shall consider the overall law, codes and practices and how intermediaries can ensure that
they have a properly regulated environment within which they may achieve their business
objectives.
10.2 The basic principle is that an intermediary should ensure that a good compliance philosophy
is established throughout its operations, and that all directors and employees fully understand
its practical applications and conduct themselves at all times in a manner consistent with the
highest expectations of clients, the market, the regulators and Government.
10.3 We shall review some of the areas that an intermediary and its staff should bear in mind when
they conduct business activities externally and internally.

The role of senior management


10.4 Senior management must provide the leadership and drive to promote, encourage and enforce,
if necessary, good compliance practices. It must establish:
(a) good line and reporting structures;
(b) clearly defined functions and responsibilities;
(c) effective communications;
(d) appropriate transparency and disclosure practices;
(e) well-defined policies, practices and procedures which are set out in writing;
(f) distinctions between supervisory and review functions, and operational and line functions;
(g) good relationships with external agencies, such as regulators and auditors;
(h) open access for complaints, which should be promptly and satisfactorily dealt with from
the point of view of the complainant as well as the business; and
(i) good corporate governance.

Corporate governance
10.5 Corporate governance has been defined in various ways. It can be seen as primarily concerned
with the proper relationship between a companys management, its board and its shareholders,
and possibly also its stakeholders (i.e. groups who have a stake in the healthy existence of a
corporation, such as employees, creditors and customers). The governance issue is therefore
also concerned with the system by which companies are directed and controlled. The
Organisation for Economic Co-operation and Development (OECD) has issued a set of core
principles of corporate governance practice to include fairness, transparency, accountability
and responsibility.
10.6 Both the SFO and the regulatory approach implemented by the SFC in its various codes of
conduct place considerable emphasis on the senior management of intermediaries setting, and
ensuring compliance with, appropriate standards of conduct (for example, the Code of
Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct)). This
requires proper systems of internal control to be implemented (e.g. as required by the
Management, Supervision and Internal Control Guidelines for Persons Licensed by or
Registered with the SFC). Such requirements are, in some aspects, a sub-topic of corporate
governance.
10.7 The activities of intermediaries frequently concern listed corporations. Accordingly, in
addition to considering their own regulatory and corporate governance position,

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intermediaries need to be aware of the wider impact of corporate governance on their clients
and the market. It is now generally accepted that investors attach considerable importance to
corporate governance when assessing the value of a stock, and that markets which exhibit a
higher degree of good corporate governance are regarded as more competitive in the
international arena.
10.8 The SFO has given greater powers to the SFC to investigate possible malfeasance in listed
companies, including the ability to obtain documents and explanations from parties connected
to the listed company, such as banks, auditors and transaction counterparties. In addition, the
Listing Rules of the SEHK (i.e. for both the Main Board and Growth Enterprise Market)
continue to be strengthened in this regard through the continuing obligations of listed
companies. In view of these added regulatory powers, corporate governance is a topic with
which bodies such as the SFC and the SEHK are increasingly concerned.

Objectives and structures


10.9 A key objective of good governance in any corporate business is to avoid management taking
improper advantage of its position to benefit itself in preference to the legitimate interests of
the company. Having regard to the general concepts set out by the OECD, some of the ways
a company may improve its governance are as follows:
(a) installing appropriate checks and balances, such as separating the functions of the
chairman and chief executive officer, appointment of independent non-executive
directors, establishment of independent audit committees, and setting up committees to
control the remuneration and benefits of directors and senior management;
(b) increasing transparency and disclosure to shareholders, stakeholders and the public;
(c) adopting international accounting and auditing standards;
(d) installing strong protective structures for minority shareholders, creditors and other
lenders; and
(e) identifying and penalising corporate wrongdoing.

Some of the effects of deficiencies in corporate governance


10.10 Deficiencies in corporate governance standards are believed to have resulted in:
(a) insider dealing;
(b) fraud, malfeasance and misconduct by directors and managers aimed at benefiting
themselves and, as a result, causing loss to corporations or their members; and
(c) connected transactions which are undervalued (for example, transfer of a company asset
to a connected person at a low price) or overvalued (for example, an asset is acquired by
the company from a connected person at an excessively high price).

Regulatory supervision by the SFC


10.11 The SFC exercises its regulatory mandate to supervise the industry through several
mechanisms:
(a) licensing, whereby only fit and proper persons are permitted to engage in RAs;
(b) supervision and monitoring, whereby intermediaries comply on an ongoing basis with
applicable laws and regulations;
(c) marketing of investment products, whereby appropriate standards are adopted through
the authorization of CIS; and
(d) discipline, whereby persons in breach of laws or regulations are suitably dealt with.

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10.12 In furtherance of these aims, the SFC conducts regular inspections of licensed corporations
which may be conducted either on-site or via a request for information to be provided. The
maintenance of proper documentation is critical in this regard.
10.13 Intermediaries with international aspects to their business operations will be aware that
regulators in different jurisdictions are increasingly co-operative in the sharing of information
and their approach to regulatory issues. It is important that these intermediaries have proper
regard to the laws, regulations and practices in other relevant jurisdictions when operating in
Hong Kong. The SFC has signed Declarations of Cooperation on Investment Management
with regulatory authorities in other jurisdictions, including the Securities and Exchange
Commission in the United States, the Financial Services Authority in the United Kingdom and
regulatory authorities in Europe.

Compliance: industry practices


10.14 In order to facilitate compliance with applicable legal and regulatory requirements (in Hong
Kong and, where applicable, in overseas jurisdictions), there is a growing tendency to adopt
a detailed compliance manual which sets out the securities dealers or advisers policies and
procedures in relation to matters of regulatory concern. In many cases, a dedicated compliance
officer is engaged to oversee adherence to the manual, maintain close contact with the
regulators and keep abreast of regulatory developments affecting the securities dealers or
advisers business.
10.15 The securities dealer or adviser may also adopt operational procedures and practices to
complement the core compliance manual in order to deal with more detailed matters such as
the requirements of particular systems (dealing, settlement etc.) as well as those of external
service providers.
10.16 In each case, the details of any compliance manual or operations manual will need to be
tailored to the specific circumstances and needs of each securities dealer or adviser.

Revision questions:

Question 12: What is corporate governance?


Answer 12: It can be seen as primarily concerned with the proper relationship between a
companys management, its board and its shareholders, and possibly also its
stakeholders (i.e. groups who have a stake in the healthy existence of a corporation,
such as employees, creditors and customers).
Question 13: Name three ways of improving corporate governance.
Answer 13: Any three of the ways as mentioned in section 10.9.

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11 Provision of information to the SFC
To provide information under the SFO, its subsidiary legislation and codes
and guidelines
11.1 In addition to the general corporate governance framework, the regulatory framework includes
specific provisions governing information flows between intermediaries and the SFC.
11.2 The SFO, its subsidiary legislation and codes and guidelines such as the Code of Conduct,
Management, Supervision and Internal Control Guidelines for Persons Licensed by or
Registered with the SFC and other guidelines, guidance notes and circulars issued by the SFC
require intermediaries, and sometimes their associated entities, to provide information to the
SFC. These reporting or notification requirements are reviewed together with relevant topics
in this manual.

To provide information when the SFC conducts inspections


11.3 Candidates should also note that s. 180, SFO gives the SFC power to (i) conduct inspections
for the purposes of ascertaining whether an intermediary or an associated entity of an
intermediary has complied with the SFO and any related notices and requirements, any terms
and conditions of any licence or registration, any other imposed condition or relevant
provisions of the Anti-Money Laundering and Counter-Terrorist Financing (Financial
Institutions) Ordinance; or (ii) require copies of documents or inquire into the affairs of a
licensed corporation or its related corporations for the purpose of providing assistance, in
relation to the licensed corporation, to an authority or regulatory organization outside Hong
Kong.
11.4 According to s. 180(1), SFO, the SFC may appoint an authorized person, usually a member
of its staff, to enter the premises of an intermediary or an associated entity of an intermediary,
inspect and make copies of relevant documents, and make inquiries of the intermediary, the
associated entity or a related corporation of an intermediary or an associated entity, and any
other person whom the authorized person has reasonable cause to believe is in possession of
any relevant record or document.
11.5 The authorized person may in writing require the person giving an answer to substantiate that
answer within a reasonable period in a statutory declaration which may be taken by the
authorized person, or to make a statutory declaration that he could not give an answer because
it was not within his knowledge.
11.6 Section 182, SFO provides that the SFC may authorize one or more of its employees or, with
the consent of the Financial Secretary, appoint one or more other persons to carry out an
investigation to follow through suspicions of malpractice, fraud or other market misconduct
or situations where the interest of the investing public may be jeopardised. The SFC can
investigate any person, including licensed and registered persons.
11.7 Section 183, SFO requires the person under investigation to:
(a) provide documents and explanations;
(b) attend before the investigator at the time and place the investigator requires in writing
and to answer questions;
(c) give the investigator all reasonable assistance, including responding to any written
question raised by the investigator;
(d) substantiate his answers, explanations or statements by making a statutory declaration;
and
(e) if he is unable to give an answer, explanation or statement regarding the investigators
inquiries for the reason that such answer, explanation or statement was not within his

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knowledge or in his possession, make a statutory declaration to verify that he is unable
to comply with the investigators inquiries due to that reason.
11.8 A person who, without reasonable excuse, fails to comply with the requests of an investigator
as mentioned in the above section, or who provides an explanation, answer or other response
which is false or misleading in material particular, is guilty of an offence. Such guilt extends
to officers or employees of a corporation who, with intent, cause or allow the corporation to
commit the offences.
11.9 Under s. 191, SFO, an employee of the SFC, an authorized person or an investigator may, in
appropriate circumstances, apply to a magistrates court for the issue of a warrant authorizing
specified persons, a police officer and such other persons as may be necessary to assist in the
execution of the warrant to enter specified premises, if necessary by force, at any time within
seven days, and:
(a) require any person on the premises to produce any record or document;
(b) prohibit any person from erasing, altering or removing any record or document;
(c) take further steps which may appear necessary to preserve records or documents and
prevent interference with them; and
(d) retain such records or documents for a period of six months, which may be extended for
criminal proceedings or for any proceedings under the SFO.
11.10 Any person who destroys, falsifies, conceals or otherwise disposes of any documents required
to be produced under Part VIII, SFO is guilty of an offence.

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Topic summary
In this Topic we reviewed the legal and regulatory structure governing the securities industry. An
overview was provided of the various sectors of the Hong Kong market, including regulators,
products, services and providers of services.
We touched upon the SFO, its subsidiary legislation, the relevant codes, guidelines and guidance
notes. An outline of other laws relevant to the securities industry was then provided, including the
company law, contract law, the law of agency, the law of tort, employment law and personal data
privacy law.
We then looked at the role and functions of the SFC, and at the roles of other regulatory authorities
in Hong Kong, such as the HKMA, the MPFA and others. This was followed by a discussion about
the role and main responsibilities of HKEX.
We then examined the overall licensing regime under the SFO and considered some of its important
aspects for which licensed corporations, registered institutions and the individuals accredited to them
should be aware of.
The definition of one of the four RAs covered in this manual (i.e. dealing in securities) was also
reviewed. The definitions of the other three are discussed in Topic 5.
The fitness and properness requirements for corporations and individuals to apply for licences or
registration were explained.
Finally, we closed with a review of general compliance, corporate governance and certain
requirements under the SFO for provision of information to the SFC.

Checklist
Below is a checklist of the main points covered by this Topic. Candidates should use the list to test
their knowledge.
The SFC adopts a risk-based approach in regulating the securities markets.
The SFO is in 17 parts with 10 schedules. It is the principal legislative document governing the
securities market in Hong Kong.
The SFO empowers the SFC to make subsidiary legislation, codes and guidelines for
implementing the detailed requirements of the SFO.
A company is a legal entity distinct from its members. It is a legal person and can make contracts,
take legal action, sue and be sued, own property and commit crimes and torts.
A private company must limit its members to 50, may not offer shares to the public and must
restrict their transfer.
A public company is one that is not a private company and is not a guarantee company.
The articles of association of a company is considered to be the single constitutional document
of the company and form an agreement between the company and its members. The articles of
association prescribe regulations for the internal management and operation of the company.
A special resolution is one passed by at least 75% of members at a general meeting, of which 21
days notice specifying the intention to pass the resolution has been given.
Examples of matters which need special resolutions are reduction of share capital, winding up
of the company voluntarily or by the court and alteration of objects, articles of association.
An ordinary resolution is a resolution which may be passed by a simple majority of those present
and voting at a meeting of members. Notice must be given.

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To ensure that the principle of majority power is not abused, certain safeguards are provided
under the NCO to protect the interests of minority shareholders.
A person cannot be a director if he is below 18, is an undischarged bankrupt, or is disqualified
by court order because he has been convicted of an indictable offence, defaults persistently in
relation to the NCO, has committed fraud, or has been found to be unfit while being a director
of an insolvent company.
Members in general meeting may only intervene in the management if the directors are unwilling
to act, seeking approval to act beyond their powers or acting in breach of their fiduciary duties.
The directors have a fiduciary relationship with the company. They must act bona fide for the
benefit of the company, to exercise his powers for his proper purpose, and not to allow any
conflict of interest between his duties as director and his personal interests.
A mixed objective and subjective test for determination of the standard of directors duty of care,
skill and diligence is introduced in s. 465, NCO.
Remedies for a breach of duty by a director are injunction, rescission, damages and possible
accounting for any profits he has made by committing the offence.
If a director is directly or indirectly interested in a transaction, arrangement or contract with the
company that is significant in relation to the companys business, he must declare the nature and
extend of that interest (if it is material) as soon as reasonably practicable.
Authority for payment is provided in the articles: for example, it provides that the remuneration
of directors will be determined by the company in general meeting. This usually covers directors
fees. If a director holds some other position, such as managing director or executive director, he
may have a service contract.
The Financial Secretary is required to appoint inspectors to investigate and report on the affairs
of a company if the court declares that an investigation should be carried out.
A compulsory liquidation is a compulsory winding-up ordered by the court, and the liquidator is
appointed by the court and acts under its control.
A voluntary winding-up may be started by members or creditors. There are fewer formalities
than with a compulsory liquidation and this route is far more popular.
A members voluntary winding up is undertaken if directors issue a certificate of solvency
(which must be issued within the 5 weeks preceding the resolution for winding up the company
and be delivered to the Registrar of Companies for registration not later than when the copy of
the winding-up resolution is delivered) to the effect that they have made a full enquiry into the
affairs of the company and formed the opinion that the company will be able to pay its debts
within 12 months.
By way of a creditors voluntary winding up, the company shall arrange a meeting of the
creditors to be held for the purpose.
Personal data means any data relating directly or indirectly to a living individual from which
it is practicable for his identity to be found (and are in a form in which access or processing is
practicable).
The six principles of data protection in the PDPO cover the purpose and manner of data collection,
its accuracy and the duration of retention, the use to which it is put, its security, the availability
of the data and access to it by the data subject.
An objective of the SFC is to provide protection to investors in securities and futures products.
An objective of the SFC is to minimize crime and misconduct in the securities and futures
industry.
A function of the SFC is to promote, encourage and enforce the proper conduct, competence and
integrity of persons carrying on RAs.

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A function of the SFC is to suppress illegal, dishonourable and improper practices in the
securities and futures industry.
The SFC has established the Takeovers and Mergers Panel to administer The Codes on
Takeovers and Mergers and Share Buy-backs.
The SFAT is an independent statutory body which hears appeals against decisions of the SFC
relating to the licensing or registration of intermediaries.
The HKMA maintains currency stability and the safety and stability of the banking system.
The institutions supervised by the HKMA must be registered with the SFC as registered
institutions if they wish to undertake activities regulated by the SFC.
The Insurance Authority authorizes and regulates insurance companies.
Insurance agents must register with The Hong Kong Federation of Insurers and comply with its
code of practice.
Insurance brokers are approved by the Hong Kong Confederation of Insurance Brokers or the
Professional Insurance Brokers Association, which regulate them.
Investment-linked assurance schemes and pooled retirement funds are authorized by the SFC.
The MPFA registers MPF schemes and approves pooled investment funds. It approves trustees
of such schemes and refers complaints about trustees to the SFC.
The SFC vets and authorizes MPF products and related marketing materials.
The SFC investigates alleged breaches of the SFC Code on MPF Products and takes enforcement
actions.
HKEX is a listed company and a recognized exchange controller, with the exchanges and
clearing houses as subsidiary companies.
The SFC supervises and monitors HKEX, the exchanges and the clearing houses.
HKEX, the exchanges and the clearing houses manage business risk and enforce their own
trading, settlement and clearing rules.
The SFC is responsible for the front-line prudential and conduct regulation of market participants.
Those requiring a licence are corporations that wish to conduct RAs and the individuals who are
accredited to them as representatives for carrying out these activities.
An AFI that wishes to conduct one or more RAs must seek registration with the SFC as a
registered institution, which will be supervised generally by the HKMA. A registered institution
should ensure that persons it engages to conduct RAs are fit and proper.
Licensed representatives may be nominated by their employer as responsible officers, subject to
approval by the SFC.
There must be at least two approved responsible officers for every RA conducted by a licensed
corporation, at least one of whom must be an executive director. There must be a responsible
officer supervising each RA of a licensed corporation in Hong Kong at all times. Similarly, there
must be at least one executive officer supervising each RA of a registered institution at all times.
RAs covered in the study manual are: dealing in securities (Type 1), advising on securities (Type
4), providing ATS (Type 7) and SMF (Type 8).
Fit and proper guidelines include the four categories of financial status or solvency, competence
and capability to carry out the appropriate functions, education, qualification or experience and
good character and integrity.
A corporation or an individual applying for a licence or registration is expected to demonstrate
that it is competent in accordance with the Guidelines on Competence.

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A corporate or individual applicant for a licence or registration should be of good character.
The SFC conducts vetting tests with the police, customs and excise authorities and overseas
regulators of the criminal and disciplinary records of applicants.
A licensed corporation must comply with the SFCs FRR requirements and a registered
institution must comply with the HKMAs capital adequacy requirements at all times.
Corporations have a duty to conduct or arrange CPT programmes for their staff.
Licensed or registered individuals have to complete a minimum of five CPT hours annually.
The role of senior management is crucial to establishing a good compliance culture in an
intermediary. (Refer to section 10.4 above for specific issues senior management must consider.)
Corporate governance is the system by which business corporations are directed and controlled
and covers the relationships between a companys management, its board, members and
stakeholders.
Good corporate governance may include appropriate checks and balances on the board and
management, adequate transparency and disclosure of material facts and information to
stakeholders, strong protective measures for minority shareholders, and the identification and
punishment of corporate wrongdoing.
Securities dealers and advisers should have designated compliance officers and written
compliance procedures, operational procedures and manuals to facilitate compliance with
applicable laws and regulations.
The SFO, its subsidiary legislation and codes and guidelines issued by the SFC include
requirements to provide information to the SFC. The SFC may appoint authorized persons to
inspect and make copies of relevant documents, and question an intermediary, an associated
entity or a related corporation.

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Appendix I
This Appendix provides an outline of the SFO.
Note: Candidates will not be examined on this material.
Part I states that most of the general definitions used throughout the SFO are set out in Schedule 1.
Part II deals with the objectives, functions, powers and general duties of the SFC, its powers of
delegation and its relationships with the Chief Executive of the Hong Kong SAR and the Financial
Secretary.
Part III provides for the recognition by the SFC of various operators of the market infrastructure in
Hong Kong, including exchange companies, clearing houses, exchange controllers and ICC. The SFC
is bound to consult and/or obtain the consent of the Financial Secretary prior to any such recognition.
Part IV deals with offers of investments to the public: It is an offence to make an offer of investments
to the public unless the circumstances of the offer are in accordance with the permitted routes of so
doing (s. 103, SFO). The SFC is empowered to grant authorization to CISs and structured products,
thereby enabling them to be marketed to the public (ss. 104 and 104A, SFO); and the SFC is
empowered to authorize the issue of advertisements and other documents that contain an offer to the
public (s. 105, SFO).
Part V deals with licensing and registration matters. It also states that any person who carries on or
holds himself out as carrying on the business of a RA commits an offence unless that person is
appropriately licensed by or registered with the SFC, or an applicable exemption applies to that
person/activity. The ten activities regulated by the SFO and the SFC are listed in Schedule 5.
Part VI defines capital requirements, safeguarding of client assets, proper keeping of records, and
provisions for accounts and audits, which are all supplemented by subsidiary rules made by the SFC.
Part V deals with licensing and registration matters, and Part VI progresses from Part V to providing
the SFC with powers to regulate certain basic aspects of intermediaries. In particular, the SFO grants
the SFC powers to make detailed rules relating to their financial resources, the handling of client
money and other client assets, the keeping of accounts and records and auditing matters.
Part VII empowers the SFC to make subsidiary legislation (s. 168, SFO) and/or codes (s. 169, SFO)
to regulate the conduct of intermediaries (including registered institutions) and their representatives
in the RAs.
Part VIII empowers the SFC to carry out inspections and investigations in relation to listed
corporations (s. 179, SFO), intermediaries and their associated entities (s. 180, SFO) and specified
transactions (s. 181, SFO).
Part IX provides that if a regulated person is guilty of misconduct, or is not a fit and proper person,
the SFC may take disciplinary action against them. Such action includes revocation or suspension of
licences, public or private reprimand, prohibition of the regulated person from applying for a licence,
registration, approval as a responsible officer or to act as an executive officer, and the payment of a
penalty. Regulated person here refers to a licensed corporation, a licensed representative, a
responsible officer of a licensed corporation, or a person involved in the management of the business
of a licensed corporation.
Part X empowers the SFC to intervene in the way a licensed corporation conducts its business to
protect the interests of investors of licensed corporations and minority shareholders of listed
corporations, and also has the effect of protecting those of trade and other creditors. It may be used
where it is in the interests of the investing public or in the public interest, or where the licensed
corporation has shown that it does not meet the fit and proper criteria, has contravened the specified
provisions of the SFO or has had its licence suspended or revoked.
Part XI provides for setting up the SFAT, chaired by a High Court judge, to hear appeals against
specified decisions made by the SFC or, in the case of registered institutions, the HKMA. The
specified decisions which can be reviewed by the Tribunal are set out in Part 2, Schedule 8, SFO.

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Part XII provides for establishing and maintaining a single Investor Compensation Fund to cover
losses incurred by clients of intermediaries in general, including non-exchange participants.
Part XIII sets up the MMT to hear cases of market misconduct, such as insider dealing, price rigging,
stock market manipulation, disclosure of confidential information and so on.
Part XIV defines the criminal regime for market misconduct and sets out the maximum penalties. All
forms of market misconduct, including some not specified in Part XIII, will be criminal offences.
Part XV reflects the modern trend towards greater disclosure and transparency in securities markets
The core requirement of Part XV is the disclosure of interests in the relevant share capital of a listed
company, i.e. its voting shares, and the threshold of disclosure of shareholdings (notifiable interests)
and the notification period.
Part XVI gathers together a number of provisions of common application as well as regulatory powers.
It includes miscellaneous provisions that do not fit elsewhere and additional ones which relate to the
increase in civil law applications, such as:
(a) secrecy provisions (s. 378, SFO) specifying various persons to whom the SFC may provide
confidential information and the circumstances in which the SFC may do so;
(b) statutory immunity provided to persons performing the SFCs statutory functions in good faith
(s. 380, SFO);
(c) auditors of listed corporations reporting suspected fraud and other improper practices they
encounter in the course of their audits who are given immunity from civil liability (s. 381, SFO);
and
(d) Powers are given to the Financial Secretary to prescribe, by notice in the Gazette:
(i) new financial products as being (or not being) securities or futures contracts, and new
financial arrangements as CISs, thus capturing new products in the regulatory net as
appropriate (ss. 392 and 393, SFO); or
(ii) any stock market, futures market, clearing houses or type of instrument for determination
of whether a financial product falls into the definition of OTC derivative product or not (s.
392A, SFO).
The provisions of Part XVII are concerned only with ensuring a smooth transition from the securities
and futures laws in place prior to the SFO, about which comprehensive information is given in
Schedule 10.

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Appendix II
This Appendix lists the major subsidiary legislation of the SFO, codes, guidelines and guidance
notes issued by the SFC which are discussed in detail in the relevant topics of this manual.

1 Major subsidiary legislation


(a) Securities and Futures (Financial Resources) Rules
(b) Securities and Futures (Client Securities) Rules
(c) Securities and Futures (Client Money) Rules
(d) Securities and Futures (Contract Notes, Statements of Account and Receipts) Rules
(e) Securities and Futures (Keeping of Records) Rules
(f) Securities and Futures (Accounts and Audit) Rules
(g) Securities and Futures (Licensing and Registration) (Information) Rules
(h) Securities and Futures (Short Selling and Securities Borrowing and Lending (Miscellaneous))
Rules
(i) Securities and Futures (Contracts Limits and Reportable Positions) Rules
(j) Securities and Futures (Short Position Reporting) Rules
(k) Securities and Futures (Professional Investor) Rules
(l) Securities and Futures (Associated Entities Notice) Rules
(m) Securities and Futures (Insurance) Rules
(n) Securities and Futures (Investor Compensation Levy) Rules
(o) Securities and Futures (Investor Compensation Compensation Limits) Rules
(p) Securities and Futures (Investor Compensation Claims) Rules
(q) Securities and Futures (Disclosure of Interests Securities Borrowing and Lending) Rules
(r) Securities and Futures (Levy) Order
(s) Securities and Futures (Miscellaneous) Rules
(t) Securities and Futures (Unsolicited Calls Exclusion) Rules
(u) Securities and Futures (Price Stabilizing) Rules
(v) Securities and Futures (Leveraged Foreign Exchange Trading) (Arbitration) Rules
(w) Securities and Futures (Stock Market Listing) Rules
(x) Securities and Futures (OTC Derivative Transactions - Reporting and Record Keeping
Obligations) Rules
(y) Securities and Futures (OTC Derivative Transactions Clearing and Record Keeping
Obligations and Designation of Central Counterparties) Rules

2 Major codes, guidelines and guidance notes issued by the SFC


(a) Licensing Handbook
(b) Fit and Proper Guidelines
(c) Guidelines on Competence
(d) Guidelines on Continuous Professional Training
(e) Code of Conduct for Persons Licensed by or Registered with the SFC

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(f) Management, Supervision and Internal Control Guidelines for Persons Licensed by or
Registered with the SFC
(g) Guidance Note on Short Position Reporting
(h) Guidelines for the Regulation of Automated Trading Services
(i) Guideline on Anti-Money Laundering and Counter-Terrorist Financing (together with the
Prevention of Money Laundering and Terrorist Financing Guideline issued by the Securities
and Futures Commission for Associated Entities)
(j) SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes
and Unlisted Structured Investment Products
(k) The Codes on Takeovers and Mergers and Share Buy-backs
(l) Client Identity Rule Policy
(m) Core Operational and Financial Risk Management Controls For Over-the-Counter Derivatives
Activities of Persons Licensed by or Registered with the SFC
(n) The Guidance Note on Short Selling Reporting and Stock Lending Record Keeping
Requirements
(o) Guidelines on Marketing Materials for Listed Structured Products
(p) Guidance Note on Position Limits and Large Open Position Reporting Requirements
(q) Advertising Guidelines Applicable to CISs Authorized under the Product Codes
(r) Guidelines on Disclosure of Inside Information

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Topic 2: Requirements of relevant subsidiary legislation
Table of contents
Topic overview 1
Learning outcomes 1
1 Securities and Futures (Financial Resources) Rules 3
Why are capital requirements necessary? 3
Capital requirements for licensed corporations and registered institutions 3
Requirements of the Securities and Futures Ordinance 3
Securities and Futures (Financial Resources) Rules 3
Liquid assets, ranking liabilities and liquid capital 4
Reporting requirements 7
Monthly returns 7
Quarterly returns 7
Half-yearly returns 7
Failure to meet financial resources requirements 8
2 Securities and Futures (Client Securities) Rules 10
Securities and Futures (Client Securities) Rules 10
Requirement for registration or deposit of client securities and securities collateral 10
Application 11
Client authority 11
Permitted transactions 12
Miscellaneous 13
Reporting for non-compliance 13
Penalties 13
3 Securities and Futures (Client Money) Rules 14
Securities and Futures (Client Money) Rules 14
Payment of client money into segregated accounts 14
Payment of money out of segregated accounts 15
Clients standing authorities 15
Reporting of non-compliance 15
Penalties 15
4 Securities and Futures (Contract Notes, Statements of Account and Receipts) Rules 16
Securities and Futures (Contract Notes, Statements of Account and Receipts) Rules 16
Contract notes 16
Daily statements of account 17
Monthly statements of account 18
Receipts 18
Other related issues 19
Penalties 19
5 Securities and Futures (Keeping of Records) Rules 21
Securities and Futures (Keeping of Records) Rules 21
Records to be kept by intermediaries 21
Records to be kept by associated entities 21
Records to be kept by securities margin financier 22
Record retention 22
Reporting of non-compliance 22
Penalties 22
6 Securities and Futures (Accounts and Audit) Rules 24
Securities and Futures (Accounts and Audit) Rules 24
Appointment of auditors 24
Annual financial statements and other documents 24
Auditors report 25
7 Rules relating to compensation and insurance 28
Investor Compensation Fund 28
Insurance covers by licensed corporations 29
8 Securities and Futures (OTC Derivative Transactions - Reporting and Record Keeping
Obligations) Rules 31
Background 31
Scope of application 31
Reporting obligations 31
Record keeping obligations 32
Consequence of breaches 33
9 Securities and Futures (OTC Derivative Transactions - Clearing and Record Keeping
Obligations and Designation of Central Counterparties) Rules 34
Background 34
Mandatory clearing obligation 34
Product subject to the clearing obligation 34
When the clearing obligation will not apply 35
Clearing related record keeping obligations 36
Consequence of breaches 36
Topic summary 37
Checklist 37
Topic overview
Part VI, Securities and Futures Ordinance (SFO) outlines the framework for ongoing financial and
related requirements, with details supplemented by way of rules and codes. The basis of this approach
is that, consistent with modern securities legislation internationally, effective regulation depends on
regulators having the flexibility to react quickly to changing market practices and global conditions
by amending the rules, rather than the primary legislation, the SFO.
This Topic covers the rules governing the financial resources, handling of client assets, provision of
contract notes, statements of account and receipts and keeping of records that must be observed by
intermediaries conducting the business of dealing in securities, advising on securities and securities
margin financing. They are:
Securities and Futures (Financial Resources) Rules (FRR);
Securities and Futures (Client Securities) Rules (Client Securities Rules);
Securities and Futures (Client Money) Rules (Client Money Rules);
Securities and Futures (Contract Notes, Statements of Account and Receipts) Rules (Contract
Notes Rules);
Securities and Futures (Keeping of Records) Rules (Keeping of Records Rules); and
Securities and Futures (Accounts and Audit) Rules (Accounts and Audit Rules).
It is important that candidates understand how the systems, procedures and practices of an
intermediary (and, where applicable, an associated entity of the intermediary) may facilitate
compliance with the standards and requirements set out in these rules.
Then, we provide an overview of:
the investor compensation arrangements for investors under the Securities and Futures (Investor
Compensation Claims) Rules (Investor Claims Rules) and the Securities and Futures
(Investor CompensationCompensation Limits) Rules (Compensation Limits Rules); and
the insurance covers that licensed corporations are required to arrange under the Securities and
Futures (Insurance) Rules (Insurance Rules).
The Compensation Limits Rules and Insurance Rules strengthen investor confidence and it is also
important for clients to be aware of the existence of the compensation arrangements and the level at
which they can be compensated, where applicable.
We further introduce the Securities and Futures (OTC Derivative Transactions - Reporting and Record
Keeping Obligations) Rules which were enacted on 10 July 2015. They are the first subsidiary
legislation of the over-the-counter (OTC) derivatives market regulatory regime advocated after the
global financial crisis in 2008.
Then, we briefly discuss the Securities and Futures (OTC Derivative Transactions Clearing and
Record Keeping Obligations and Designation of Central Counterparties) Rules, which were enacted
on 1 September 2016.

Learning outcomes
At the end of this Topic, candidates should be able to:
(a) explain the features and practical applications of the FRR;
(b) explain the features and practical applications of the Client Securities Rules;
(c) explain the features and practical applications of the Client Money Rules;
(d) explain the features and practical applications of the Contract Notes Rules;

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(e) explain the features and practical applications of the Keeping of Records Rules;
(f) explain the features and practical applications of the Accounts and Audit Rules;
(g) be aware of Investor Compensation Fund and requirements for licensed corporations to arrange
insurance covers;
(h) explain the features of the reporting and record keeping obligations of licensed corporations
under the Securities and Futures (OTC Derivative Transactions Reporting and Record
Keeping Obligations) Rules; and
(i) explain the features of the clearing and record keeping obligations in relation to dealer-to-dealer
OTC derivative transactions under the Securities and Futures (OTC Derivative Transactions
Clearing and Record Keeping Obligations and Designation of Central Counterparties) Rules.

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1 Securities and Futures (Financial Resources) Rules
Why are capital requirements necessary?
1.1 The capital market relies on investors confidence that intermediaries have sufficient capital:
(a) to support the level of their business activities;
(b) to meet their liabilities as they fall due; and
(c) to provide buffers in the event of sudden market changes, disruptions or loss of
confidence.

Capital requirements for licensed corporations and registered


institutions
1.2 The prescribed calculations for the minimum capital levels for licensed corporations and
registered institutions are quite complicated in each case. For registered institutions, it is
sufficient to meet the capital requirements set by the Hong Kong Monetary Authority
(HKMA). There is no additional requirement for registered institutions to meet the capital
requirements set by the Securities and Futures Commission (SFC) as well. In view of their
complexity, these requirements will not be discussed further here.
1.3 Licensed corporations (but not registered institutions) must meet the FRR set by the SFC.
1.4 The financial resources requirements set by the SFC under the FRR are designed to enable it
to make timely assessment of the solvency of licensed corporations and an accurate
assessment of the risks involved in any corporations regulated activities (RAs). This, in
turn, ensures more effective regulation of the industry and management of risks in the interests
of investor protection and systemic stability.
1.5 While it is the responsibility of the accounts personnel in a licensed corporation to prepare for
the various financial statements and returns in accordance with the FRR, responsible officers
have the overall responsibility to ensure compliance and to inform the regulator promptly of
any non-compliance.

Requirements of the Securities and Futures Ordinance


1.6 Sections 145 to 147, SFO specifies the financial resources requirements for licensed
corporations.
1.7 The SFC has made the FRR, which specify:
(a) requirements as to the amount of capital that should be maintained by a licensed
corporation; and
(b) other related matters concerning the financial resources of the corporation.

Securities and Futures (Financial Resources) Rules


1.8 A corporation must meet the capital requirement to obtain a licence and continue to maintain
sufficient paid-up share capital and liquid capital at all times for its business. The level of
paid-up share capital and liquid capital required for each type of RA is set out in the FRR.
1.9 The structure of the FRR is very detailed and quite complex, and candidates are not required
to know the full details for this paper. In simple terms, a licensed corporation must have an
adequate amount of liquid assets to meet its liabilities, which are all likely to be short-term
items except for the shares, debt securities or other longer-term loans.

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1.10 The balance sheet provides the information used to check the financial health of a licensed
corporation. For the purpose of the FRR, the balance sheet should be prepared or adjusted on
specified bases:
(a) it must be in accordance with generally accepted accounting principles;
(b) the bases used must recognize the substance of transactions;
(c) the individual items must be calculated on trade and not settlement dates; and
(d) liabilities not stated on the balance sheet will normally have to be included in the
calculations unless the SFC is satisfied that they can be excluded.

Paid-up share capital requirements


1.11 Table 1, Schedule 1, FRR sets out the paid-up share capital for each RA. Licensed corporations
are required to maintain the following paid-up share capital in relation to Type 1, Type 4 and
Type 8 RAs:
Dealing in securities (Type 1 RA), HK$10,000,000
where securities margin financing is provided

Others HK$5,000,000
Advising on securities (except for those that do not hold HK$5,000,000
client assets) (Type 4 RA)

Securities margin financing (Type 8 RA) HK$10,000,000

1.12 If a licensed corporation conducts more than one RA, it must maintain the highest single
requirement applicable to the individual activities. Some classes of licensed corporations, such
as approved introducing agents and securities advisers not holding client assets, do not have
paid-up share capital requirements.

Liquid assets, ranking liabilities and liquid capital


Liquid assets
1.13 In drafting the FRR, the SFC has considered how much the assets are worth if they have to be
quickly realized to cover liabilities. To be on the safe side, the regulators make specific rules
to be applied to each and every asset of the licensee based on how much these would be worth
if they had to be realized urgently.
1.14 So cash and near-cash items which are readily available are given full value, 100%, in the
calculation of liquid assets; or, looking at it from opposite direction, a deduction of 0% is
made when working out their liquid value.
1.15 At the other end of the scale, the licensee may have fixed assets such as real estate and
intangible assets such as goodwill and patents. These cannot be converted into cash quickly,
and will normally take the longest time to convert. So they are given a deduction or haircut
of 100%, i.e. they are marked down to nil value.
1.16 The many classes of assets between these two extremes are given various haircut
percentages, as they are called.
1.17 Examples of assets that a licensed corporation cannot include as liquid assets are:
(a) assets it beneficially owns, but which it has provided to others as security for its liabilities
or obligations (however, see section 1.20 below); and

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(b) assets held in foreign currency which are not, or the realized proceeds of which are not,
freely remittable to Hong Kong.
1.18 Examples of assets that a licensed corporation can include as liquid assets are:
(a) cash in hand and bank deposits (with maturity not exceeding six months) which it
beneficially owns;
(b) the net amount receivable from a client (after setting off the amount payable to the client
and provision for bad debts) arising from the purchase and sale of securities by the client
on a cash-against-delivery basis;
Note: The amount has to be lower than the market value of the securities held for the
client after haircut.
(c) net amounts receivable from other licensed corporations providing securities margin
financing (SMF) with which it has common clients arising from dealing in securities
for those clients;
(d) amount receivable from another securities dealer arising from the sale of securities by it
to the securities dealer;
(e) cash provided as security for short selling if the securities have not yet been delivered to
the counterparty for settlement;
(f) market value of listed shares it beneficially owns less the haircut amounts. A haircut
amount is derived from the respective haircut percentages of the shares market value
which are set out in Schedule 2, FRR;
(g) amounts receivable from clearing houses other than the specified amounts such as client
money held in a segregated account maintained with the clearing houses; amounts
receivable from a lender of the securities to whom cash was provided as security for
borrowing securities from the lender under a securities borrowing and lending agreement;
(h) fees, commissions, commission rebates and interest charges to which it is beneficially
entitled and which arise from the carrying on of RAs, to be first due for billing within the
next three months or have been billed but remain outstanding within 1 month or less after
the date they were billed;
(i) deposits which it beneficially owns and which are maintain with Hong Kong Exchanges
and Clearing Limited (HKEX) as security for its stamp duty obligations or liabilities
on contract notes;
(j) prepaid operating expenses which will be incurred within the next three months;
(k) tax reserve certificates issued by the Commissioner of Inland Revenue which it
beneficially owns; and
(l) dividends receivable on shares listed on stock markets recognized by the SFC which it
beneficially owns.

Ranking liabilities
1.19 Ranking liabilities comprise money the licensed corporation owes. In principle, practically
most, if not all, liabilities of the licensed corporation must be included in the calculation of
ranking liabilities. Examples are:
(a) amounts payable to clients, counterparties (e.g. other brokers) and clearing houses arising
from RA, except for items such as client money held in segregated accounts with banks
or clearing houses and amounts that have been set off against receivables from clients
arising from their purchases of securities;
(b) net amounts payable to other licensed corporations providing SMF with which it has
common clients arising from dealing in securities for those clients;

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(c) market value of securities in short positions which it holds for its own account;
(d) the aggregate value of cash and securities collateral (after haircut) deposited with its
lender under securities borrowing and lending agreements, less certain percentages of the
market value of the securities borrowed; and
(e) any amount payable by the corporation in relation to:
(i) overdrafts;
(ii) loans;
(iii) accrued expenses;
(iv) tax; and
(v) provisions made for contingent liabilities.
1.20 The above examples are only general guidelines for determining liquid assets and ranking
liabilities. Licensed corporations will look into their specific circumstances when they apply
the FRR. For example, a general rule is that assets beneficially owned by a licensed
corporation but provided to another person as security (as mentioned in section 1.17(a) above)
should not be included as a licensed corporations liquid assets. However, such assets may
constitute liquid assets for FRR purposes if the security interest is granted to a bank or other
licensed corporation for credit facilities.
1.21 The SFC may on application approve the following for specified periods or until approval is
withdrawn:
(a) modification or waiver in the calculation of liquid capital;
(b) modification or waiver of the FRR provided that it will not prejudice the interests of any
client or the investing public (it will be published by notice on the Internet for reasons of
transparency and general awareness); and
(c) the adoption of an accounting principle other than one of those generally accepted.

Liquid capital
1.22 Liquid capital means the amount by which liquid assets exceed ranking liabilities:
Liquid capital = liquid assets - ranking liabilities
1.23 A licensed corporation must maintain at all times adequate liquid capital for Type 1, Type 4
or Type 8 RAs. The FRR required that the liquid capital of a licensed corporation must be
greater than the required liquid capital (RLC) (see below). The RLC for the said three RAs
are:
Dealing in securities (Type 1 RA) HK$3,000,000
(A licensed corporation which is also a participant of The
Stock Exchange of Hong Kong Limited should comply with
additional financial requirements imposed by The Stock
Exchange of Hong Kong Limited)
Advising on securities (Type 4 RA):
where it does not hold client assets HK$100,000
where it holds client assets HK$3,000,000
Securities margin financing (Type 8 RA) HK$3,000,000

Required liquid capital (RLC)


1.24 The objective of the liquid capital requirement is to enable the SFC and the licensed
corporation to determine how much the assets of the corporation are worth in the case of the

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assets having to be realized to cover liabilities urgently. The regulator is not fully satisfied if
there is merely a positive liquid capital, and will therefore require more. The collective
experience of regulators has been that it is safer if the liquid capital is always greater than a
buffer figure or the RLC. The SFC specifies the rules for computation of the RLC in the FRR.
Approved introducing agents and licensed corporations for Type 4 RA who do not hold client
assets have lower RLC requirements.
1.25 The FRR require that the liquid capital must be greater than the RLC. The first point for a
licensed corporation to note, therefore, is that the liquid capital should not be less than the
RLC and paid-up shares capital should not be lower than the minimum paid-up share capital
requirement at all times.
1.26 The RLC that a licensed corporation has to maintain depends on the number and types of RA
being carried on, and is the higher of the specified minimum amounts and the amount
computed in accordance with the FRR.
1.27 A sharp decline in the market may result in a significant lower liquid assets and this, in turn,
may result in a breach of FRR liquid capital requirements.

Reporting requirements
1.28 A licensed corporation conducting the business of dealing in securities, advising on securities
or securities margin financing is required under the SFO, FRR and the Accounts and Audit
Rules to furnish to the SFC various notifications and returns.

Monthly returns
1.29 A licensed corporation must submit monthly returns in accordance with the FRR within three
weeks after the months end. Examples of items to be included in the monthly returns are:
(a) a liquid capital computation;
(b) an RLC computation;
(c) a summary of bank loans, advances, credit facilities and other forms of financial
accommodation available to it;
(d) an analysis of margin clients;
(e) an analysis of collateral received from margin clients; and
(f) an analysis of client assets.

Quarterly returns
1.30 A licensed corporation is required, in respect of each three-month period during which it
carries on any RA, concluding at the end of March, June, September and December, to prepare
and submit to the SFC, no later than three weeks after the end of the period to which it relates,
the following returns:
(a) an analysis of its clientele; and
(b) an analysis of its proprietary derivative positions.

Half-yearly returns
1.31 A licensed corporation licensed for advising on securities is required, for each six-month
period during which it carries on the RA, concluding at the end of the months of June and
December, to prepare and submit to the SFC, no later than three weeks after the end of the
period to which it relates, the following returns:
(a) a liquid capital computation;

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(b) an RLC computation;
(c) a profit and loss account; and
(d) an analysis of its clientele.
Note 1: Securities advisers that do not hold client assets are only required to submit financial
returns semi-annually (June and December); and
Note 2: The SFC allows electronic submission of FRR returns, making the submission more
convenient.
1.32 In particular, under the FRR a licensed corporation must notify the SFC in writing of certain
circumstances:
(a) if its liquid capital falls below 120% of its RLC (the buffer), or falls below 50% of the
last liquid capital stated in the last return submitted to the SFC;
(b) if its paid-up share capital falls below the requirements;
(c) if the information submitted in any earlier return is or has become false or misleading in
a particular;
(d) if it has drawn down, in aggregate amounts, on any loan or financial accommodation etc.
from any of its bankers which exceed the aggregate of its credit limits; and
(e) if it changes its accounting principles in a way that may materially affect the liquid capital
or paid-up share capital that it maintains or is required to maintain.
1.33 Under the SFO, a licensed corporation or the associated entity of an intermediary is required
to report various financial matters to the SFC. Please refer to section 6 of this Topic.

Failure to meet financial resources requirements


1.34 In the event that a licensed corporation is unable to comply with the specified liquid or paid-
up share capital requirements in the FRR, it must:
(a) as soon as reasonably practicable notify the SFC in writing; and
(b) immediately cease carrying on any RA, unless otherwise permitted by the SFC.
1.35 Where the licensed corporation is unable to comply with any other requirements of the FRR,
it must, within one business day of becoming aware of the failure, notify the SFC in writing.
1.36 In addition to the foregoing, where the SFC reasonably believes that a licensed corporation
cannot comply with the specified capital requirements, it may by notice in writing suspend
the corporations licence, or only allow it to continue subject to conditions.
1.37 A licensed corporation will commit an offence if it:
(a) fails to comply with certain of the SFCs financial resources requirements, including
breaching any condition imposed by the SFC; or
(b) continues to trade while in breach of the FRR without the SFCs permission.
1.38 A breach of the FRR may lead to a fine and/or imprisonment. For example, any failure to
comply with the requirements as mentioned in section 1.34 above is an offence punishable
with a fine up to HK$1 million and two years imprisonment.

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Revision questions:

Question 1: What is the objective of the FRR?


Answer 1: They are designed to enable the SFC to make timely assessment of the solvency of
licensed corporations and accurate assessment of the risks involved in any licensed
corporations RAs. This, in turn, can ensure more effective regulation of the industry
and management of its risks in the interests of investor protection and systemic
stability.
Question 2: Who sets the capital requirements for licensed corporations, and who sets the
requirements for registered institutions?
Answer 2: The SFC and HKMA, respectively.

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2 Securities and Futures (Client Securities) Rules
2.1 Intermediaries in the securities and futures industry are called upon to handle client assets,
including money, in a fiduciary capacity. The SFC protects the assets of clients by making
rules regarding:
(a) the holding of and dealing with client assets and securities collateral (under s. 148, SFO);
and
(b) the holding of and dealing with client money (under s. 149, SFO) (see section 3 of this
Topic).
2.2 No person may receive or hold in Hong Kong client assets of an intermediary unless the person
is:
(a) the intermediary;
(b) an associated entity of the intermediary; or
(c) an excluded person (see Note below).
Note: The term excluded person covers any authorized financial institution (AFI),
another intermediary with whom client securities collateral is deposited under
financial accommodation arrangements, any company or overseas company approved
by the SFC, and any person specified under rules made by the SFC with whom
designated trust accounts or client accounts are to be maintained (see s. 164, SFO).
2.3 We shall first consider client securities and securities collateral, and then take up client money
in section 3 below. The SFC has made the Client Securities Rules under s. 148, SFO, which:
(a) provide for intermediaries and associated entities receiving client assets and securities
collateral to deposit them in safe custody, in segregated accounts, or to register them in
the names of the clients; and
(b) specify the circumstances in which the intermediaries or associated entities may deal with
these assets or collateral.

Securities and Futures (Client Securities) Rules


2.4 The intermediary or its associated entity shall, as soon as reasonably practicable after
receiving client securities or securities collateral, deal with them as mentioned in the sections
below.

Requirement for registration or deposit of client securities and


securities collateral
2.5 If a deposit is to be made, it must be:
(a) with any of:
(i) an AFI;
(ii) an approved custodian (see section 2.16 below); or
(iii) another intermediary licensed for dealing in securities (Type 1 RA);
(b) in the following manner:
(i) in the case of client securities and securities collateral, in safe custody in separate
segregated accounts for each of these two categories, designated as trust accounts or
client accounts; or

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(ii) in the case of securities collateral only, it may also be deposited in an account in the
name of the intermediary or its associated entity maintained with any of the above
entities.
2.6 If registered, it must be done in the name of:
(a) the client on whose behalf the client securities or securities collateral has been received;
(b) an associated entity of the intermediary; or
(c) additionally, in the case of securities collateral only, the intermediary itself.

Application
The assets
2.7 The assets to which the Client Securities Rules apply are limited to client securities or
securities collateral of an intermediary that are:
(a) either listed or traded on a recognized stock market (i.e. a stock market operated by a
recognized exchange company, currently only The Stock Exchange of Hong Kong
Limited (SEHK)); or interests in collective investment schemes (CISs) authorized
by the SFC under s. 104, SFO; and
(b) received or held in Hong Kong by or on behalf of the intermediary (in the course of
conducting a RA) or an associated entity of the intermediary in relation to such RA; and
further
(c) they do not apply to client securities of an intermediary that are in an account in a clients
name, set up by that client with persons other than the intermediary or its associated entity.
Note: There are limitations to the application of the Client Securities Rules. Importantly,
they only apply to Hong Kong stocks (not overseas stocks) received or held in Hong
Kong (not to those received or held overseas), and then only to those received by an
intermediary or associated entity in the course of conducting RAs.

Client authority
2.8 A standing authority is the normal standing instruction from a client to an intermediary or
associated entity which enables the intermediary or associated entity to deal with client assets.
(a) It is a written notice authorizing the intermediary or associated entity to deal with the
assets in specified ways.
(b) It specifies a period, which must not be more than 12 months, during which it will be
effective (no limit has been specified by the SFC for a client who is a professional
investor (PI)).
(c) It specifies the way in which it may be revoked.

Renewal
2.9 A standing authority may be renewed or deemed to be renewed at any time prior to expiry for
further periods, each not exceeding 12 months (or for any duration in the case of a PI):
(a) on the written request of the client; or
(b) by the intermediary or associated entity giving written notice at least 14 days before the
expiry date, reminding the client of the impending expiry and informing him that it will
be renewed on the same terms for an equivalent period, or for a period not exceeding 12
months (a period of any duration for a PI if the original was for a specific period) unless
the client objects.

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Under the latter procedure, which provides for a deemed renewal, the intermediary or
associated entity has to provide written confirmation of the renewal within a week after the
expiry date.

Handling of client securities and securities collateral


2.10 Section 6, Client Securities Rules considers three basic authorities under which the
intermediary or its associated entity may deal with client securities or securities collateral:
(a) an oral or written direction to sell or settle a sale order;
(b) a written direction; or
(c) a standing authority.
2.11 The Client Securities Rules do not allow the use of the standing authority by the intermediary
or its associated entity to:
(a) transfer client securities or securities collateral to an account of the intermediary, its
associated entity or any entity which has a controlling entity relationship with the
intermediary or is linked to the associated entity by a controlling entity relationship,
unless that account is one mentioned in section 2.5 above;
(b) make any such transfer to any officer or employee of these entities unless that officer or
employee is the client; or
(c) deal with the client securities or securities collateral in any manner that is unconscionable.
(For clarification, unconscionable refers to something contrary to a sense of justice,
decency or reasonableness.)
2.12 Generally, the Client Securities Rules allow, with the written agreement of the client, for:
(a) the withdrawal of client securities to sell or settle a sale order on his behalf; or
(b) the disposal or initiation of the disposal of client securities and securities collateral, in
settlement of a liability of the client to the intermediary, associated entity or a third person.

Permitted transactions
2.13 If it has a standing authority to do so, an intermediary licensed or registered to conduct Type
1 RA (dealing in securities) or its associated entity may:
(a) use the client securities or securities collateral it holds for a stock borrowing and lending
transaction;
(b) re-pledge the securities collateral with an AFI to borrow money (but subject to the
limitations mentioned in section 2.14 below);
(c) deposit the securities collateral with a recognized clearing house or another Type 1
intermediary as collateral for settlement obligations; or
(d) if the intermediary provides financial accommodation to a client in the course of its Type
1 RA, apply or deposit any securities collateral in the manner stated in this section.
2.14 In relation to the re-pledging of securities collateral, intermediaries licensed for dealing in
securities (Type 1 RA), as well as intermediaries licensed for SMF (Type 8 RA), must
ascertain the aggregate market value of the re-pledged securities collateral by reference to
respective closing prices of the collateral on that business day. If the aggregate value exceeds
140% of the intermediarys aggregate margin loans on the same business day, the intermediary
must by the close of the next business day reduce the aggregate value of re-pledged securities
collateral so that it does not exceed 140% of aggregate margin loans.

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Miscellaneous
2.15 Intermediaries and their associated companies are not permitted to deal with client securities
and securities collateral otherwise than as provided in Part 2, Client Securities Rules.
2.16 The SFC may approve, in writing and subject to such conditions as it considers appropriate,
any company or overseas company as being a suitable custodian for safe custody of client
securities and securities collateral of an intermediary.

Reporting for non-compliance


2.17 Non-compliance with the specified provisions of the Client Securities Rules must be reported
to the SFC within one business day after discovery.

Penalties
2.18 An intermediary or an associated entity that fails to comply with certain sections of the Client
Securities Rules without reasonable excuse commits an offence. Such a breach with intent to
defraud carries a maximum sentence of a fine up to HK$1 million and imprisonment for seven
years if convicted.

Revision question:

Question 3: How should an intermediary deal with securities collateral it has received from a
client?
Answer 3: The intermediary should, as soon as practicable, deposit the securities collateral with
an AFI, approved custodian or another intermediary licensed to conduct dealing in
securities, in the name of the intermediary or its associated entity maintained with any
of the above entities, or register them in the name of the client, an associated entity or
the intermediary.

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3 Securities and Futures (Client Money) Rules
3.1 The Client Money Rules prescribe the manner in which licensed corporations and their
associated entities should deal with client money received or held in Hong Kong.
Requirements are specified for payment of client money into segregated accounts and
payments out of the accounts, for the treatment of interest earned and for reporting non-
compliance.

Securities and Futures (Client Money) Rules


3.2 The Client Money Rules have been made by the SFC under s. 149, SFO, and apply to client
money of a licensed corporation that is received or held by or on behalf of:
(a) the licensed corporation in the course of conducting a RA; or
(b) its associated entity in relation to that activity.
3.3 The Client Money Rules do not apply to client money of a licensed corporation that:
(a) is received or held outside Hong Kong by the licensed corporation or its associated entity
while it remains outside Hong Kong;
(b) has at any time been received or held in Hong Kong by the licensed corporation or its
associated entity, once that money has been transferred outside Hong Kong in accordance
with the Client Money Rules; or
(c) is held in a bank account by the client in his own name.

Payment of client money into segregated accounts


3.4 A licensed corporation or its associated entity that receives or holds client money should
establish and maintain in Hong Kong one or more segregated accounts for the client money,
each of which should be designated as a trust or client account.
3.5 The accounts must be maintained with an AFI or a person approved by the SFC.
3.6 Within one business day of receiving the above money, the licensed corporation or associated
entity should pay the money:
(a) into a segregated account;
(b) to the client directly;
(c) in accordance with a written direction; or
(d) in accordance with a standing authority.
3.7 Under the Client Money Rules, client money to be safeguarded includes all amounts received
by the licensed corporation or its associated entity, from or on behalf of clients, less amounts
due from the clients and any proper charges payable. Client money to be safeguarded consists
of amounts received in Hong Kong for the clients dealing in securities:
(a) less brokerage and other proper charges for the clients trading in securities;
(b) except money in Hong Kong that will be used to meet the clients settlement or margin
obligations within the next two business days; and
(c) except amounts owed by a client to a licensed corporation (for example, money that a
licensed corporation has paid to a clearing house for a client to meet his settlement or
margin obligations).

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Payment of money out of segregated accounts
3.8 The licensed corporation or associated entity that holds any amount of client money in a
segregated account shall retain it there until it is:
(a) paid to the client;
(b) required in order to meet the clients obligations for settlement or margin requirements,
incurred by the licensed corporation on behalf of the client;
(c) used as payment for an amount owed to the intermediary or an associated entity;
(d) paid according to the written direction of the client; or
(e) paid according to the clients standing authority (also see section 3.11 below).
3.9 Client money may not be paid out of the account if:
(a) it would be unconscionable to do so;
(b) the standing authority authorizes payment to the licensed corporation, its associated entity
or a linked corporation, and the receiving account is not a segregated account; or
(c) the payment is to any officer or employee of the licensed corporation, or an officer or
employee of a linked corporation, unless that person is the client.
3.10 The licensed corporation or its associated entity is required to pay any money held in a
segregated account which is not client money out of that account within one business day of
becoming aware of the fact.

Clients standing authorities


3.11 The requirements in respect of standing authorities for client money are exactly the same as
those for client securities and securities collateral, including the renewal by notification from
the licensed corporation and the simplification of the rules for PIs (see sections 2.8 and 2.9
above).

Reporting of non-compliance
3.12 A licensed corporation or associated entity which becomes aware of a failure to meet the
requirements to open a segregated account, to pay money into the account or to retain money
in the segregated account as specified must report the fact to the SFC within one business day
after becoming aware of any such failure.

Penalties
3.13 A failure by a licensed corporation or associated entity to comply with the requirements to pay
money into or out of a segregated account in the manner specified, without reasonable excuse
or with an intention to defraud, is an offence and the offender is liable to penalties and to
imprisonment on conviction.

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4 Securities and Futures (Contract Notes, Statements of
Account and Receipts) Rules
Securities and Futures (Contract Notes, Statements of Account and
Receipts) Rules
4.1 The SFC has made the Contract Notes Rules to require intermediaries and associated entities
to provide clients with timely documents containing valid information about client
transactions and assets.
4.2 The Contract Notes Rules prescribe the way in which intermediaries must prepare contract
notes, statements of account and receipts. Their associated entities which receive client assets
should also prepare receipts. In particular, the Contract Notes Rules set out the detailed
information that must be included in the documents and the periods within which they must
be delivered to clients. All responsible officers must familiarise themselves with these
requirements.

Professional investors
4.3 The Contract Notes Rules relating to the provision of contract notes, statements of account
and receipts to clients do not apply to PIs if:
(a) they are PIs as specified in Schedule 1, SFO, the intermediary has notified the clients in
writing about the non-provision of such documents, and the clients do not object; or
(b) they are PIs as specified in the Securities and Futures (Professional Investor) Rules and
the clients have agreed in writing not to require these documents.

Avoidance of duplication
4.4 In the case of a mutual client of two intermediaries both operating in Hong Kong, only one
intermediary needs to issue the contract notes, statements of account or receipts (see the
sections below), provided that there is an agreement in writing as to who that issuer is. For
example, introducing brokers and asset managers are not required to issue contract notes to a
client when the executing broker has already done so.

Contract notes
4.5 A contract note must be in either English or Chinese. Whenever an intermediary deals in
securities for a client, including a transaction under a securities borrowing and lending
agreement, it must issue a contract note to the client no later than the end of the second
business day after entering into the contract. A contract note is usually prepared in respect of
a single transaction but several contracts on the same day for the same client may be included
in a single contract note or consolidated into the daily statement.
4.6 A contract note in respect of a contract for dealing in securities must include, where applicable,
the following information:
(a) company name of the intermediary;
(b) name and account number of the client;
(c) full particulars of the contract, including:
(i) quantity;
(ii) name and description of the securities to enable it to be identified, and the nature of
the dealing;
(iii) price per unit for a purchase or sale of the securities; or, at the request of the client,
the average price per unit of the same description of securities;

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(iv) name of the market or exchange on which it has been executed;
(v) whether the contract is for opening or closing a position;
(vi) an indication of where it relates to a short selling order or a borrowing or lending
under a securities borrowing and lending agreement; and
(vii) amount of consideration payable;
(d) an indication that the intermediary is acting as a principal, if this is the case;
(e) date:
(i) on which the contract is entered into;
(ii) of settlement; and
(iii) on which the contract note is prepared;
(f) commission payable;
(g) amount of charges, stamp duty and/or levy payable; and
(h) an indication if the account is a margin account.

Daily statements of account


4.7 A statement of account must be in either English or Chinese. A daily statement must be
prepared:
(a) by intermediaries providing securities margin finance (financial accommodation) and
their associated entities when specified events, including deposit or withdrawal of client
assets, take place; and
(b) by intermediaries conducting margined transactions with or on behalf of a client, when
such a transaction is entered into and also when it is closed.
It must be issued to the client no later than the end of the second business day after the
specified events take place.
4.8 Information in the daily statements of account should include:
(a) name of the intermediary and its principal place of business;
(b) name, address and account number of the client;
(c) date the statement is prepared;
(d) the name of the intermediarys associated entity which holds the client assets;
(e) outstanding balance of a clients account at the beginning and end of each day and all
movements in the balance;
(f) quantity, market price and market value of each security and collateral held at the end of
that day;
(g) the margin ratio and margin value of each securitys collateral held for that account at the
end of that day;
(h) details of all movements of client securities and collateral held for the account during
that day;
(i) details of all disposals of client securities and collateral initiated by the intermediary and
arrangements for the proceeds;
(j) breakdown of income credited to and charges levied against the account during that day;
and
(k) details of all financial accommodation provided to the client during the day, including:

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(i) the nature;
(ii) the clients credit limit;
(iii) the expiry date of the accommodation; and
(iv) the basis for calculating interest charges and interest income on credit balances.

Monthly statements of account


4.9 A monthly statement of account must be in either English or Chinese. It must be prepared by
an intermediary for all clients. All monthly statements must contain the information about the
client and intermediary mentioned in section 4.8(a)-(d) above. They should also include full
details of:
(a) all contracts entered into by the intermediary for the client during the month;
(b) outstanding balances of the account at the beginning and end of the month, and the
movements in these balances during the month; and
(c) all open positions held at the end of the month etc..
4.10 The statement must be issued within seven business days of the end of each monthly
accounting period (which can be four-weekly cycles and not necessarily calendar months) to
the client or his designated person. The only case when no monthly statement needs to be
issued is if there is no activity whatever on the account during the month and no balances at
the end of it.
4.11 The following are examples of when a monthly statement of account must be issued, if:
(a) the intermediary is required to prepare and deliver to the client a contract note, daily
statement of account or receipt during a monthly accounting period;
(b) an associated entity of the intermediary is required to prepare and deliver to the client a
receipt during a monthly accounting period;
(c) the client has a credit or debit balance at any time during a monthly accounting period;
(d) the client has an open position at the end of a monthly accounting period; and
(e) the intermediary or its associated entity holds client securities and collateral or security
at any time during the monthly accounting period in relation to a margined transaction.

Receipts
4.12 An intermediary or associated entity must issue a receipt in English or Chinese each time it
receives client assets, or security provided in relation to margined transactions, no later than
the end of the second business day following receipt of such assets or security.
4.13 No receipts are required for the following, where:
(a) client money is deposited directly by the client into the intermediarys account or
associated entitys account with a bank (since the client will necessarily receive a receipt
from the bank as evidence of the deposit);
(b) the intermediary is a registered institution (a bank) or the associated entity is an AFI;
(c) scrip is deposited directly with the intermediarys or associated entitys scrip custodian,
which has issued a receipt to the client; or where securities in a scripless form are
transferred to an account maintained with a custodian of the intermediary or an associated
entity of an intermediary by or on behalf of the client; and
(d) a contract note or statement of account is issued which expressly states that it serves as a
receipt and includes the specified information.

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Note: An intermediary must issue a receipt if the client money is paid into the intermediarys
bank account by the intermediary or one of its associated entities.

Other related issues


Record retention
4.14 The intermediary or associated entity must retain:
(a) contract notes, daily statements of account and receipts, which must be kept for a
minimum period of two years; and
(b) monthly statements of account, which must be kept for a minimum period of seven years.

Any other person to receive documents


4.15 Employees or officers of an intermediary are not allowed to receive contract notes, statements
of account or receipt documents on behalf of their clients. This is to protect the clients
interests. A client can designate any other person (except employees or officers of an
intermediary) to be the recipients of contract notes, statements of accounts or receipts by
giving written notice to the intermediary or its associated entity.

Duty to provide statements of account upon request


4.16 The general rule is that a client is entitled:
(a) to receive copies of contract notes, statements of account and receipts as soon as practical
upon request; and
(b) upon applying to the SFC, and subject to the SFC giving directions, to inspect copies of
contract notes, statements of account and receipts kept by the intermediary.
Reporting of non-compliance
4.17 If an intermediary or an associated entity becomes aware that it does not comply with specified
provisions of the Contracts Notes Rules, it must give written notice to the SFC within one
business day.

Penalties
4.18 Failure to comply with any provision of the Contract Notes Rules without reasonable excuse
is a criminal offence punishable with a fine at level 4.
4.19 A breach of the Contract Notes Rules with intent to defraud carries a maximum sentence of
up to HK$1 million and seven years imprisonment (if convicted on indictment), or a fine of
up to HK$500,000 and one years imprisonment (on summary conviction).

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Revision questions:

Question 4: Describe the aim of the Contract Notes Rules.


Answer 4: The Contract Notes Rules prescribe the way in which intermediaries must prepare
contract notes, statements of account and receipts. Their associated entities which
receive client assets should also prepare receipts. In particular, the Rules set out the
detailed information that must be included in the documents and the periods within
which they must be delivered to clients. All responsible officers must familiarize
themselves with these requirements.
Question 5: Is an introducing broker required to issue contract notes etc.?
Answer 5: Introducing brokers are not required to issue contract notes to a client when the
executing broker has already done so.

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5 Securities and Futures (Keeping of Records) Rules
Securities and Futures (Keeping of Records) Rules
5.1 The SFC has made the Keeping of Records Rules, under s. 151, SFO, for intermediaries and
their associated entities. The SFC has stated that the records which are required to be kept
apply to RAs only. However, as the records should be sufficient to produce financial
statements, they must show all liabilities. There are other record keeping requirements under
the SFCs codes and guidelines and they will be discussed in Topic 3 of this manual.

Records to be kept by intermediaries


5.2 These provide for the keeping of sufficient accounting, trading and other records by
intermediaries:
(a) to explain and reflect the financial position and operations of the regulated businesses;
(b) to enable financial statements to be prepared from time to time;
(c) to show all client assets handled and movements of these assets;
(d) to enable monthly reconciliations with external parties to be made;
(e) to demonstrate compliance with the FRR, and the specified provisions of the Client
Money Rules and the Client Securities Rules;
(f) to demonstrate that the intermediary has systems of control to ensure compliance with
the specified provisions of the Client Money Rules and the Client Securities Rules;
(g) to allow audits to be conveniently and properly carried out; and
(h) to accord with generally accepted accounting principles.
The records should include all the items specified in the Keeping of Records Rules and the
Schedule attached to the Keeping of Records Rules. A detailed knowledge of the items in the
Schedule is not required for the purposes of this manual.

Records to be kept by associated entities


5.3 The requirements are similar to those for intermediaries above, in particular the keeping of
records by associated entities of client assets, movements in them and in financial items
relating to them.
5.4 The Keeping of Records Rules require an associated entity which receives or holds client
assets of the intermediary to keep sufficient records in accordance with generally accepted
accounting principles in order to:
(a) account for the client assets that it receives or holds;
(b) enable all movements of client assets to be traced through its accounting and stockholding
system;
(c) show separately and account for all receipts, payments, deliveries and other uses of client
assets made by it; and
(d) reconcile each month its balances or positions with the intermediary of which it is an
associated entity, recognized exchange companies, clearing houses, other intermediaries,
custodians and banks, identify any differences and show how such differences were
resolved.
5.5 The associated entity must be able to demonstrate that:
(a) it is in compliance with the requirements of the Client Money Rules and the Client
Securities Rules; and

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(b) it has systems of control in place to ensure compliance with these rules.
5.6 The records must be kept in a manner that will enable an audit to be conveniently and properly
carried out.
5.7 The records required to be kept must include at least the following:
(a) contracts the associated entity has entered into;
(b) records establishing that an investor is a PI and any related agreement; and
(c) any authority or specific direction from clients.

Records to be kept by securities margin financier


5.8 An intermediary which provides to its clients financial accommodation for purchasing
securities must keep sufficient records to show:
(a) its margin policy and lending policy;
(b) all securities and client collateral and with whom and on whose behalf such securities
and collateral are deposited, showing separately the quantity and market value of
securities deposited for safe custody, and client collateral deposited in relation to
margined transactions; and
(c) particulars of each client, including the market value and margin value of each type of
client securities collateral deposited with it, and margin calls made.

Record retention
5.9 The general rule is that all records should be kept for at least seven years unless other periods
are specified by legislation for any particular type of records. For example, the Keeping of
Records Rules require records documenting orders and instructions received and copies of
contract notes to be kept for at least two years (see section 4.14 above). Also, the definition of
a record in s. 2, Keeping of Records Rules excludes telephone recordings, which are covered
in the Code of Conduct for Persons Licensed by or Registered with the SFC.
5.10 The records should be kept, in Chinese or English, in writing or in any other form that may be
readily accessed and converted into writing. The Keeping of Records Rules require all
reasonable procedures to be adopted to guard against, and to enable discovery of, any
falsifications.
5.11 There are specific retention requirements in the SFO or other subsidiary legislation for specific
situations; for example, documentary assurances for short sales are only required to be kept
for one year.

Reporting of non-compliance
5.12 If an intermediary or an associated entity becomes aware that it does not comply with the
specified provisions of the Keeping of Records Rules (for example, those requirements
mentioned in sections 5.2 to 5.8 above), it must give written notice to the SFC within one
business day.

Penalties
5.13 An intermediary or an associated entity that fails to comply with the specified provisions of
the Keeping of Record Rules without reasonable excuse commits an offence.
5.14 A breach of the rules with intent to defraud (for example, deleting, destroying, removing or
falsifying any record) carries a maximum sentence of a fine up to HK$1 million and
imprisonment for seven years (if convicted on indictment), or a fine up to HK$500,000 and
imprisonment for one year (on summary conviction).

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Revision question:

Question 6: What are the most important types of information that must be kept by a securities
margin financier?
Answer 6: Its margin policy and lending policy, all securities and client collateral and with whom
and on whose behalf such securities and collateral are deposited and particulars of
each client, including the market value and margin value of each type of client
securities collateral deposited with it, and margin calls made.

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6 Securities and Futures (Accounts and Audit) Rules
Securities and Futures (Accounts and Audit) Rules
6.1 The SFC is charged with the responsibility of ensuring that only licensed corporations and
associated entities of intermediaries that are financially sound are allowed to conduct business.
6.2 The Accounts and Audit Rules apply to licensed corporations and to associated entities of
intermediaries. The Rules do not apply to registered institutions. Financial requirements and
monitoring of related reporting by registered institutions are the responsibility of the HKMA.
6.3 Provisions relating to accounting and auditing matters are contained in ss. 151 and 153 to 163,
SFO. Further details may also be found in the Accounts and Audit Rules.

Appointment of auditors
6.4 A licensed corporation and an associated entity are required to appoint an independent auditor
within one month of becoming licensed or becoming such an associated entity, or whenever
there is a vacancy, and to notify the SFC in writing of the auditors name and address within
seven business days of the appointment (s. 153, SFO).
6.5 A licensed corporation or an associated entity commits an offence if it fails within the specified
periods:
(a) to appoint an auditor; or
(b) to notify the SFC.
6.6 The licensed corporation and an associated entity must notify the SFC within one business
day after it gives notice of a motion to remove or replace an auditor, or the auditor otherwise
ceases to be its auditor before the expiration of his term of office (s. 154, SFO). It is an offence
to fail to notify the SFC of such a change.
6.7 The licensed corporation and an associated entity must notify the SFC in writing of the date
on which its financial year ends, within one month after it becomes licensed or becomes such
an associated entity (s. 155, SFO).
6.8 The financial year may not exceed 12 months, nor may the financial year-end be changed,
without the written permission of the SFC. Permission may be given subject to such conditions
as the SFC considers appropriate, on application.
6.9 Failure to abide by the above provisions is an offence.

Annual financial statements and other documents


6.10 Section 156, SFO requires a licensed corporation and an associated entity to submit financial
statements, an auditors report and other documents to the SFC not later than four months after
the end of the financial year or, in the case of cessation accounts, four months after the date
of cessation.
6.11 The SFC may, on application and where it is satisfied that there is a reasonable excuse, extend
the period for submission. Failure to submit accounts without a reasonable excuse or with
intent to defraud is an offence. The degree of the offence is greater where there is intent to
defraud, and the penalty which may be imposed in such a case is correspondingly greater.
6.12 The documents that must be submitted by a licensed corporation for each financial year,
include:
(a) a set of accounts prepared in accordance with generally accepted accounting principles,
consisting of:
(i) a profit and loss account;

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(ii) a balance sheet; and
(iii) notes to the accounts;
(b) annual returns, including, for example:
(i) a liquid capital computation;
(ii) a summary of bank loans, advances, credit facilities and other financial
accommodation available to it;
(iii) an analysis of margin clients;
(iv) an analysis of collateral received from margin clients; and
(v) an analysis of client assets; and
(c) a business and risk management questionnaire.
6.13 The documents that must be submitted by an associated entity (not an AFI) of an intermediary,
including the associated entity of a registered institution, include:
(a) a set of accounts prepared in accordance with generally accepted accounting principles,
consisting of:
(i) a profit and loss account;
(ii) a balance sheet; and
(iii) notes to the accounts;
(b) an analysis of client assets as at the end of the financial year; and
(c) a business and risk management questionnaire.

Auditors report
6.14 The annual accounts of a licensed corporation and an associated entity must be accompanied
by an auditors report. The auditors report should, according to the Accounts and Audit Rules,
contain a statement as to whether in the auditors opinion:
(a) the profit and loss account and the balance sheet are in accordance with the records kept
by the licensed corporation or its associated entity under the Keeping of Records Rules
and satisfy the requirements of those rules;
(b) the balance sheet and profit and loss account give a true and fair view of the state of
affairs of the licensed corporation or the associated entity at the financial year-end, and
of their profit and loss for the financial year, respectively;
(c) the returns specified in section 6.12 above have each been compiled correctly from the
records of the licensed corporation and, if not, the nature and extent of the incorrectness;
(d) the licensed corporation or the associated entity, during the financial year, has complied
with the Keeping of Records, Client Money and Client Securities Rules;
(e) the licensed corporation or the associated entity has adequate systems of control that
adequately ensure compliance with the customer protection requirements of the Client
Money and Client Securities Rules; and
(f) there appears to have been any contravention of the FRR by the licensed corporation
during the financial year.
6.15 An auditor shall, as soon as reasonably practicable, make a written report to the SFC if in the
course of performing his duties as an auditor of a licensed corporation or an associated entity
(s. 157, SFO):
(a) he becomes aware of a reportable matter; or

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(b) he proposes to include a qualification or an adverse statement in any report.
Note 1: A reportable matter for a licensed corporation is one which:
(i) constitutes a failure to comply with any prescribed requirement (see Note 3
below);
(ii) adversely affects the financial position of the licensed corporation or any of its
associated entities to a material extent; or
(iii) involves a breach of the FRR.
Note 2: A reportable matter for an associated entity is one which:
(i) constitutes a failure to comply with any prescribed requirement (see Note 3 below);
or
(ii) where the associated entity is not an AFI, adversely affects its financial position
to a material extent.
Note 3: Prescribed requirements have now been specified in s. 5, Accounts and Audit Rules as
including various provisions of the Keeping of Records Rules.
6.16 If an auditor resigns, does not seek reappointment or otherwise ceases to be an auditor of a
licensed corporation or an associated entity, he must notify the SFC in writing within one
business day, giving reasons or stating that there are no reasons to give.

Auditors immunity
6.17 An auditor communicating with the SFC under s. 157, SFO in the above circumstances, in
good faith, will not be held to have breached any duty as an auditor. The protection extends to
a former auditor, and to an auditor or former auditor of a former licensed corporation or a
former associated entity of an intermediary (s. 158, SFO).

6.18 The SFC may appoint an auditor to examine and audit a licensed corporation or an associated
entity if (s. 159, SFO):
(a) the SFC has reasonable cause to believe that:
(i) it has not complied with the FRR;
(ii) it has failed to comply with any prescribed requirement or failed to submit annual
accounts and reports; or
(b) the SFC has received an auditors report which states that the licensed corporation or its
associated entity has failed to comply with any prescribed requirement.
6.19 Under s. 162, SFO, the appointed auditor has extensive powers to:
(a) examine on oath officers, employees, agents and auditors of the target entities; and
(b) exercise these powers in respect of any business carried on by the licensed corporation
or any of its associated entities if this is relevant to the audit.
6.20 A person who, without reasonable excuse, fails to comply with any requirements imposed on
him under s. 162 commits an offence.
6.21 It is also an offence under s. 163, SFO for a person, with intent to prevent, delay or obstruct
the audit, to:
(a) delete, destroy, mutilate, falsify, conceal, alter or otherwise make unavailable any records
relating to an audit or to help another person to do so;
(b) dispose of, or procure the disposal of, any property relevant to the audit; or
(c) leave, or attempt to leave, Hong Kong.

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Revision question:

Question 7: Which provision of SFO a licensed corporation or an associated entity has to comply
with regarding submission of financial statements and an auditors report and what
are the requirement?
Answer 7: Section 156, SFO requires a licensed corporation and an associated entity to submit
financial statements, an auditors report and other documents to the SFC not later than
four months after the end of the financial year or, in the case of cessation accounts,
four months after the date of cessation.

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7 Rules relating to compensation and insurance
7.1 This section covers two issues: compensation arrangements for investors and insurance covers
by licensed corporations.

Investor Compensation Fund


7.2 One of the declared regulatory objectives of the SFC is to secure an appropriate degree of
protection for members of the public investing in or holding financial products. Regulatory
measures are established in the SFO with this objective in mind. One of these measures is the
provision of arrangements for compensating investors for losses caused by defaults of market
intermediaries arising from insolvency or dishonesty. These are covered under the Investor
Claims Rules and the Compensation Limits Rules.

A single investor compensation fund


7.3 The Investor Compensation Fund (ICF) is a single investor compensation fund which covers
claims from clients of a broad range of intermediaries, whether they are exchange participants
or not. These intermediaries include those:
(a) licensed or registered for dealing in securities or futures contracts; and
(b) licensed for SMF (Type 8 RA).
7.4 The ICF covers only exchange-traded products in Hong Kong.

Investor Compensation Company Limited (ICC)


7.5 ICC is the body responsible for the management and administration of the ICF, including
determination of claims for compensation. ICC is a wholly-owned subsidiary of the SFC. It is
recognized by the SFC for the administration of the ICF and processing of claims. Its board
of directors is appointed by the SFC.

Funding arrangement
7.6 The funding arrangement is based on the principle of user pays and equal treatment for all
retail investors, irrespective of the intermediary through whom they trade.
7.7 The ICF was initially funded through the assets of the previous compensation scheme, but,
under the Securities and Futures (Investor Compensation Levy) Rules, it is now supported
by a special levy on transactions on the SEHK and Hong Kong Futures Exchange Limited
(HKFE). For example, a seller and a buyer of securities traded on the SEHK must contribute
to the ICF 0.002% of the sale/purchase consideration.
7.8 When the net asset value of the ICF exceeds HK$1.4 billion, the SFC will waive the levy,
which has been so waived since 2005. The levy will be reinstated if the ICFs net asset value
falls below HK$1 billion.

Who can claim against the ICF?


7.9 An investor of any nationality who suffers pecuniary losses as a result of defaults by
intermediaries in relation to exchange-traded products in Hong Kong can claim against the
ICF.
Note: The ICF does not cover any loss on A shares bought through the Shanghai-Hong Kong
Stock Connect and Shenzhen-Hong Kong Stock Connect as a result of default by the
intermediaries.
7.10 A default by an intermediary means the insolvency, bankruptcy or winding-up of the
intermediary, or any breach of trust, defalcation, fraud or misfeasance committed by the

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intermediary, a corporation who receive or hold client assets of that intermediary or their
employees.
7.11 Since the ICF is aimed at protecting retail investors, institutional investors are not entitled to
claim compensation against the fund. They are better equipped to assess their counterparties
and in fact do so in practice. Those excluded are:
(a) corporations licensed by the SFC;
(b) AFIs;
(c) HKEX, a recognized exchange company, a recognized exchange controller, or a
recognized clearing house;
(d) automated trading service providers;
(e) authorized insurers;
(f) managers or operators of CISs;
(g) associates of a defaulting intermediary which is a corporation;
(h) the Hong Kong or any overseas government; and
(i) the trustee or custodian of the above persons, schemes or arrangements.

Limits of claim
7.12 The maximum amount of compensation that may be awarded to one claimant as a result of
the default of an intermediary in relation to exchange-traded securities is a maximum of
HK$150,000. Similarly, a claimant is entitled to a maximum of HK$150,000 compensation in
relation to exchange-traded futures contracts. Thus, an investor who suffers loss due to the
default of the same intermediary for both securities and futures contracts trading may be
subject to a maximum compensation of HK$300,000.
7.13 Each holder of a joint account is regarded as a claimant and so each is able to claim a
maximum of HK$150,000. The coverage for an investor with multiple accounts with the same
intermediary is capped at HK$150,000 for all such accounts.

Making a claim
7.14 The ICC may publish notice in at least one Chinese and one English newspaper to invite
claims regarding default of a particular intermediary to be lodged with the SFC or the ICC
within the time specified in the notice, usually 3 months from the date of the notice. An
aggrieved investor must lodge a claim before the deadline given in the notice. If no such notice
is published, he must lodge a claim to the ICC within six months of his first becoming aware
of the default. ICC may not accept a claim lodged after the deadline.

Insurance covers by licensed corporations


7.15 The maintenance of insurance cover by a licensed corporation is a necessary condition for the
granting of a licence by the SFC (s. 116, SFO). The SFC has made the Insurance Rules under
the SFO.

Application of the Insurance Rules


7.16 The Insurance Rules apply to all licensed corporations other than those which have a licensing
condition that they may not hold client assets and are not exchange participants of either the
SEHK or HKFE. These licensed corporations are referred to as specified licensed corporations
in the Insurance Rules. Under the Insurance Rules, maintenance of insurance is compulsory
for a specified licensed corporation and the SFC may approve master policies of insurance.

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Master policies
7.17 The Insurance Rules provide that the SFC may approve one master policy for SEHK exchange
participants and another for HKFE exchange participants.
7.18 The SFC has approved a master policy for SEHK participants under the Insurance Rules. The
Insurance Rules provide that SEHK exchange participants must take out and maintain
insurance under the SFC-approved master policy (in addition to any other cover that the SEHK
exchange participants may be required to take). Failure to pay the insurance premium renders
a licensed corporation in breach of the licensing conditions and could result in disciplinary
action.
7.19 Where the SFC has approved a master policy in respect of a particular RA, it requires specified
licensed corporations to take out insurance under the master policy, or a policy arranged
individually with an independent insurer which is not a related corporation of the licensed
corporation and which has a specified credit rating (set out in the Insurance Rules) on the date
the policy begins.

Indemnity coverage
7.20 The insurance covers risk of loss of client assets due to:
(a) fraudulent or dishonest acts committed by employees of the specified licensed
corporation or its associated entity or service bureau;
(b) robbery or theft while the client assets are in the custody of the specified licensed
corporation or its associated entity;
(c) forgery or fraudulent alteration of a cheque or other negotiable instrument;
(d) fraudulent use of an information system; and
(e) forged or fraudulent instructions relating to client assets.

Indemnity limit
7.21 Schedule 2, Insurance Rules specifies the amounts of cover for each RA. The insured amount
applicable for dealing in securities (Type 1 RA) and SMF (Type 8 RA) is HK$15 million in
either case.
7.22 Where a licensed corporation carries out more than one RA, and maintains a single policy of
insurance for all its RAs, the insured amount is HK$25 million. If it has a separate policy for
each RA, it is HK$15 million per RA.

Revision question:

Question 8: Who can claim against the ICF?


Answer 8: An investor of any nationality who suffers pecuniary loss as a result of a default of a
licensed corporations or AFI in relation to exchange-traded products in Hong Kong.

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8 Securities and Futures (OTC Derivative Transactions -
Reporting and Record Keeping Obligations) Rules
Background
8.1 Following the global financial crisis in 2008, there has been an international effort to reduce
systemic risks in the OTC derivatives market. This has led to the introduction of requirements
to report transactions to trade repositories and that standardised OTC derivatives transactions
must be cleared through central counterparty clearing facilities. Together, these requirements
provide for greater transparency allowing regulators to better monitor risks in the financial
system.
8.2 As of 10 July 2015 a new set of requirements for mandatory reporting and record keeping has
been implemented in Hong Kong. The broad requirements are set out in Part IIIA of the SFO,
which empowers the SFC to make detailed rules, which it has done so in the Securities and
Futures (OTC Derivative Transactions - Reporting and Record Keeping Obligations) Rules
(together with Part IIIA of the SFO, the OTCD Reporting Rules).
8.3 This Topic explains the main requirements of the foregoing which can be said to turn on two
main factors: what transactions and what persons are subject to the requirements. As regards
persons, this Topic addresses the requirements applying to licensed corporations.

Scope of application
8.4 The OTCD Reporting Rules specify which OTC derivative products are subject to reporting
and record keeping obligations, and the SFC may specify other products from time to time.

Specified product classes and product types


8.5 At present, there are only two specified product classes: interest rate swaps (IRS) and
currency-based non-deliverable forwards (NDF). Amongst these two classes, only
transactions in three specified product types are required to be reported. Table 1 is a summary
of them.

Table 1
Product class Product type
IRS plain vanilla IRS (floating vs. fixed)
plain vanilla basis swap (floating vs. floating)
both in currencies and interest rates specified by the
HKMA
NDF NDF in currencies specified by the HKMA

Note: As at the date of the OTCD Reporting Rules being implemented, there are 176 specified
currencies and 315 specified floating interest rate indices.

Reporting obligations
8.6 All licensed corporations are subject to the OTCD Reporting Rules, unless exempted. The
reporting obligation may arise in the following ways:
(a) on the date a product becomes a specified product type: the licensed corporation itself is
a counterparty to a specified product type;
(b) on or after the date a product becomes a specified product type, the licensed corporation:
(i) enters into a transaction in a specified product type as counterparty;

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(ii) has conducted a transaction in a specified product type in Hong Kong on behalf
of an affiliate (an affiliate means another corporate in the same group of companies
as the licensed corporation);
(iii) loses its exempt status (see section 8.12 below); or
(c) on or after the date a product becomes a specified product type, the corporation holding
positions in (i.e. being a counterparty to the transaction in) the specified product type
becomes a licensed corporation.
8.7 Once a reporting obligation has arisen, the licensed corporation will need to report all
transactions in the specified product type which it has previously entered into as counterparty
and which remain outstanding, as well as whenever any subsequent event occurs, the
subsequent event i.e. that causes a change to the terms and conditions or parties to a transaction
after the transaction was entered into.

Means and timing of reporting


8.8 All reporting of transaction information is to be made to the HKMA via the Hong Kong Trade
Repository (HKTR) electronic reporting system operated by the HKMA. To make a report
via the system, it is necessary to become a member of the HKTR.
8.9 In general, reports must be made on a T+2 basis, i.e. within two business days after any
transaction events occur. However, the details and timing of what needs to be reported will be
subject to special requirements applying to transactions occurring during the concession
period and whether a grace period applies to the licensed corporation at the time of the
event.

Information to report
8.10 The OTCD Reporting Rules contain detailed provisions as to what information needs to be
reported. The information includes the product class and product type, the date transaction
entered into, becomes effective and matures, particulars of the counterparties, clearing
information, the references assigned to the transaction, particulars of the transaction
(including the relevant notional amount, currency, interest rate or index, fixing and value dates
etc.) and subsequent event.

Relief if an affiliate has reported


8.11 The primary obligation to make reports rests with the licensed corporation. However, where
the relevant transaction is one that the licensed corporation has conducted on behalf of an
affiliate (see section 8.6 above), the affiliate may instead make the report. In this case, the
licensed corporation will need to obtain from the affiliate a written confirmation that the report
has been made in order for the licensed corporation to demonstrate compliance with its
reporting obligation.

Exemptions
8.12 A licensed corporation is exempted from the obligation to report if, on or at any time after the
product class specification day, the sum of the notional amount of all outstanding OTC
derivative transactions within the specified product class to which the licensed corporation is
a counterparty, does not exceed US$30 million.
8.13 However, an exemption for a specified product class will cease to be available for the licensed
corporation once the licensed corporations position in that product class has exceeded US$30
million the exemption is lost permanently.

Record keeping obligations


8.14 Records of specified OTC derivative transactions must be kept for at least five years after the

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termination or maturity date of the transaction, irrespective of whether the transaction was
conducted partly or wholly outside of Hong Kong. The records must be sufficient to
demonstrate compliance with the applicable reporting obligations and must be readily
accessible. The OTCD Reporting Rules specify the records required to be kept.
8.15 Where an exemption from reporting is relied on, the licensed corporation will still need to
maintain records, including those sufficient to demonstrate the exemption was properly relied
on.

Consequence of breaches
8.16 The SFC is empowered to bring licensed corporations that breach the rules before the Court
of First Instance. The maximum penalty that may be imposed by the Court is HK$5 million.

Revision question:

Question 9: Is every OTC derivative product subject to the OTCD Reporting Rules?
Answer 9: No, the OTCD Reporting Rules specify which OTC derivative products are subject
to reporting and record keeping obligations, and the SFC may specify other products
from time to time.

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9 Securities and Futures (OTC Derivative Transactions -
Clearing and Record Keeping Obligations and Designation
of Central Counterparties) Rules
Background
9.1 Regulatory oversight of the OTC derivatives market has been introduced in stages since the
2008 global financial crisis. The overall objective being pursued internationally is to bring
transparency to the OTC derivatives market so as to facilitate regulatory assessment of
systemic risks. The primary means of achieving this has been to specify (i) which OTC
derivative transactions will need to be reported to centralized information repositories and
cleared through central counterparty (CCP) clearing facilities; and (ii) who will be subject
to the requirements.
9.2 The first stage of this process, introduced in Hong Kong in July 2015, was restricted to
imposing mandatory reporting and record keeping on licensed corporations (with slightly
different requirements for authorized institutions), subject to exemptions. This was done via
amendments to the SFO that empower the SFC to make detailed rules covering reporting and
record keeping obligations. Two product classes were specified as being subject to the new
requirements: IRS and currency-based NDF, it being noted that amongst these two classes,
only transactions in three specified product types are required to be reported. For details, see
section 8 above.
9.3 The reporting requirements were an important precursor to implementing the next stage, the
introduction of mandatory clearing. These changes have been implemented by new subsidiary
legislation to the SFO introduced by the SFC, namely, the Securities and Futures (OTC
Derivative Transactions - Clearing and Record Keeping Obligations and Designation of
Central Counterparties) Rules (together with Part IIIA of the SFO, the OTCD Clearing
Rules). The mandatory clearing requirements is being introduced in phases, the first phase,
introduced on 1 September 2016, is discussed below.

Mandatory clearing obligation


9.4 Where a clearing obligation arises in relation to an OTC derivative transaction, the transaction
must be cleared through a designated CCP within one business day after the transaction is
entered into, unless a relevant exemption applies.
Note: The SFC has designated which persons are eligible to act as a CCP. Only recognized
clearing houses under the SFO or persons authorized by the SFC to provide automated
trading services are eligible act as a CCP.
9.5 Where a person is unable to clear a transaction in time, it would be necessary to terminate the
transaction in order to avoid being in breach of the OTCD Clearing Rules. While a failure to
comply with the clearing obligation does not affect the validity of a transaction, it does have
other consequences (see section 9.13 below.)

Product subject to the clearing obligation


9.6 The only class of product subject to mandatory clearing in the first phase is IRS with specified
tenors (ranging from a week up to many years), including the three specified product types:
fixed to floating IRS, floating vs. floating IRS (also known as basis swaps), and overnight
index swaps.

Persons subject to the clearing obligation


9.7 To be subject to the clearing obligation the transaction must be a dealer-to-dealer transaction,
i.e. one between a prescribed person, and either another prescribed person or a person who

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has been designated by the SFC as a financial services provider.
Note: Prescribed persons includes AFIs, approved money brokers (AMBs) and licensed
corporations or other persons who are specified in the OTCD Clearing Rules as being subject
to the clearing obligation. A financial services provider is a person who has been
designated by the SFC as being actively engaged in activities relating to OTC derivative
transactions or OTC derivative products outside Hong Kong and this includes all systemically
important banks globally.
9.8 In addition, both parties to the dealer-to-dealer transaction must be larger and more significant
participants in the OTC derivatives market. For this purpose, the OTCD Clearing Rules
specifies a clearing threshold that refers to the average total position of a person in OTC
derivative transactions. The clearing threshold in effect only applies to prescribed persons
since financial services providers are by definition regarded as a significant player in the
market.
Note 1: Smaller participants in the market are not subject to the clearing obligation because
the objective of regulatory oversight is to catch systemic risks posed by larger and
more significant participants in the OTC derivatives market.
Note2: The calculation includes only positions in products covered by the OTCD Clearing
Rules, is calculated over a specified period, and is subject to various exclusions. The
clearing threshold is set at US$20 billion.
9.9 Persons who reach the clearing threshold are regarded as having crossed it at all times
thereafter. However, where a person subsequently changes their business model or trading
profile such that their position falls below the clearing threshold by a specified amount for 12
consecutive months, they may submit an exit notice to avoid being subject to the clearing
obligation thereafter (the notice is given to their frontline regulator, i.e. the HKMA if they are
an AFI or AMB, or the SFC if they are a licensed corporation).
Note: Where one of the parties is a prescribed person and has not reached the clearing
threshold (or has and has given a valid exit notice), the transaction is not subject to the
clearing obligation.

When the clearing obligation will not apply


9.10 Many OTC derivative transactions will involve a cross border element. The SFC has approved
over thirty designated jurisdictions as having requirements and other arrangements that are
comparable to the requirements in Hong Kong. Where a transaction has been cleared under,
and in accordance with, the laws of a designated jurisdiction through a designated CCP, it will
not be necessary to clear the transaction in Hong Kong. This is known as substituted
compliance.
9.11 The OTCD Clearing Rules also provide for three circumstances in which the clearing
obligation does not apply to a prescribed person:
(a) where the transaction is entered into with a group company member that has previously
been identified as satisfying the requirements to be treated as an exempt affiliate;
(b) where the transaction is recorded in the books of the prescribed person in another
jurisdiction that has previously been identified as satisfying the requirements to be treated
as an exempt jurisdiction; and
(c) where the transaction has been entered into by a third party, pursuant to instructions, on
a multilateral basis for the purposes of reducing operational or counterparty credit risk
for the parties (known as a multilateral portfolio compression cycle transaction).

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Clearing related record keeping obligations
9.12 Records sufficient to demonstrate compliance with the applicable clearing obligations (or
exemptions therefrom) must be readily accessible and kept for at least 5 years after the
termination or maturity date of the transaction, irrespective of whether the transaction was
conducted partly or wholly outside of Hong Kong or whether one or more of the counterparties
are located outside Hong Kong.

Consequence of breaches
9.13 The SFC is empowered to bring licensed corporations that breach the OTCD Clearing Rules
before the Court of First Instance. The maximum penalty that may be imposed by the Court
is HK$5 million. In addition, the SFC (in respect of licensed corporations) may consider
imposing disciplinary sanctions in respect of the breach.

Revision question:

Question 10: Is every OTC derivative transaction to which a licensed corporation is party subject
to the OTCD Clearing Rules?
Answer 10: No, the OTCD Clearing Rules only apply to transactions between larger and more
significant participants in the OTC derivatives market that pose systemic risks.

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Topic summary
In this Topic, we reviewed the financial resources requirements, handling of client assets, provision
of contract notes, statements of account and receipts, keeping of records requirements, and accounts
and audit requirements which intermediaries conducting the business of dealing in securities, advising
on securities and providing margin financing in Hong Kong, and where appropriate, their associated
entities, must observe. In the last section, we discussed compensation and insurance issues.
We first looked at the financial resources requirements for licensed corporations conducting the
business set by the SFC under the FRR.
Next we looked at the requirements set out in the Client Securities Rules and the Client Money Rules
for protection and proper handling of client assets.
We also reviewed the Contract Notes Rules which set out the requirements for intermediaries to
provide clients with accurate, timely and meaningful information about their transactions.
We then discussed the requirements under the Keeping of Records Rules and the Accounts and Audit
Rules.
We also considered the ICF and the requirements for licensed corporations to arrange insurance
covers.
At the end of this Topic, we discussed the reporting and record keeping obligations of licensed
corporations under the OTCD Reporting Rules and the clearing and record keeping obligations in
relation to dealer-to-dealer OTC derivative transactions under the OTCD Clearing Rules.

Checklist
Below is a checklist of the main points covered by this Topic. Candidates should use the list to test
their knowledge.
The financial resources requirements set by the SFC under the FRR are designed to enable it to
make timely assessment of the solvency of licensed corporations and accurate assessment of the
risks involved in any licensed corporations RAs.
A corporation must meet the capital requirement before obtaining a licence and continue to
maintain sufficient paid-up share capital and liquid capital at all times for its business. The level
of paid-up share capital and liquid capital required for each type of RA is set out under the FRR.
A licensed corporation has to report to the SFC promptly if it becomes aware of its inability to
meet the FRR.
Failure to comply with the FRR, without reasonable excuse, is a criminal offence.
The Client Securities Rules prescribe the way in which intermediaries and their associated
entities must treat and deal with client securities and securities collateral received or held in Hong
Kong.
The Client Money Rules prescribe the manner in which licensed corporations and their
associated entities must treat and deal with client money received or held in Hong Kong. The
Client Money Rules do not apply to client money which is held in a bank account by the client
in his own name.
A licensed corporation or its associated entity that receives or holds client money should
establish and maintain in Hong Kong one or more segregated accounts for the client money, each
of which should be designated as a trust or client account. The accounts must be with an AFI or
a person approved by the SFC. The deadline to segregate client money is one business day after
receipt of the money from the client.

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Intermediaries licensed or registered for different types of RAs and their associated entities must
prepare contract notes, statements of account and receipts. There are exceptions for PIs.
The Keeping of Records Rules set out records required to be kept to explain transactions, to
account for client assets, and to reflect the intermediarys financial position.
Associated entities which receive or hold client assets must be able to account properly for, and
maintain records on, client securities and other assets held on behalf of an intermediary.
An intermediary which provides to its clients financial accommodation for purchasing securities
must keep records to show the market value and margin value of each type of securities collateral
deposited with it and margin calls made.
The Account and Audit Rules apply to licensed corporations and to associated entities of
intermediaries. The Account and Audit Rules do not apply to registered institutions. Financial
requirements and monitoring of related reporting by registered institutions are the responsibility
of the HKMA.
The ICC is the body responsible for the management and administration of the ICF.
An investor of any nationality who suffers pecuniary losses as a result of defaults by
intermediaries in relation to exchange-traded products in Hong Kong can claim against the ICF.
Since the ICF is aimed at protecting retail investors, institutional investors are not entitled to
claim compensation against the fund.
The maintenance of insurance cover by a licensed corporation is a necessary condition for the
granting of a licence by the SFC.
The Insurance Rules apply to all licensed corporations other than those which have a licensing
condition that they may not hold client assets and are not exchange participants of either the
SEHK or HKFE.
The insurance covers risk of loss of client assets due to certain events such as fraudulent acts by
the corporations employees, theft of client assets kept in the custody of the corporations
associated entity, and forged or fraudulent instructions relating to client assets.
Reporting obligation arises when a licensed corporation enters into or has conducted in Hong
Kong on behalf of an affiliate a transaction in an OTC derivative product specified by the OTCD
Reporting Rules.
Records of specified OTC derivative transactions must be kept for at least five years after the
termination or maturity date of the transaction.
Where a clearing obligation arises in relation to an OTC derivative transaction, the transaction
must be cleared through a designated CCP within one business day after the transaction is entered
into, unless a relevant exemption applies.
To be subject to the clearing obligation the transaction must be a dealer-to-dealer transaction,
i.e. one between a prescribed person, and either another prescribed person or a person who has
been designated by the SFC as a financial services provider.
The OTCD Clearing Rules specifies a clearing threshold that refers to the average total
position of a person in OTC derivative transactions.
Records sufficient to demonstrate compliance with the applicable clearing obligations (or
exemptions therefrom) must be readily accessible and kept for at least 5 years after the
termination or maturity date of the transaction.

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Topic 3: Management and supervision of securities business
Table of contents
Topic overview 1
Learning outcomes 1
1 Duties and liabilities of responsible officers and executive officers 3
Requirements under the Securities and Futures Ordinance 3
Requirements under the new Companies Ordinance 4
Requirements under the Code of Conduct for Persons Licensed by or Registered with the
Securities and Futures Commission (Code of Conduct) 4
General duties of management 4
Management, supervision and internal control 5
2 Code of Conduct for Persons Licensed by or Registered with the Securities and Futures
Commission 6
Introduction 6
Effect of breaches of the Code of Conduct 6
The nine general principles 6
General principle 1 honesty and fairness 6
General principle 2 diligence 7
General principle 3 capabilities 8
General principle 4 information about clients 8
General principle 5 information for clients 12
General principle 6 conflicts of interest 13
General Principle 7 compliance 15
General principle 8 client assets 17
General principle 9 responsibilities of senior management 17
Professional investors 18
Electronic trading 21
Alternative liquidity pools 21
3 Management, Supervision and Internal Control Guidelines for Persons Licensed by or
Registered with the Securities and Futures Commission 23
Management and supervision 24
Segregation of duties and functions 24
Personnel and training 25
Information management 25
Compliance 26
Audit 26
Operational controls 27
Risk management 28
Additional information about operational controls and risk management 29
Risk management techniques 31
4 Code of Conduct requirements for licensed or registered persons dealing in securities
listed or traded on The Stock Exchange of Hong Kong Limited 34
Options client agreement 34
Time stamping 34
Options trade confirmations 34
Adjustments to contracts 35
Clients money in relation to exchange-traded options business 35
5 Prevention of money laundering and terrorist financing 36
Legislation 36
Regulation by the Securities and Futures Commission 38
Policies and procedures to combat money laundering and terrorist financing 39
Examples of suspicious transactions 41
Topic summary 43
Checklist 43
Topic overview
This Topic addresses the management and supervision of licensed corporations dealing in securities,
giving securities investment advice and providing margin financing. It is important that responsible
officers of licensed corporations and executive officers of registered institutions have a full and clear
understanding of their managerial and supervisory roles.
We commence the Topic by highlighting the range of duties, responsibilities and liabilities of
responsible officers and executive officers under the Securities and Futures Ordinance (SFO) and
the new Companies Ordinance (NCO). There follow brief introductions to the relevance of codes
and the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures
Commission (Code of Conduct) and the Management, Supervision and Internal Control Guidelines
for Persons Licensed by or Registered with the Securities and Futures Commission (ICG) to the
supervision of the types of business mentioned above.
In the second section, we review the nine general principles of the Code of Conduct and its detailed
guidance on the practices and standards that licensed or registered persons are expected to comply
with. There are detailed discussions of the know your client requirement, the special requirements
for regarding professional investors (PIs), electronic trading and alternative liquidity pools
(ALPs).
In the third section, the ICG are discussed. The ICG contain control guidelines and suggested control
techniques and procedures which licensed corporations and registered institutions may follow to
structure an effective internal control system to manage, supervise and operate their business.
In the fourth section, we consider the particular Code of Conduct requirements for dealing in
securities listed or traded on The Stock Exchange of Hong Kong Limited (SEHK).
We then close the Topic with a discussion about the prevention of money laundering and terrorist
financing activities, and the related laws and guidelines addressing such issues. Securities market is
one of the means by which money launderers and terrorists may use to conduct illegal activities.

Learning outcomes
At the end of this Topic, candidates should be able to:
(a) understand the duties, responsibilities and liabilities of responsible officers and executive
officers in a business;
(b) have a good knowledge of the general principles of the Code of Conduct and the related practices;
(c) be able to apply each general principle to conducting and supervising the business;
(d) understand the know your client requirement and know how to put it into practice;
(e) understand the special requirements regarding PIs, electronic trading and ALPs;
(f) understand the importance and structure of good internal control systems to the intermediarys
business;
(g) be aware of the directing role of management in an efficient and compliance-conscious business;
(h) be conversant with good operational control and risk management techniques;
(i) be aware of additional conduct requirements for dealing in securities listed or traded in the SEHK,
as set out in a schedule to the Code of Conduct;
(j) understand the basic measures against money laundering and terrorist financing, i.e. the
application of the four main pieces of legislation in Hong Kong concerned with the prevention
of such activities;

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(k) be able to identify all necessary policies and procedures to prevent money laundering and
terrorist financing; and
(l) be able to recognise suspicious circumstances and activities related to money laundering.

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1 Duties and liabilities of responsible officers and executive
officers
Requirements under the Securities and Futures Ordinance
Minimum number of responsible officers or executive officers (s. 125, SFO)
1.1 Every licensed corporation must have at least two responsible officers approved by the
Securities and Futures Commission (SFC). A responsible officer is one who actively
participates in, or supervises, the regulated activities (RAs) of a licensed corporation. Every
executive director of a licensed corporation is required to obtain the approval of the SFC as a
responsible officer. At least one of the responsible officers must be an executive director. A
registered institution must have at least two executive officers.
1.2 Responsible officers or executive officers are the controlling minds of the licensed
corporation or the registered institution, as the activities and operations of the corporation are
ultimately in the hands of these officers.

Fitness and properness (s. 129, SFO)


1.3 Responsible officers, together with the senior management of a licensed corporation (and, in
the case of a registered institution, the executive officers), assume primary responsibility for
ensuring that the intermediary complies at all times with the SFCs fit and proper guidelines
in order to remain licensed or registered. A review on fitness and properness is provided in
section 9 of Topic 1.

Management liability (ss. 194 and 196, SFO)


1.4 The SFO expressly introduces liability for responsible officers or persons involved in the
management of the business of a licensed corporation, or executive officers of a registered
institution, or persons involved in the management of the business constituting a RA of the
registered institution, where they have consented to, connived at or been neglectful of
misconduct by the licensed corporation or registered institution.
1.5 There are a number of provisions in the SFO which mean that both the responsible officers of
a licensed corporation and the executive officers of a registered institution and the corporation
itself are liable for breaches by the corporation of certain fundamental regulatory requirements:
(a) Section 194 provides that if a regulated person is guilty of misconduct or is not a fit and
proper person, the SFC may:
(i) in the case of a responsible officer, revoke or suspend approval as a responsible
officer;
(ii) in the case of a licensed person, revoke or suspend his licence in respect of all or part
of the licensed RA;
(iii) publicly or privately reprimand the regulated person;
(iv) prohibit the regulated person from applying for licences, registrations, approvals and
entry in the Hong Kong Monetary Authority (HKMA) register, or from acting as
an executive officer; and
(v) separately or in addition, order the regulated person to pay a penalty of up to HK$10
million or three times any profit gained or loss avoided as a result of his misconduct,
whichever is the greater.
(b) Section 196 provides similar powers to s. 194 to be used in similar circumstances in
respect of regulated persons, as defined for registered institutions.

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Note: A regulated person is one who is a licensed person, a responsible officer of a licensed
corporation or a person involved in the management of the business of a licensed
corporation. In case of registered institutions, a regulated person is one who is a
registered institution, an executive officer of a registered institution or a person
involved in the management of the business of a registered institution.
1.6 If an offence under the SFO committed by a licensed corporation is aided or abetted,
counselled or procured by, or committed with the consent or is attributable to the recklessness
of, an officer of the corporation, that officer will be guilty of the offence and be punishable
accordingly.
1.7 There is a defence available to such an officer in this regard. The defence is expressly provided
for under Part XVI, SFO and essentially discharges a member of management from liability
if he can show that he honestly and reasonably believed the failure would not occur. Also if,
upon becoming aware of the breach, he acted promptly in notifying the SFC and, until then,
had honestly and reasonably believed that the failure would not occur.

Requirements under the new Companies Ordinance


1.8 As set out in section 3 of Topic 1, the NCO contains provisions governing the duties and
liabilities of directors.

Requirements under the Code of Conduct for Persons Licensed by


or Registered with the Securities and Futures Commission (Code
of Conduct)
1.9 The relevant requirements of Code of Conduct are reviewed in sections 2.58 to 2.61 of this
Topic.

General duties of management


1.10 In general, the duties of responsible officers and executive officers who actively participate
in, or supervise, the intermediarys business may include:
(a) ensuring the intermediary has developed policies appropriate for its business;
(b) establishing appropriate standards of business conduct and procedures, and ensuring
proper compliance by staff at all times;
(c) establishing adequate internal controls and suitable risk management systems and
ensuring they are strictly complied with;
(d) employing only staff who meet the licensing requirements of the SFC, and ensuring that
they are sufficiently competent and experienced to perform their work;
(e) ensuring the intermediary complies with the capital and financial reporting requirements
of the SFC, exchange and clearing house;
(f) ensuring the intermediary and its staff comply at all times with the applicable laws, the
rules, regulations, guidelines and codes of the SFC, the exchange and clearing house, and
the professional bodies of which it is a member;
(g) properly managing the risks associated with the business of the intermediary, including
performing periodic evaluation of its risk management processes;
(h) establishing procedures to ensure that proper dealing practices are observed at all times
in particular, that clients interest are protected;
(i) ensuring that the intermediarys systems, procedures and practices can facilitate
compliance with the standards and requirements set out in the relevant laws, the rules,
codes and guidelines of the SFC, exchanges and clearing houses;

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(j) establishing procedures and systems for the proper handling of the intermediarys assets
and clients assets;
(k) establishing procedures to ensure that the intermediary provides its clients with accurate,
timely and meaningful information about their trading;
(l) reporting to the SFC on discovery of the matters mentioned in section 2.53 of this Topic;
(m) ensuring that the intermediary has adequate insurance coverage for its business; and
(n) clearly understanding the extent of their own authority and responsibilities.

Management, supervision and internal control


1.11 The SFC has published the ICG to provide guidance to licensed or registered persons on the
SFCs expectations in relation to internal controls. The licensed or registered person and its
senior management are ultimately responsible for the adequacy and effectiveness of the
internal control system that is implemented. ICG are discussed in section 3 of this Topic.

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2 Code of Conduct for Persons Licensed by or Registered
with the Securities and Futures Commission
Introduction
2.1 The Code of Conduct applies to all licensed and registered persons. It concentrates on the
external relationships of licensed or registered persons, particularly with clients. The nine
general principles which govern the Code of Conduct are based on the seven regulatory
principles proposed by the International Organization of Securities Commissions (IOSCO),
a global group of securities regulators which promotes cooperation and high standards of
regulation in order to maintain fair, efficient and sound markets. The SFC is a full member of
IOSCO.

Effect of breaches of the Code of Conduct


2.2 A failure on the part of an intermediary or its representative to comply with the Code of
Conduct is not a breach of law and does not by itself constitute an offence under the law.
However, it should be noted that breaches of the Code of Conduct may be taken into account
in two important respects:
(a) the SFC may consider the breach to raise questions as to whether the intermediary or
representative is a fit and proper person to remain licensed or registered; and
(b) a court hearing legal proceedings under the SFO shall consider the provisions of the Code
of Conduct if the court considers it relevant to the determination of any question arising
in the proceedings. This gives the Code of Conduct a degree of legal recognition.

The nine general principles


2.3 The nine general principles on which the Code of Conduct is based are:
(a) honesty and fairness;
(b) diligence;
(c) capabilities;
(d) information about clients;
(e) information for clients;
(f) conflicts of interest;
(g) compliance;
(h) client assets; and
(i) responsibility of senior management.
These will be explained in the sections which follow.

General principle 1 honesty and fairness


2.4 In conducting its business activities, a licensed or registered person should act honestly, fairly,
and in the best interests of its clients and the integrity of the market. This principle is
expanded in the Code of Conduct to the following situations:
(a) Representations and information to clients should be accurate and not misleading.
(b) Charges to clients should be fair and reasonable.

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(c) Invitations and advertisements should not contain information that is false, misleading or
deceptive; and they should not contain derogatory comments about products or services
provided by others.
(d) It should be aware of and comply with the provisions of the Prevention of Bribery
Ordinance (PBO) and any related guidelines issued by the Independent Commission
Against Corruption. Section 9, PBO makes it an offence for an agent such as a licensed
or registered person to solicit or accept unfair advantages which might induce him not to
act in the best interests of his client. It also makes it an offence to offer an advantage to
an agent.
In particular, a representative acting as an agent should not, without the permission of his
principal, solicit or receive an advantage such as money, gift, employment, service or
favour that would interfere with or prejudice his conduct in any way.

General principle 2 diligence


2.5 In conducting its business activities, a licensed or registered person should act with due skill,
care and diligence, in the best interests of its clients and the integrity of the market. Some of
the specified practical situations are:
(a) prompt execution a licensed or registered person should take reasonable steps to
execute client orders promptly and in accordance with clients instructions. Client orders
should not be held up or withdrawn for the convenience of the licensed or registered
person or persons other than the client placing the order;
(b) best execution a licensed or registered person should execute client orders on the best
available terms;
(c) prompt and fair allocation orders executed for clients should be promptly and fairly
allocated to those clients;
(d) clients should be advised with due skill, care and diligence advice and
recommendations should be based on thorough analysis and take into account available
alternatives;
(e) no withholding of orders for convenience when clients place market or limited orders,
they may not be withdrawn or withheld for the convenience of the salesman, the licensed
or registered person or any other person;
(f) separate accounts should be kept for each client for securities or futures contract dealings
or trading in leveraged foreign exchange contracts, distinguishing cash accounts from
margin accounts;
(g) a licensed or registered person should record and immediately time-stamp records of
orders for clients and other orders (such as house or staff orders). Where orders are
received by telephone, a telephone recording system should be used to record the order,
and recordings maintained for at least six months. The use of mobile phones for receiving
client order instructions is strongly discouraged, and should be prohibited on the trading
floor, in the trading room, in the usual place of business where orders are received or
where business is conducted. However, where orders are accepted by mobile phone
outside these areas, the time of receipt and the order details should be recorded
immediately (by means of a call to the office telephone recording system);
(h) a licensed or registered person should act in the best interests of its clients in providing
services or recommending the services of an affiliated person;
(i) a licensed or registered person should collect promptly from clients any account due as
margin; and

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(j) in promoting a specific investment product to a client, a licensed or registered person
should not offer any gift other than a discount of fees or charges.

General principle 3 capabilities


2.6 A licensed or registered person should have and employ effectively the resources and
procedures which are needed for the proper performance of its business activities. It should
have:
(a) staff who are fit and proper to carry out their designated responsibilities;
(b) adequate and diligent supervision of the staff appointed to conduct its business; and
(c) satisfactory internal control procedures, financial resources and operational systems,
procedures and technology which can reasonably be expected to protect from loss both
its own operations and any third parties it transacts with.

General principle 4 information about clients


2.7 A licensed or registered person should seek from its clients information about their financial
situation, investment experience and investment objectives relevant to the services to be
provided. This principle has been extended into three sections covering:
(a) know your client (sometimes referred to as KYC);
(b) client agreements; and
(c) discretionary accounts.

Know your client


2.8 A licensed or registered person should take all reasonable steps to establish the clients:
(a) true and full identity;
(b) financial situation or strength;
(c) investment experience; and
(d) investment objectives.

KYC-identity requirements
2.9 Prior to executing any transaction for a client, a licensed or registered person is required to
satisfy itself on reasonable grounds of the identity, address and contact details of the ultimate
originator and the ultimate beneficiary of a transaction and keep a record of the information
used to establish the same. In the case of a collective investment scheme (CIS) or
discretionary account, this will require the licensed or registered person to establish the
identity of the CIS or account and its manager the identities of the ultimate beneficiaries
only need to be established where they are in fact giving the instructions.

Third party authorization to operate a clients account


2.10 Before a licensed or registered person accepts orders from a third party in respect of a client
account, the Code of Conduct requires the licensed or registered person and its staff to take
reasonable steps to establish the true and full identity of the third party and keep a record of
that partys identity information. A written authorization from the client for the third party to
operate the clients account should be obtained.

Client Identity Rule Policy


2.11 The SFC has also issued the Client Identity Rule Policy, which explains the approach the SFC
will take in enforcing the client identity requirements. Where the SFC requests information

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on the identity of ultimate clients, it will consider the requirements to have been complied
with if the licensed or registered person provides the necessary information in relation to
ultimate clients within two business days of the request. Failure to comply with the request
will reflect adversely on the fitness and properness of a licensed or registered person. However,
the Policy provides examples of cases where the SFC will take into consideration commercial
circumstances which may make it difficult for a licensed or registered person to obtain and
provide such information.
2.12 The requirements apply to transactions in securities listed or traded on a recognized stock
market in Hong Kong, or in derivatives based on these underlying instruments:
(a) a licensed or registered person must satisfy itself on reasonable grounds regarding the
identity, address and contact details of:
(i) a person or entity ultimately responsible for originating the transaction; and
(ii) (except for an investment fund or discretionary account) the person or entity that is
the ultimate beneficiary of the transaction or that will bear the risk;
(b) a licensed or registered person must keep records of the identity etc. and provide the SFC
with access to the records on request;
(c) a licensed or registered person should not enter into any transaction with the person
without obtaining these details and recording them; and
(d) a licensed or registered person should be satisfied about the identity, address and contact
details of the person or entity ultimately responsible for originating the transaction
instructions.
2.13 In the case of a collective investment scheme or discretionary account, it is the manager of the
scheme or account whose details are required and not, for example, details of unit holders in
a unit trust.

Suitability and mis-selling


2.14 When making a recommendation or solicitation, a licensed or registered person should ensure
its suitability for the client having regard to information about the client which it is (or should
be) aware of through the exercise of due diligence.
2.15 As part of the know-your-client procedures, a licensed or registered person should assess the
clients knowledge of derivatives and characterise the client according to the sum of this
knowledge. Where a client without knowledge of derivatives wishes to invest in a derivative
product that the licensed or registered person has not recommended, the risks should be
explained. If the product is not traded on an exchange, the licensed or registered person should
provide appropriate advice to the client. A record of any warning given and other
communications with the client should be kept. If the transaction is assessed by the licensed
or registered person to be unsuitable for the client, the licensed or registered person may only
proceed to effect the transaction if to do so would be acting in the best interests of the client
in accordance with the general principles of the Code of Conduct.
2.16 In May 2007, the SFC reiterated that mis-selling of products should not be engaged in, and
indicated that it regards the primary obligation relating to suitability to rest with the licensed
or registered person, not the client. The SFC also stated that instances of non-compliance
would be taken into account when considering whether a licensed or registered person was fit
and proper to engage in the financial planning and wealth management business. The SFC has
posted frequently asked questions (FAQs) and answers regarding suitability obligations on
its website under the FAQ column.

Client agreement
2.17 A written client agreement should be entered into with a client before a licensed or registered

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person provides services to the client. The agreement should be in Chinese or English at the
option of the client, and the relevant risks drawn to his attention. A copy is to be provided to
the client if the agreement is not entered into in a face-to-face meeting between staff of the
licensed or registered person and the client, and satisfactory steps should be taken to verify
the signature of the client.
2.18 In particular, the Code of Conduct specifies the provisions which all client agreements are
required to contain, including:
(a) full names and addresses of the client (verified by reliable proof) and the licensed or
registered person;
(b) undertakings by the parties to notify material changes of information to each other;
(c) a full description of the services to be provided and the charges to be paid by the client,
with details of any special services (e.g. margin financing or short-selling facilities and
derivatives trading); and
(d) the appropriate risk disclosure statements as specified in Schedule 1, Code of Conduct.
2.19 The Code of Conduct also requires licensed or registered persons to:
(a) include in each client agreement a clause: If we [the intermediary] solicit the sale of or
recommend any financial product to you [the client], the financial product must be
reasonably suitable for you having regard to your financial situation, investment
experience and investment objectives. No other provision of this agreement or any other
document we may ask you to sign and no statement we may ask you to make derogates
from this clause.; and
(b) preclude incorporation of any clause, provision or term in the client agreement or any
other document signed or statement made by the client at the request of the licensed or
registered person which:
(i) is inconsistent with its obligation under the Code of Conduct; and
(ii) misdescribes the actual services to be provided to the client.
2.20 A licensed or registered person should ensure that client agreements do not remove, exclude
or restrict the legal rights of a client or the legal obligations of the licensed or registered person.

Non-face-to-face approach
2.21 If the account opening documents cannot be executed in the presence of an employee of the
licensed or registered person, the signing of the client agreement and sighting of related
identity documents should be certified by another licensed person or registered person, a
Justice of the Peace or a professional person such as a bank branch manager, certified public
accountant, lawyer or notary public. Certification services recognized by the Electronic
Transactions Ordinance may also be employed.
2.22 Alternatively, the licensed or registered person may verify the identity of a non-corporate
client by the following procedures:
(a) obtaining a copy of the clients identity document;
(b) obtaining a copy of the signed client agreement;
(c) obtaining a cheque for an amount not less than HK$10,000 issued by the new client in
his name, as shown in the identity document, which is drawn on the clients account with
a licensed bank in Hong Kong and duly paid; and
(d) checking the clients signatures on the cheque are the same as that on the client agreement.

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Discretionary accounts
2.23 A discretionary account is a client account in respect of which the client has authorized the
licensed or registered person or any person employed by it (who must in turn be a licensed or
registered person) to effect transactions on behalf of the account without the clients prior
approval for each transaction. The discretion may be absolute or subject to conditions (for
example, that transactions be carried out by the licensed or registered person only under
specified restrictions).
2.24 The Code of Conduct imposes the following requirements on the establishment and operation
of discretionary accounts:
(a) the clients authority must be in writing;
(b) the authority should specify the person who is authorized to operate the account, stating
that the person is an employee or agent of the licensed or registered person, if the
authority is granted to such person;
(c) the terms of the authority should be explained by the licensed or registered person or a
person employed by it to the client if the authority is given to such persons to operate the
account;
(d) the authority should be confirmed annually by the licensed or registered person with the
client for this purpose, it is permissible for the licensed or registered person to notify
the client before the expiry date that it will be automatically renewed unless the client
specifically revokes it in writing before the expiry date;
(e) the account should be designated as a discretionary account;
(f) senior management should approve the opening of the account; and
(g) internal control systems should be installed to ensure that the operation of the account is
properly supervised.

Risk disclosure statements


2.25 A client agreement should contain risk disclosure statements, and declarations by a member
of the staff of the licensed or registered person that he has provided the client with the
appropriate risk disclosure statements in a language of the clients choice (English or Chinese)
and invited the client to read the risk disclosure statements, ask questions and take independent
advice if he so wishes. The client is required to sign and date his acknowledgement of these
matters.
When opening an account other than through a face-to-face meeting, the covering
correspondence to the client should specifically direct his attention to the appropriate risk
disclosure statements.
2.26 The risk disclosure statements deal with the particular risks of carrying out the respective
activities, the need for obtaining professional advice and the degree of protection given by
limits the client may put on trades:
(a) Risk of securities trading
This refers to possible sudden dramatic movements in the prices of stocks which may
result in losses.
(b) Risk of trading futures and options (in addition to a short statement, a more detailed
model statement is provided for use at the option of the licensed or registered person;
refer to the Code of Conduct for details)
This refers to extra exposure due to trading in small amounts (on margin) where the
underlying risk may be for large amounts; the risk that a client may lose his initial margin
very quickly and will have to meet extra margin calls at short notice, failing which the

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position may be liquidated at a loss, leaving the client liable for the deficit. The placement
of stop-loss orders may not be effective in limiting a loss due to market conditions. The
statement asks the client to consider the suitability of investing in these instruments.
(c) Risk of trading Growth Enterprise Market (GEM) stocks
This refers to the high volatility of GEM stocks, their shorter track record and the need
to seek professional advice.
(d) Risks attaching to client assets received or held outside Hong Kong
This refers to the possible differences between overseas laws and those of Hong Kong,
where assets received or held overseas may not have protection under Hong Kong law.
(e) Risk of providing an authority to re-pledge clients securities collateral
This refers to the risks of providing an authority to a licensed or registered person to re-
pledge the securities collateral for financial accommodation and the need to renew such
authorities annually (unless the client is a PI) and other matters. If the licensed or
registered person defaults, the client could lose his securities.
(f) Risk of providing an authority to hold mail or to direct mail to third parties
This points out the need for the client to collect all contract notes and statements of
account promptly in order to detect any mistakes or differences.
(g) Risk of margin trading
This refers to the danger of the client losing more than his margin deposits and being
called upon to make more deposits and to the possibility of the licensed or registered
person liquidating the collateral if the client fails to meet a margin call. The placement of
stop-loss orders may not be effective in limiting loss due to market conditions. The
statement asks the client to consider the suitability of margin financing carefully in the
light of his financial position and investment objectives.

General principle 5 information for clients


2.27 A licensed or registered person should make adequate disclosure of relevant material
information in its dealings with clients. The SFC expects a licensed or registered person to
provide information to its clients in order to maintain transparency as well as to let them know
about transactions on their accounts. The information to be provided is given in paragraphs
8.1 to 8.5 of the Code of Conduct.
2.28 Information about the licensed or registered person includes:
(a) adequate and relevant information about its business, including contact details, services
provided, and the identity and status of employees and others acting on its behalf with
whom the client will have contact;
(b) clear information about which company the individual contact is acting for where a
financial services group is concerned; and
(c) audited financial statements and information on corporate actions, which should be
provided to the client upon request.
2.29 A licensed or registered person should confirm with clients promptly the essential information
of transactions carried out for them (not applicable for a discretionary account).
2.30 A licensed or registered person is required to disclose to its clients any benefits it (or any of
its associates) directly or indirectly receives from a product issuer for distributing an
investment product. Such disclosures should be specific and made on a transaction-by-
transaction basis. Where a benefit is not quantifiable prior to or at the point of entering the
transaction, or is of a non-monetary nature, the existence and nature of such benefits should
be disclosed.

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2.31 The following sales-related information needs to be disclosed to a client prior to or at the point
of entering into the transaction:
(a) the capacity (principal or agent) in which a licensed or registered person is acting;
(b) any affiliation of the licensed or registered person with the product issuer;
(c) disclosure of monetary and non-monetary benefits (as discussed in section 2.30 above);
and
(d) any terms and conditions in generic terms under which the client may receive a discount
of fees and charges from a licensed or registered person.
If the disclosure cannot be made in writing before a transaction is concluded, the licensed or
registered person should make a verbal disclosure and provide such information in writing to
the client as soon as practicable after the conclusion of the transaction.

General principle 6 conflicts of interest


2.32 A licensed or registered person should try to avoid conflicts of interest and, when they cannot
be avoided, should ensure that its clients are fairly treated.
2.33 A licensed or registered person should try to avoid conflicts of interest, which may arise
between:
(a) one client and another client; and/or
(b) a client and the licensed or registered person or its staff.
2.34 There are various ways such conflicts may arise and the Code of Conduct deals with them as
follows:
(a) the avoidance of conflicts in connection with the handling of client orders;
(b) the actions required of a licensed or registered person where there are actual or potential
conflicts which cannot be avoided;
(c) potential conflict issues arising in connection with a licensed or registered persons
rebates and soft dollar practices; and
(d) potential conflicts arising in connection with the preparation and issue of research reports.
These are reviewed in the following sections.

Handling of client orders


2.35 The Code of Conduct requires a licensed or registered person to handle client orders fairly and
in which they are received. They should have priority over orders for the account of the
licensed or registered person or for that of any employee or agent of the licensed or registered
person.
2.36 Where a licensed or registered person has aggregated orders for several clients or orders for a
client with orders for its own account, it must give priority to the orders of clients in any
subsequent allocation if all the orders cannot be filled. In practice, the SFC would expect that,
in allocating orders to several clients which cannot be fully satisfied, the licensed or registered
person will avoid giving unfair preference to any one client.
2.37 When handling client orders, a licensed or registered person will also acquire client
information of a non-public nature. This information should not be used for the benefit of the
licensed or registered person or its staff, and the Code of Conduct requires a licensed or
registered person to ensure that neither it nor its employees deal (whether for the benefit of
the licensed or registered person, its employee or a client):
(a) ahead of transactions pending for other clients (front running); or

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(b) on the basis of having non-public information which is likely to affect the price of the
instruments when it is publicly released.

Withdrawal from business


2.38 Paragraph 9.4 of the Code of Conduct further requires that licensed or registered persons
ceasing to carry out a RA should promptly notify clients.

Actual or potential conflicts


2.39 Where conflicts cannot be avoided, paragraph 10 of the Code of Conduct requires the licensed
or registered person not to advise or deal in relation to the transaction unless it has disclosed
the conflict of interest to the client and has taken all reasonable steps to ensure fair treatment
for the client.

Rebates, soft dollars and connected transactions


2.40 A licensed or registered person that acts for a client in the exercise of investment discretion
may arrange to receive money (rebates) or goods or services (soft dollars) from a broker in
consideration of directing transactions effected on behalf of the client to that broker, subject
to the requirements set down by the Code of Conduct. A central concern behind the SFCs
requirements is reducing the risk of conflicts arising from these financial arrangements, which
could result in a licensed or registered person not giving the client proper service.
2.41 The requirements in relation to the receipt of soft dollars are:
(a) the goods or services must be of demonstrable benefit to the licensed or registered
persons clients; in this regard the SFC has provided a list of the goods and services which
the SFC will normally permit, and those which it will not (see below);
(b) transaction execution must be consistent with best execution standards;
(c) brokerage rates are not in excess of customary full-service brokerage rates;
(d) the client has consented in writing to the receipt of the goods or services; this may be
provided for in the client agreement or other investment management agreement; and
(e) disclosure is made to the client of the licensed or registered persons soft-dollar practices
and must include a description of the goods and services received; this must be provided
to the client on at least an annual basis.
2.42 Goods and services permitted by the SFC are:
(a) research and advisory services;
(b) economic and political analysis;
(c) portfolio analysis, including valuations and performance measurement;
(d) market analysis;
(e) data and quotation services;
(f) computer hardware and software incidental to the above goods and services;
(g) clearing and custodial services; and
(h) investment-related publications.
2.43 Goods and services not permitted by the SFC are:
(a) travel;
(b) accommodation;
(c) entertainment;
(d) general administrative goods or services;

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(e) general office equipment or premises;
(f) membership fees;
(g) employee salaries; and
(h) direct cash payments.
2.44 The requirements in relation to the receipt of money or cash rebates are:
(a) the licensed or registered person must have described its practices in relation to rebates
and the client consented in writing to the licensed or registered person receiving and
retaining the rebates; this may be provided for in the client agreement or other investment
management agreement. In addition, the licensed or registered person should disclose to
its clients at least annually details of the goods and services received;
(b) brokerage rates are not in excess of customary full-service rates; and
(c) the rebates and their approximate values are disclosed to the client; such information must
be provided to the client at least twice annually, or in each contract note.
2.45 Where a client exercises his right under a cooling-off mechanism incorporated in an
investment product, the clients instruction should be executed promptly and the client should
receive a full refund including any sales commission (this covers any sales commission
retained by the licensed or registered person in relation to that transaction). The licensed or
registered person may deduct an administrative charge provided that such charge is reasonable,
is disclosed to the client at or prior to point of sale and does not contain any profit margin.

Analysts
2.46 In recent years, there has been an increased focus on the influence of research on traded
securities and the ethical standards adopted by firms (i.e. intermediaries and their group of
companies) and analysts (i.e. individuals) that are preparing and issuing such research. Of
particular concern is that commercial or investment interests of a firm or an analyst may create
potential conflicts of interest which affect the research recommendations that are made.
2.47 The Code of Conduct addresses firms and analysts that issue investment research, or have an
influence, on securities traded in Hong Kong. It has now been extended to cover securities to
be issued by a new listing applicant (including a real estate investment trust) which will be
traded in Hong Kong. It requires firms to establish mechanisms, including policies and
procedures, to ensure that analysts are held to high standards of integrity and ethical behaviour.
The approach taken in paragraph 16 of the Code of Conduct is to set out a number of principles
that the SFC considers of fundamental importance, which are then discussed in section 5 of
Topic 5.

General Principle 7 compliance


2.48 A licensed or registered person should comply with all regulatory requirements so as to
promote the best interests of clients and the integrity of the market. Regulatory requirements
include the law (and also subsidiary legislation made by the SFC), rules, regulations and codes
administered or issued by the SFC, the rules of exchanges and clearing houses in which
licensed or registered persons are participants, and the requirements of any other regulatory
authority which apply to them. The provisions of the Code of Conduct in this area cover
obligations under the Financial Dispute Resolution Scheme (FDRS), employee dealings,
responsibility for acts of employees, and complaints and circumstances calling for reports to
the SFC.

Obligations under the FDRS


2.49 A licensed or registered person (other than those carrying on Type 10 RA under the SFO)
should fully comply with the FDRS for managing and resolving disputes administered by the

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Financial Dispute Resolution Centre Ltd. (FDRC) and be bound by the dispute resolution
processes provided for under the FDRS.

Employee dealing
2.50 A licensed or registered person must have a written policy issued to employees specifying
whether or not they can deal or trade for their own accounts in securities or futures contracts.
If employees are permitted to deal or trade, the policy should specify the following matters:
(a) the conditions on which employees may do so;
(b) that employees should identify all related accounts and report them to senior management
(related accounts refers to accounts of minor children and accounts in which employees
have a beneficial interest.);
(c) that employees should generally be required to deal through the licensed or registered
person or its affiliates;
(d) that if employees are allowed to deal in securities through other licensed or registered
persons, the licensed or registered person (principal) and the employees should arrange
for duplicate trade confirmations and statements of account to be provided to the senior
management of the licensed or registered person (principal);
(e) that any transactions covered by this section should be separately recorded and identified
in the licensed or registered persons records;
(f) that transactions on employees and related accounts should be reported to and actively
monitored by senior management, who should ensure that there are no irregularities and
that the transactions are not prejudicial to the interests of clients; and
(g) that a licensed or registered person should not knowingly have another licensed or
registered persons employee as a client without the written consent of that employees
principal.

Complaints from clients


2.51 A licensed or registered person is required to:
(a) handle complaints from clients in a timely and appropriate manner;
(b) investigate them and respond promptly;
(c) if it is unable to do so, advise the client of any further steps available to him under the
regulatory system including the right to refer the dispute to the FDRC; and
(d) review the subject matter of a complaint properly upon receipt. If the subject matter
relates to other clients, or raises issues of broader concern, the licensed or registered
person should take steps to investigate and remedy the matter, even if such other clients
have not filed any complaint with the licensed or registered person and/or the FDRC.

Responsibility for acts of employees


2.52 The Code of Conduct states that a licensed or registered person should be responsible for the
acts or omissions of its employees and agents in the conduct of its business. This provision
reflects the usual legal responsibility of an employer for the actions of its employees and
agents acting within their apparent authority.

Notification to the SFC


2.53 The Code of Conduct specifies that a licensed or registered person is required to make reports
to the SFC immediately upon discovery of:
(a) material breaches or suspected material breaches (by the licensed or registered person or
its employees or agents) of any law; or rules, regulations and codes administered or issued

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by the SFC; or the rules of the exchanges and clearing houses of which the licensed or
registered person is a participant, or any other authorities which apply to it;
(b) any insolvency situations affecting it, its substantial shareholders or its directors;
(c) any disciplinary actions taken against it by regulators or other professional or trade bodies;
(d) any material problems with its business systems or equipment;
(e) any suspected material breach of market misconduct provisions under the SFO by its
client; or
(f) any determination or settlement of a complaint with the FDRS.
It may be noted that the SFO and its subsidiary legislation also contain a number of provisions
specifying circumstances where a licensed corporation or registered institution is required to
notify the SFC.
2.54 A licensed or registered person should make honest and diligent disclosure before mediators
and/or arbitrators in connection with the FDRS; and render all reasonable assistance to the
FDRS.

Expert witness
2.55 Unless with reasonable reason, a licensed or registered person, as a firm, should not prohibit
its employees from performing expert witness services for the SFC and the Hong Kong
Monetary Authority.

General principle 8 client assets


Safeguarding of client assets
2.56 A licensed or registered person (or a third party acting on its behalf) should ensure that client
assets are promptly and properly accounted for and safeguarded adequately. This principle is
put into application by the subsidiary legislation under the SFO, namely the Securities and
Futures (Client Securities) Rules (Client Securities Rules) and the Securities and Futures
(Client Money) Rules (Client Money Rules), which are reviewed in Topic 2.

Disclosure of risk to client assets received or held outside Hong Kong


2.57 The Client Money Rules do not apply to client money received or held overseas. Licensed
corporations are, however, required under the Code of Conduct to provide additional
disclosure to their clients regarding the risk of client money being received or held outside
Hong Kong, in that such money may not enjoy the same protection as that available to client
assets received or held in Hong Kong (see section 2.26(d) above).

General principle 9 responsibilities of senior management


2.58 The senior management of a licensed or registered person should bear primary responsibility
for ensuring the maintenance of appropriate standards of conduct and adherence to proper
procedures by the firm. In this respect, the SFC will have regard to an individuals apparent
or actual authority in relation to particular matters and to certain others discussed in paragraph
1.3, Code of Conduct.
2.59 The requirement is that senior management of the licensed or registered person should
properly manage the risks associated with the business, including performing periodic
evaluations of its risk management processes. To be able to do this, they should:
(a) understand:
(i) the nature of the business;
(ii) its internal control systems and procedures;

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(iii) its risk management policies; and
(iv) the extent of their own authority and responsibilities; and
(b) have access to all:
(i) relevant information about the business on a timely basis; and
(ii) necessary advice on the business or their own responsibilities.

Managers-in-charge of core functions


2.60 The senior management of a licensed corporation will include persons who are managers-in-
charge of core functions (MICs). MICs are individuals who undertake and are principally
responsible for (either alone or together with others) any of the following functions:
(a) overall management oversight;
(b) key business line;
(c) operational control and review;
(d) risk management;
(e) finance and accounting;
(f) information technology;
(g) compliance; and
(h) anti-money laundering and counter-terrorist financing.
Licensed corporations have a number of key obligations in this regard. They are required to
ensure MICs are fit and proper, as required by paragraph 4.1 of the Code of Conduct. An
organisational chart and the name of each MIC are required to be provided to the SFC, and
these must be updated where there are subsequent changes. In general, MICs do not typically
need to be licensed by the SFC, however, the SFC does expect that persons who are MICs
under categories (a) or (b) above should be licensed and approved as responsible officers. All
MICs are subject to the SFCs disciplinary powers.
2.61 The SFC recognises that some aspects of compliance with the Code of Conduct may not be
within the control of a representative. In determining where responsibility lies, and the degree
of responsibility of a particular individual, it will have regard to that individuals apparent or
actual authority in relation to the particular business operations. The SFC will consider their
levels of responsibility within the business, any supervisory duties they may perform, and the
levels of control or knowledge they may have concerning any failure.
Note: A reference in the Code of Conduct to a representative has the same meaning as under
s. 167, SFO (a) in relation to a licensed corporation, an individual who is licensed
for a RA and who carries out that activity in the licensed corporation to whom he is
accredited; and (b) in relation to a registered institution, an individual whose name is
registered under the Banking Ordinance to carry out that activity for that registered
institution.

Professional investors
2.62 The SFO provides for the concept of a PI, being a person in respect of whom different legal
and regulatory requirements will apply in view of his knowledge, experience and financial
resources. While the SFO sets out a list of persons who are to be regarded as PIs, it also
empowers the SFC to make rules that define additional persons as PIs, and the SFC has for
this purpose made the Securities and Futures (Professional Investor) Rules (PI Rules).
2.63 This gives rise to three classes of PIs, with slightly different legal and regulatory conditions
applying to each class:

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(a) PIs that are defined in Schedule 1, SFO (Institutional Professional Investors
(Institutional PIs));
(b) PIs defined in the PI Rules that are corporates, trusts or partnerships (Corporate
Professional Investors (Corporate PIs)); and
(c) PIs defined in the PI Rules who are individuals (Individual Professional Investors
(Individual PIs)).

Institutional PIs
2.64 Institutional PIs include:
(a) entities such as exchange companies specified in Part III, SFO;
(b) licensed corporations or registered institutions and similar investment service providers
regulated overseas; also their wholly owned subsidiaries, holding companies (100%
holding) and wholly owned subsidiaries of the holding companies;
(c) authorized financial institutions (AFIs) and similar overseas institutions; also their
wholly owned subsidiaries, holding companies and the wholly owned subsidiaries of the
holding companies;
(d) insurers authorized and regulated under the Insurance Companies Ordinance and their
regulated overseas counterparts;
Note: Effective as from 26 June 2017, the Insurance Companies Ordinance is renamed
the Insurance Ordinance.
(e) CISs authorized in Hong Kong and their operators; and their regulated overseas
counterparts;
(f) registered schemes as defined in the Mandatory Provident Fund Schemes Ordinance and
Occupational Retirement Schemes Ordinance and their approved trustees, service
providers, investment managers, administrators and regulated overseas counterparts; and
(g) governments, central banks and multilateral agencies.

Corporate PIs
2.65 Corporate PIs include:
(a) trustee companies responsible for total assets of not less than HK$40 million (or its
equivalent);
(b) corporations or partnerships having either a portfolio of not less than HK$8 million or
total assets of not less than HK$40 million (or their equivalents); and
(c) corporations that act solely as investment holding companies and are wholly owned by
one of the foregoing or by an Individual PI.
Note: For the purposes of Corporate PIs and Individual PIs, portfolio means securities,
certificates of deposit issued by a regulated bank or money.

Individual PIs
2.66 Individual PIs are those who have a portfolio of not less than HK$8 million (or its equivalent).
Note: Individuals include spouses and children where they hold a portfolio jointly.

Provisions of the SFO not applicable to PIs


2.67 All categories of PI are excluded from the following provisions of the SFO.
(a) the unsolicited calls provisions of s. 174, SFO (i.e. they may be cold-called); and
(b) the requirements for offers by intermediaries or representatives specified in s. 175, SFO.

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Note: The PI definition may also be relevant for certain licensing and product authorization
purposes.

Provisions of the Code of Conduct


2.68 The Code of Conduct operates by specifying for a set of requirements that apply to all
customers and then specifying which of them may be exempted in respect of the different
classes of PI. Subject to assessment and compliance arrangements usually undertaken in
connection with the client on-boarding process, the requirements that may be waived are:
(a) information for clients:
(i) the need to provide information about the licensed or registered person and its
employees;
(ii) the need to make prompt confirmation of transactions to clients;
(iii) the need to disclose transaction related information; and
(iv) the need to provide documentation on the Nasdaq-Amex Pilot Programme;
(b) information about clients:
(i) the need to establish the clients financial situation, investment experience and
investment objectives (except in relation to providing advice on corporate finance);
(ii) the need to ensure the suitability of a recommendation or positive invitation; and
(iii) the need to assess the clients knowledge of derivatives;
(c) client agreement: the need to enter into a written client agreement and provide risk
disclosure statements; and
(d) discretionary accounts:
(i) the need to obtain the clients prior authority in writing before effecting transactions;
and
(ii) the need to explain the written authority and confirm it annually (note that the
authority should still be obtained).

Institutional PIs
2.69 Licensed and registered persons are automatically exempted from all the requirements listed
in section 2.68 above.

Corporate PIs and Individual PIs


2.70 To apply exemptions to a Corporate or Individual PI, the licensed or registered person must
inform the client of the consequences of being treated as a PI, that treatment as a PI is in
relation only to a particular product and market, explain its right to withdraw as a PI at any
time, and obtain the clients written consent. The confirmation of PI status and a written
reminder to the client of the risks and consequences of being treated as a PI should be
undertaken annually.
2.71 Where the foregoing has been complied with, the licensed or registered person is exempted
from complying with the information for clients requirements listed in sections 2.68(a)(i), (ii)
and (iv) above.

Corporate PIs
2.72 Corporate PIs that are exempt under the foregoing compliance arrangements may be exempted
from additional requirements where it is reasonably clear that the Corporate PI has an
appropriate corporate structure and investment processes and controls, those responsible for
making its investment decisions have sufficient investment background and experience, and

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the Corporate PI is aware of the risks involved in terms of the person(s) making the investment
decisions.
2.73 If the licensed or registered person is reasonably satisfied that the Corporate PI satisfies the
foregoing, it is exempted from all the requirements listed in section 2.68 above.
2.74 Where relevant, separate assessments should be made in respect of different product types or
markets; if there has been no investment activity in a particular product or market for a period
of more than two years, an additional assessment should be undertaken.
2.75 Assessments that have been satisfactorily made for the purposes of applying the PI exemptions
should be recorded in writing and all documentation relevant to the assessments kept.

Electronic trading
2.76 The Code of Conduct requirements on electronic trading went into effect in January 2014. The
requirements are discussed in Topic 5.

Alternative liquidity pools


2.77 A licensed or registered person which operates an alternative liquidity pools should comply
with the conduct requirements as set out in paragraph 19 of the Code of Conduct. Details of
these conduct requirements are discussed in section 7 of Topic 5.

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Revision questions:

Question 1: What important information about a client must a licensed or registered person
obtain from a potential client when an account is opened?
Answer 1: A licensed or registered person should take all reasonable steps to establish the
clients true and full identity, financial situation or strength, investment experience
and investment objectives.
Question 2: What is client priority?
Answer 2: When a licensed or registered person to handle clients orders fairly and in the order
in which they are received. Transactions for clients have priority over orders from
the licensed or registered person and its staff.
Question 3: Can an employee of a licensed or registered person deal through another licensed or
registered person? If so, what arrangements should he make?
Answer 3: He may deal through other licensed or registered persons if his principal consents.
He must arrange for duplicate confirmations and statements of account to be
provided to the senior management of his own principal.
Question 4: According to the Code of Conduct, under what circumstances must a licensed or
registered person make a report to the SFC?
Answer 4: The Code of Conduct specifies that a licensed or registered person is required to
make reports to the SFC immediately upon discovery of:
material breaches or suspected material breaches (by the licensed or registered
person or its employees or agents) of any law; or rules, regulations and codes
administered or issued by the SFC; or the rules of the exchanges and clearing
houses of which the licensed or registered person is a participant, or any other
authorities which apply to it;
any insolvency situations affecting it, its substantial shareholders or its
directors;
any disciplinary actions taken against it by regulators or other professional or
trade bodies;
any material problems with its business systems or equipment;
any suspected material breach of market misconduct provisions under the SFO
by its client; or
any determination or settlement of a complaint with the FDRS.

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3 Management, Supervision and Internal Control Guidelines
for Persons Licensed by or Registered with the Securities
and Futures Commission
3.1 The ICG, issued by the SFC pursuant to s. 399, SFO, sets out the SFCs expectations
concerning a licensed or registered persons fitness and properness in relation to the manner
in which it structures, manages and operates the RAs for which it is licensed or registered. In
particular, the ICG is concerned with the establishment of satisfactory internal control and
management systems (together referred to as internal controls hereafter) so as to provide
reasonable assurance of:
(a) its ability to carry on the business in an orderly and efficient manner;
(b) safeguarding the assets of its clients and its own;
(c) the maintenance of proper records and the reliability of financial and other information
used within and published by the business; and
(d) compliance with all applicable laws and regulatory requirements.
3.2 The ICG applies to all licensed corporations and registered institutions, and their respective
representatives.
3.3 As with other codes issued by the SFC, the ICG does not have the force of law, but breaches
of the ICG may be relevant to a persons ongoing fitness and properness and may also be taken
into account by a court in connection with any proceedings under the SFO. In its treatment of
breaches, the SFC has indicated that it will adopt a pragmatic approach and take all relevant
factors into account, for example, the size of the business or the use of any management and
supervisory measures to compensate for the apparent failure to meet any specified requirement.
3.4 The ICG identifies eight key areas of internal control:
(a) management and supervision;
(b) segregation of duties and functions;
(c) personnel and training;
(d) information management;
(e) compliance;
(f) audit;
(g) operational controls; and
(h) risk management.
Each of these eight areas in the ICG is identified by reference to an overall objective, followed
by more specific control guidelines which facilitate meeting the stated objective. The
guidelines are not intended to be exhaustive and each licensed or registered person will still
need to consider its own organisational and legal structure as well as the nature and scope of
its business activities when implementing appropriate internal controls.
These eight areas are reviewed in the sections that follow.
3.5 Responsible officers together with senior management of a licensed or registered corporation
are charged with the duty of ensuring that the corporation is fit and proper in the manner in
which it conducts the business in RAs and that it has maintained an adequate and effective
internal control system.

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Management and supervision
Objective
3.6 The objective is that senior management should establish and operate an effective
management and organisational structure which ensures that the business is conducted in a
sound, efficient and effective manner. Senior management of an intermediary includes its
board, chief executive officers, managing director and other senior management personnel.

Control guidelines
3.7 The main features of senior managements role in such a structure are:
(a) its assumption of full responsibility for all operations, including the development,
implementation and ongoing effectiveness of internal controls, and adherence to them;
(b) establishing regular communication of control information to various levels of senior
management as it relates to:
(i) the firms policies, procedures, operations and financial position;
(ii) qualitative and quantitative risks and detected weaknesses;
(iii) any non-compliance with laws and regulations; and
(iv) any deviations from the business objectives;
(c) identification of clear reporting lines and assignment of supervisory and reporting
responsibilities;
(d) setting up detailed definitions of authorities for key positions, policies and procedures for
necessary authorisations, and their communication throughout the business;
(e) assignment of management and supervisory functions to suitably qualified and
experienced persons.

Segregation of duties and functions


Objective
3.8 Incompatible duties and functions should be segregated, particularly those which, when
performed by the same person, may provide opportunities for abuse or result in the
overlooking of errors, thereby exposing the intermediary and its clients to risk.

Control guidelines
3.9 The main features of satisfactory segregation of duties (and functional separation) are as
follows:
(a) policy making, supervisory, advisory, compliance and internal audit functions should not,
where practicable, be performed by staff with line operational duties;
(b) wherever practical, functions such as sales, dealing, accounting and settlement should be
segregated from each other;
(c) research functions should also be segregated from sales and dealing to avoid conflicts of
interest. Where practical, research and corporate finance functions should also be
segregated from each other; and
(d) where possible, compliance and internal audit should be separate from and independent
of operational functions, and reports made directly to senior management.
The failure to separate incompatible functions has often led to manipulation, misappropriation
and fraud.

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Personnel and training
Objective
3.10 Recruitment and training policies and procedures should be established and implemented to
ensure compliance with the intermediarys operational and internal control policies and
procedures, and all applicable legal and regulatory requirements.

Control guidelines
3.11 These will include:
(a) the implementation of procedures for employing fit and proper persons and arranging to
have them licensed or registered where necessary;
(b) the provision of comprehensive and up-to-date information to staff on the intermediarys
policies and procedures, including those relating to internal controls and personal dealing;
and
(c) the provision of adequate training suitable for the specific duties of staff, and to meet
continuous professional training requirements.

Information management
Objective
3.12 Policies and procedures should be established to ensure the integrity, security, availability,
reliability and completeness of all information and documentation relating to the business, in
whatever form it is stored.

Control guidelines
3.13 The principal features of good information management are as follows:
(a) information, whether in physical or electronic form, should be managed by qualified and
experienced staff;
(b) the firms operating and information management systems (including electronic data
processing systems) should be adequate and operated in a secure and controlled
environment;
(c) there are clear definitions of information management reporting requirements to ensure
that internal and external reports are produced in time and contain the necessary
information;
(d) the information management systems design specifications and implementation
programme are sufficiently documented and regularly reviewed for adequacy and
effectiveness;
(e) adequate and effective electronic data processing and data security policies and
procedures are implemented to prevent or detect:
(i) errors, omissions or unauthorised insertions, alterations or deletions of information;
(ii) intrusion into the data processing system and/or database; or
(iii) unauthorised access to and/or extraction of confidential information such as that
belonging to clients or which is price-sensitive; and
(f) effective record retention policies are operated to ensure that all relevant legal and
regulatory requirements are complied with, and that information likely to be required by
the intermediary, auditors, SFC and other authorised parties is held in the records.

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Compliance
Objective
3.14 Policies and procedures shall be established and operated to ensure that the intermediary and
its staff comply with all applicable laws and regulations and with the intermediarys own
internal policies and procedures.

Control guidelines
3.15 Senior management should:
(a) establish and maintain an effective compliance function which is independent of all
operational and business functions and reports directly to senior management;
(b) ensure that compliance staff have the necessary skills, qualifications and experience;
(c) establish and enforce policies and procedures to provide compliance staff with full access,
as far as practicable, to all necessary records and documentation and to all areas of the
business;
(d) require and assist the compliance staff to establish effective and comprehensive
compliance procedures, covering:
(i) legal and regulatory requirements including licensing, registration and financial
resources requirements;
(ii) record keeping (see section 5 of Topic 2);
(iii) business practices;
(iv) prevention of money laundering (see section 5 of this Topic);
(v) internal controls; and
(vi) client, proprietary and staff dealings;
which will provide it with assurance that the intermediary complies with all requirements
at all times;
(e) establish proper complaints handling procedures, which should be in writing;
(f) establish prompt reporting to senior management by compliance staff of material
breaches of:
(i) the legal and regulatory requirements; and
(ii) the intermediarys own policies and procedures; and
(g) promptly report occurrences of material non-compliance with legal and regulatory
requirements by the intermediary and its staff to the appropriate regulators.

Audit
Objective
3.16 The objective is to establish and operate an audit policy and review function which
independently examines, evaluates and reports on the adequacy, effectiveness and efficiency
of the intermediarys management, internal controls and operations. The review functions can
be performed by internal staff or external consultants, such as firms of accountants who may
be asked to carry out ad-hoc or regular reviews.

Control guidelines
3.17 Some of the features of an internal audit function (and, where specified, the external audit)

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are as follows:
(a) it should be established by senior management as an independent function, where
practicable, free of operating responsibilities and reporting directly to senior management
or the audit committee;
(b) the persons performing the review function should have the necessary technical
competence and experience;
(c) clearly defined terms of reference should be drafted which set out its scope, objectives,
approach and reporting requirements;
Note: These are prescribed for the external audit as well in the ICG, but in practice it
will not be possible for senior management, by prescribing terms of reference, to
limit the responsibilities of external auditors, who owe a duty to the shareholders
and to the regulators and clients, but not to senior management. It is always
possible for senior management to ask the external auditors to carry out
additional work as part of a special agreement.
(d) the relative roles and responsibilities of internal and external auditors and the working
relationship between them may be defined with the agreement of the external auditor;
and
Note: The external auditors will generally be prepared to divide the work only if they
are satisfied with the competence and independent authority of the internal audit
staff.
(e) senior management should ensure that there is adequate planning, control and recording
of all audit and review work performed, and provide for timely reporting of findings,
conclusions and recommendations to senior management, including follow-up action
relating to any weaknesses found.

Operational controls
Objective
3.18 This area is very important as it covers the way in which the operations are run and controlled.
The objective is to have effective policies, procedures and controls over day-to-day business
operations which ensure:
(a) that information exchanges between the intermediary and its clients are adequate and in
line with the Code of Conduct;
(b) the integrity of the intermediarys dealing practices and the fair, honest and professional
treatment of clients;
(c) the safeguarding of the assets of clients and the intermediary;
(d) the maintenance of reliable and accurate records and information; and
(e) compliance by the intermediary and persons acting on its behalf with relevant legal and
regulatory requirements.

Control guidelines
3.19 Senior management is required to establish policies and procedures in order:
(a) to obtain and confirm the true identity of every client, the beneficial owner of each client
account, the persons authorised to give instructions for its operation, and information
regarding the clients financial position, investment experience and objectives (to be
obtained before opening the account);

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(b) to establish precise terms and conditions for operating discretionary accounts (which
should be communicated to the client) and to ensure that transactions are consistent with
the information relating to the client;
(c) to ensure that any investment advice given for remuneration is supported by a contractual
advisory agreement, and investment recommendations are made after thorough analysis,
are suitable for the client and are properly documented;
(d) to minimise the potential for conflicts of interest and, where these may exist and cannot
be reasonably avoided, the clients are fully informed of the circumstances and are treated
fairly;
(e) to ensure that whenever the intermediary or its staff have a material interest in a
transaction with a client, the fact is disclosed to the client prior to executing the
transaction;
(f) to ensure that:
(i) client orders are handled in a fair manner complying with procedures specified in
codes and regulations;
(ii) that complete audit trails are created with records and times of orders received from
clients or orders generated internally, from origination through execution and
settlement, using sequential numbering and time-stamping; and
(iii) there is fair and timely allocation of client orders;
(g) to ensure proper safeguards exist to prevent the intermediary or staff from:
(i) taking advantage of confidential price-sensitive information; or
(ii) executing transactions for insiders contravening the SFO;
(h) to prevent or detect errors, omissions, fraud and other unauthorised or improper activities;
(i) to protect the assets of clients and the intermediary from theft, fraud and other acts of
misappropriation, particularly to ensure that:
(i) the authority of the intermediary and its staff to handle assets of clients and the
intermediary are clearly defined and adhered to; and
(ii) all assets are properly safeguarded when under the control of the intermediary and
that client assets are treated according to the Client Securities Rules and Client
Money Rules; and to ensure the creation of audit trails which enable the intermediary
to detect and investigate improprieties; and
(j) to ensure that regular reconciliations of the intermediarys records with external records
and reports are carried out so that:
(i) errors, omissions, and discrepancies are followed up; and
(ii) the reconciliations are reviewed by independent senior staff.

Risk management
Objective
3.20 This is another important area that should not be neglected. The objectives are to establish and
maintain effective policies and procedures to:
(a) ensure the proper management of the risks to which the intermediary and its clients (if
applicable) are exposed;
(b) identify and quantity such risks; and

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(c) provide timely and adequate information to senior management, enabling it to contain
and manage such risks.

Control guidelines
3.21 The control guidelines provide for the establishment of:
(a) a risk management function consisting of suitably qualified and experienced
professionals;
(b) procedures to limit the exposure of the intermediary to risk of suffering loss, as a result
of client default or changing market conditions, to acceptable levels;
(c) trading and position limits for proprietary trading and their monitoring at the end of the
trading day, the limits to be reviewed on a timely basis for their effectiveness;
(d) comprehensive risk-focused reviews at suitable intervals, and whenever there are
significant changes in the business, operations or staff, to limit the exposure of the
intermediary to loss as a result of fraud, other dishonest acts, errors, omissions,
interruptions or other operational or control failures;
(e) regular reporting of exposures and significant variances to senior management; and
(f) a risk policy defined by senior management, including maintenance of risk measurement
and reporting methodologies appropriate to the business strategy, size, complexity of
operations and the risk profile of the intermediarys business.

Additional information about operational controls and risk


management
3.22 The ICG includes an appendix which contains suggested control techniques and procedures
applicable to the areas of operational controls and risk management. The appendix covers
common industry practices. Some of the more important matters are mentioned in the
following sections.

Operational controls

Account opening
3.23 The suggested control techniques and procedures regarding account opening may include:
(a) establishing clear procedures following strictly the know your client principle;
(b) recording all relevant client information establishing the true identities, the beneficial
owners, financial position, investment experience and objectives of the clients;
(c) reviewing client information, using criteria approved by management;
(d) ensuring that the client has adequate information about the firm, its services, risk
disclosure statements, and the nature and scope of fees, penalties and other charges the
firm may levy; and
(e) ensuring that the client is provided with information regarding his rights for example,
protection under the Investor Compensation Fund arrangement.

Operating discretionary accounts


3.24 The SFCs ICG include the following suggested operational control techniques and
procedures:
(a) executing a discretionary account agreement which includes the investment objectives
and strategies of the client and the terms under which such discretion will be exercised;
(b) regularly reviewing the performance of the account;

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(c) providing the client with regular statements and timely ad hoc reports on account balance
and transaction details; and
(d) clearly separating the investment decision-making process from the dealing process.

Providing investment advice


3.25 Intermediaries advising on investments for remuneration should implement special
procedures, including the following measures:
(a) they should establish clear requirements and procedures regarding adequacy of research
work and the preparation and retention of documentation supporting their
recommendations to clients;
(b) they should document the rationale underlying the investment advice given and provide
copies to the client. Their recommendations made must accord with the clients particular
investment experience, objectives and financial position; and
(c) they should provide the client with written details of the applicable fees, charges and
penalties.

Dealing practices
3.26 Order handling procedures should cover:
(a) the recording and immediate time stamping of records of orders for clients and other
orders (such as house or staff orders);
(b) checks on the availability of funds or credit (for buy orders) and stocks (for sell orders);
(c) checks on any special instructions relating to the particular client, such as the operating
authority and limits on the person placing an order;
(d) circumstances in which client orders may be delayed or withheld; and
(e) procedures for passing orders to the dealing room, including giving sufficient details to
ensure client priority; and, where practicable, assigning responsibility for allocating client
orders to independent senior staff.

Chinese walls
3.27 Chinese walls should be established to ensure that price-sensitive information is not leaked to
operating staff who may be able to misuse the information; for example, corporate finance
advisory staff may have advance information of a potential takeover which can be used by
other staff to deal for profit in the market.

Back office and accounting


3.28 Back office and accounting cover a wide area and only some matters are dealt with in the ICG.
These are:
(a) the processing of deal tickets by the back office and their comparison with external
reports such as those from the exchanges, counterparties or executing dealers to
identify errors and unusual trades for follow-up;
(b) prompt confirmation of trades with clients using reliable methods; and
(c) the recording in an error or suspense account of dealing errors for prompt correction and
their investigation or review by compliance/internal audit staff.

Asset protection
3.29 The suggested operational control techniques and procedures for asset protection may include:

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(a) establishing effective procedures for handling licensed or registered person and client
assets;
(b) ensuring that the representative has his clients authority to handle his assets for each
asset movement;
(c) securely storing licensed or registered person and client assets, cheque books, contract
notes etc.; promptly depositing cheques and other negotiable instruments and securities
into the appropriate accounts at banks or security depositories. During the period that
physical scrip or cash is held at the licensed or registered persons premises, routine
counts are conducted;
(d) maintaining reliable and adequate audit trails;
(e) encouraging clients to open stock-segregated accounts with the Central Clearing and
Settlement System through the licensed or registered person so that they can receive
statements of stock movements and monthly balances direct from the Hong Kong
Securities Clearing Company Limited; and
(f) conducting regular compliance reviews and audits.

Risk management
3.30 Risks can be defined in many ways, and some specific types of risk, such as credit, market,
liquidity and operational risks, are considered here. The SFC uses risk criteria in assessing the
intermediaries it regulates.
3.31 Intermediaries may face the following risks:
Credit risk in this usage, credit risk is the danger that a client or counterparty may default
on his obligations to the intermediary or be unable to perform his part of a contract. Firms
should establish and maintain an effective credit rating system to evaluate client and
counterparty creditworthiness objectively.
Market risk market risk in this context is the risk that an intermediary may suffer loss due
to adverse movements in the market value of its assets or liabilities. Senior management
should specify products and instruments the firm may deal in and enforce procedures to ensure
compliance, establish and maintain effective risk management measures to quantify the
impact from changing market conditions on the firm and (if applicable) on clients, and use
risk-adjusted remuneration measures.
Liquidity risk in this context, liquidity risk is that a product may not be realisable in the short
term without material loss, or that a market is illiquid and it is not possible to sell, or that a
person is unable to meet his liabilities in the short term. Senior management should set,
monitor and enforce concentration limits with respect to particular products, markets and
business counterparties in the light of liquidity risk policies, as well as putting in place
appropriate procedures to deal with defaults.
Operational risk this can be understood for our purposes as the risk of loss to the
intermediary as a result of errors, omissions, inefficiencies or negligence in operations or in
compliance with applicable laws and regulations, excluding the three other risks already
covered. Fraud has been included as an operational risk, but it is arguable that it cannot be
avoided altogether by installing internal controls. Senior management should regularly review
the firms operations to ensure that its risk of losses, whether financial or otherwise, from
fraud, errors, omissions and other operational and compliance matters is adequately managed,
including an effective business continuity plan and adequate insurance cover.

Risk management techniques


3.32 The following are risk management techniques covered in the guidelines on credit, market,
liquidity and operational risks.

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Credit risk
3.33 The suggested techniques include:
(a) the intermediary establishing and maintaining an effective system to evaluate client and
counterparty creditworthiness, and setting appropriate credit limits for all clients. The
system may include:
(i) the clients credit rating by a reputable credit rating agency;
(ii) past payment records and defaults;
(iii) the clients capital base; and
(iv) any known events which may have an adverse impact on the clients financial status;
and
(b) the risk management staff closely monitoring the intermediarys credit exposure in
relation to clients, including pre-settlement credit exposures and settlement risk. Where
credit is extended to clients for margin trading, appropriate haircuts are made to the
market value of the securities pledged.

Market risk
3.34 The intermediary should protect itself against the adverse impact of market risk by:
(a) placing restrictions on the instruments which may be traded by the intermediary and its
staff, and establishing control procedures to check compliance with such restrictions;
(b) placing trading and position limits for proprietary trading and open positions which
should be controlled by the risk managers; and
(c) establishing risk management measures to check the effect of adverse market conditions
on the intermediary, such as value at risk methodology for market risk in general,
sensitivity checks for specific market risk factors, and stress testing by calculating the
effect of abnormal shifts in the market, such as the possible effect of a 30% drop in the
Hang Seng Index.

Liquidity risk
3.35 The suggested techniques include:
(a) using the factors affecting liquidity at the time and overall broad liquidity measures. The
Securities and Futures (Financial Resources) Rules have established such liquidity
measures based on concentrations of illiquid collateral and of receivables from individual
clients of an intermediary;
(b) management setting and enforcing concentration limits for particular products, markets
and business counterparties;
(c) measuring mismatches in the timing of receipts and payables, receipt and delivery of
products and so on; and monitoring the levels of arrears and defaults; and
(d) management establishing default procedures to alert liquidity management staff to
potential problems and to provide them with adequate time to take appropriate action to
minimise the impact of client or counterparty liquidity problems.

Operational risk
3.36 It is suggested that operational risk should be managed by:
(a) physical and functional segregation of incompatible duties such as trade, settlement, risk
management and accounting;

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(b) the timely production and keeping of proper and adequate accounting and other records
and the ability to detect fraud, errors, omissions and non-compliance with regulatory
authorities and internal requirements;
(c) analysis of these records and preparing exception reports to highlight unusual activities,
adverse patterns and trends; and
(d) the employment of staff with sufficient skill and experience to minimise the risk of loss
due to the absence or departure of key staff member(s).
3.37 An effective business continuity plan appropriate to the size of the intermediary should be
implemented to ensure that the intermediary is protected from the risk of interruption to its
business. Key processes in this area include: a business impact study, identification of likely
scenarios involving interruptions (e.g. breakdown in its data processing systems) and
documentation and regular testing of the intermediarys disaster recovery plan.
3.38 The intermediary must have adequate insurance cover for different types of exposures, for
examples, fidelity insurance and replacement of equipment and other business and data
processing devices.

Revision questions:

Question 5: What are the functions in a securities firm that must be separated from other
functions?
Answer 5: Dealing function must be kept separate from accounting and settlement functions,
and compliance must be independent of operational and business functions.
Question 6: Describe the essentials of operating a client discretionary account.
Answer 6: An appropriate discretionary account agreement should be executed before any
transaction is carried out. Performance of the account should be regularly reviewed.
Clients should be provided with regular statements and timely ad hoc reports.
Question 7: Name the types of risk faced by a securities firm.
Answer 7: Credit, market, operational and liquidity risks.

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4 Code of Conduct requirements for licensed or registered
persons dealing in securities listed or traded on The Stock
Exchange of Hong Kong Limited
4.1 This section deals with the business conduct requirements for all licensed or registered persons
that deal in securities listed or traded on the SEHK, in addition to the general obligations
discussed earlier. They are set out in Schedule 3 to the Code of Conduct.
4.2 Candidates should note that some of the requirements apply to SEHK exchange participants
only, but some apply to all licensed or registered corporations involved in the relevant RA.

Options client agreement


4.3 A licensed or registered person that is an options exchange participant or engaged in exchange
traded options business should ensure that the options client agreement contains the following
information:
(a) the clients confirmation that the options account is operated solely for his own benefit
or his disclosure in writing of the identity of the ultimate beneficiary of the account;
(b) the clients acceptance of the terms of the contract;
(c) the clients agreement to provide the licensed or registered person with cash or securities
or other assets (margin) as security for the clients obligations to the licensed or
registered person. The amount of the margin should not be less than that required by
applicable laws, rules or regulations relating to the clients open positions and delivery
obligations, and further margin may be required to reflect changes in market value;
(d) the clients agreement to indemnify the licensed or registered person against all losses
and expenses resulting from breach of the clients obligation. If the client fails to comply
with any of his obligations for example, fails to provide margin the registered person
has the right to refuse further instructions from the client and close out the client contracts;
(e) the licensed or registered persons undertaking to:
(i) keep information relating to the clients options account confidential (except from
the SFC, SEHK and clearing house);
(ii) provide the client, upon request, with the product specifications for options contracts;
and
(iii) notify the client of material changes in the licensed or registered persons business;
(f) the clients right to claim under the Investor Compensation Fund under the SFO if the
licensed or registered person defaults; and
(g) risk disclosure statements.

Time stamping
4.4 A licensed or registered person should maintain a record of the date and time at which it
receives each options trading instruction from a client, and also of the date and time at which
it originates a purchase or sales of options contracts for its house account. It should
immediately time-stamp the records of client instructions and the origination of orders for its
house account.

Options trade confirmations


4.5 An options trade confirmation should include details of transactions, in particular:

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(a) a risk disclosure statement Options can involve a high degree of risk and may not be
suitable for every investor. Investors should ensure they understand those risks before
participating in the options market; and
(b) a statement drawing attention to the clients right to claim under the Investor
Compensation Fund under the SFO in the event of a default of the licensed or registered
person.

Adjustments to contracts
4.6 Where The SEHK Options Clearing House Limited makes adjustments to the terms of the
contracts of an option series in accordance with the clearing rules, a licensed or registered
person which is an options exchange participant should inform its client details of such
adjustments within one business day after the adjustments have been announced.

Clients money in relation to exchange-traded options business


4.7 Each licensed or registered person which is an options exchange participant should maintain
a separate ledger account for each of its clients. Each account should be entered sufficient
unique particulars to identify unambiguously all trades in relation to and all collateral and
money received from each client.

Revision question:

Question 8: Name three items that are required to be included in an options client agreement.
Answer 8: Any three of the items as mentioned in section 4.3.

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5 Prevention of money laundering and terrorist financing
5.1 The term money laundering describes the activities and processes by which property
obtained as a result of illegal activities is altered so that it is given the appearance of coming
from a legitimate source. The term terrorist financing describes (i) the provision or
collection of property or the provision of financial services which are to be used towards the
commission of a terrorist act or which are made available to a terrorist or their associates; and
(ii) the collection of property or solicitation of financial services for a terrorist or terrorist
associate. The use of cash is commonly involved in both money laundering and terrorist
financing as it is more difficult to trace.
Note: As the provisions in respect of anti-money laundering have been extended to counter-
terrorist financing, these two matters will be generally referred to as money
laundering in this section.
5.2 The primary means by which the money laundering problem is combated is through
legislation, which is applicable to both licensed corporations and registered institutions, as
well as to their associates.
5.3 In addition, the SFC has issued regulatory guidelines that provide guidance to assist licensed
corporations and their staff, and their associated entities, in complying with applicable
legislation. Each of the legal and regulatory requirements is reviewed in the sections that
follow.

Legislation
5.4 The four main pieces of legislation in Hong Kong which specifically address money
laundering are: the Anti-Money Laundering and Counter-Terrorist Financing (Financial
Institutions) Ordinance (AMLO), the Drug Trafficking (Recovery of Proceeds) Ordinance
(DTRPO), the Organized and Serious Crimes Ordinance (OSCO) and the United Nations
(Anti-Terrorism Measures) Ordinance (UNATMO). Each of these is reviewed below.

AMLO
5.5 The objective of the AMLO is to enhance the anti-money laundering regime in Hong Kong
for the financial sector, including banking, securities, insurance and remittance, and money
changing. For the purposes of this manual, it is primarily concerned with the following
matters:
(a) imposing requirements relating to customer due diligence (CDD);
(b) imposing record-keeping requirements (see sections 5.32 to 5.35 below);
(c) providing relevant authorities (such as the SFC and the HKMA) with powers to
investigate and supervise licensed corporations and registered institutions for compliance
with the AMLOs requirements, and to discipline them where they have been found to
be non-compliant; and
(d) the establishment of a disciplinary review tribunal.
Note 1: The requirements relating to CDD and record keeping are set out in Schedule 2,
AMLO.
Note 2: While the AMLO applies to a number of financial institutions (including banks and
insurers), the summary of the AMLO in this manual will only be concerned with its
application to licensed corporations and registered institutions.
5.6 The AMLO defines money laundering and terrorist financing, which have similar
meanings to those referred to in section 5.1 above.

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5.7 The AMLO imposes a general duty on licensed corporations and registered institutions to take
all reasonable measures to:
(a) ensure proper safeguards exist to prevent a contravention of the foregoing requirements;
and
(b) mitigate money laundering risks.
The Guideline on Anti-Money Laundering and Counter-Terrorist Financing (GAML) has
been issued pursuant to the AMLO to assist licensed corporations comply with these
requirements, and is discussed in sections 5.18 to 5.42 below.
5.8 A breach of the AMLO requirements is a criminal offence. Employees or managers of licensed
corporations and registered institutions who knowingly cause or permit the corporate entity to
breach a specified provision of the AMLO are also committing a criminal offence. The
maximum penalty is a fine of HK$1 million and imprisonment for two years. If fraud (on any
relevant authority or the licensed corporation or registered institution) is involved, there is a
maximum term of imprisonment of seven years and a fine of HK$1 million.
5.9 A breach of the AMLO requirements will also render a licensed corporation or registered
institution subject to regulatory discipline.

DTRPO
5.10 The DTRPO makes it an offence to deal with property that is known or believed to be the
proceeds of drug trafficking. Dealing includes:
(a) receiving or acquiring the property;
(b) concealing or disguising the property;
(c) disposing of or converting the property;
(d) moving it in or out of Hong Kong; and/or
(e) using the property to borrow money or as security.
5.11 The DTRPO requires any person who knows or suspects that any property relates to drug
trafficking should, as soon as it is reasonable, report to an authorized officer, who may be a
police officer, a customs and excise officer or the Joint Financial Intelligence Unit (JFIU),
which has been set up and is operated by the Hong Kong Police Force and the Customs and
Excise Department. A report can also be made to any person designated for the purpose by
the employer. Failure to disclose is an offence, but with the defence that a disclosure was
intended but there was a reasonable excuse for the failure.
5.12 It is also an offence, in certain circumstances, to disclose to another person that a disclosure
has been made as above. This is presumably to cover the need for an investigation to be done
in secret. A person making a disclosure to the authorities is excused from any resulting breach
of any contract or professional obligation and will not be liable for any loss or damage arising
from the disclosure.
5.13 The DTRPO also provides for the issuing of restraint and charging orders on the property of
a person charged with a drug trafficking offence. Licensed corporations and registered
institutions may receive such orders and may be required to deliver documents or information
under the order. Failure to do so will be an offence.

OSCO
5.14 The term organized crime covers a number of offences but it is not necessary for
examination purposes to have a detailed knowledge of them. The OSCO gives the police
powers to obtain a court order to compel a person to provide information or material relating
to the investigation of an organized crime and to conduct searches. The requirements to
disclose and to submit to searches override any duties of secrecy and confidentiality.

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5.15 The OSCO also contains provisions similar to those in the DTRPO that were dealt with in
sections 5.10 to 5.13 above, relating to dealing, disclosure, immunity and the issuing of
restraint orders.

UNATMO
5.16 For the purposes of this manual, it should be noted that the UNATMO:
(a) makes it a criminal offence, inter alia, to provide property or financial services to
terrorists or their associates or to collect property or solicit financial services for terrorists
or their associates;
(b) permits terrorist property to be frozen and/or forfeited; and
(c) requires a person to report knowledge or suspicion of terrorist property to an authorized
officer, and makes it an offence to fail to do so.
5.17 In this context, property, terrorist, terrorist associate and terrorist act are defined in
the UNATMO. Lists of terrorists and terrorist associates are published from time to time in
the Gazette. The UNATMO makes provisions similar to those in the DTRPO and OSCO for
disclosure and immunity.

Regulation by the Securities and Futures Commission


5.18 Section 7, AMLO empowers the SFC to issue guidance in relation to the operation of any
provision of Schedule 2, AMLO. The SFC has issued the GAML to provide general practical
guidance to assist licensed corporations and their senior management in designing and
implementing policies, procedures and controls that will facilitate compliance with the
statutory requirements.
5.19 Associated entities of licensed persons will also need to note the requirements of the
Prevention of Money Laundering and Terrorist Financing Guideline issued by the SFC for
Associated Entities. While the provisions of these guidelines are broadly similar in nature to
the GAML, their details are outside the scope of this manual.
Note: An associated entity of an intermediary is any company that (i) is in a controlling
entity relationship with the intermediary and (ii) receives or holds in Hong Kong client
assets of the intermediary.
5.20 Although registered institutions and their associated entities are subject to guidelines issued
by the HKMA rather than the GAML issued by the SFC, they will need to have regard to
certain aspects of the GAML, such as examples of suspicious transactions relating to the
securities sector. The HKMAs guidelines are in general not different from the GAML, but
their specific contents are outside the scope of this manual.
5.21 The GAML and the HKMA guidelines do not have the force of law but their provisions may
be taken into account in proceedings under the AMLO before a court, and failure to comply
may reflect adversely on the fitness and properness of a licensed or registered person.
5.22 The GAML describes the three common stages identified in the process of money laundering:
(a) placement - the first stage is the physical disposal of cash proceeds derived from illegal
activities;
(b) layering - the second stage is the separation of the illicit proceeds from their source by
creating a number of financial transactions (layers) designed to hide the source of the
money, subvert the audit trail and provide anonymity; and
(c) integration - the final stage is the creation of an impression of apparent legitimacy of
criminally derived wealth in order to integrate the laundered proceeds back into the
general financial system, i.e. without being connected with the illegal activity that was
its source.

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5.23 The activities regulated by the SFC are, in practice, generally not cash-based and so it is more
difficult to make use of the first stage of money laundering in the securities and futures
markets. However, where cash does enter the financial markets, money launderers can use
RAs in an attempt to hide their trails.
5.24 The second stage, layering, is the most likely point at which a licensed corporation could
become involved in a money laundering scheme by, for example, the transfer of funds into a
series of securities transactions. The liquidity of the securities and futures markets makes it
possible to establish complicated trails intended to confuse law enforcement agencies.
5.25 The Financial Action Task Force (FATF), supported by the membership of 35 jurisdictions
(as at April 2017) including Hong Kong and two regional organisations, is an inter-
governmental body whose purpose is the development and promotion of policies, at both
national and international levels, to combat money laundering and terrorist financing. The
FATF has published 40 recommendations and nine special recommendations for dealing with
money laundering, which have been adopted by the members and subsequently expanded in
the area of terrorist financing.

Policies and procedures to combat money laundering and terrorist


financing
5.26 The GAML specifies the need for awareness and vigilance and the setting up of a system to
report suspicious transactions. It requires licensed corporations to:
(a) issue statements of policies and procedures to staff reflecting the provisions of the GAML;
(b) ensure that staff understand the GAML and maintain their awareness and vigilance;
(c) regularly review their anti-money laundering policies and procedures by their compliance
and audit function; and
(d) appoint a money laundering reporting officer as a central reference point for reporting
suspicious transactions.
5.27 A licensed corporation is also required to have measures in place to check that its policies and
procedures ensure its ability to comply with relevant laws and regulations. Such measures
should be appropriate in the context of the size and risk profile of its business.

Client identification
5.28 Licensed corporations should adopt a risk-based approach in their CDD process. This means
that an enhanced CDD process is adopted for higher-risk categories of customers, business
relationships or transactions. Conversely, a simplified CDD process may be adopted for
lower-risk categories of customers, business relationships or transactions. In determining the
risk profile of customers, the following factors, among others, should be taken into account:
(a) Product/service risk
Services that provide more anonymity.
(b) Delivery/distribution channel risk
Sales through online, postal or telephone channels involving non-face-to-face account
opening approach.
(c) Customer risk
(i) background or profile of the customer (e.g. a politically exposed person);
(ii) unduly complex ownership structure, without good reason;
(iii) nature, scope and location of the customers business that generate the funds/assets,
having regard to sensitive or high-risk activities; and

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(iv) means and types of payment (e.g. cash-intensive businesses).
(d) Country risk
Nationality, citizenship and residence status of the customer (place of incorporation for
a corporate customer), and its place of business (e.g. non-cooperative countries and
territories identified by the FATF to have critical deficiencies in their anti-money
laundering systems).
5.29 A greater degree of alertness in opening accounts is now required, particularly with overseas
clients. If an account is opened using a non-face-to-face approach, care should be taken to
note the requirements of the Code of Conduct (discussed in section 2 of this Topic) in addition
to the CDD requirements set out in the GAML. Credible sources should be used to verify
overseas accounts. Anonymous accounts are not permitted.
5.30 The detailed guidelines also highlight the different considerations in the CDD process that are
relevant to different classes of customer, such as corporations, individuals, listed companies,
trust companies, politically exposed persons etc..

Ongoing monitoring
5.31 Once a customer has been brought on board, its activities must be subject to ongoing
monitoring to detect unusual or suspicious activities. This would require monitoring, for
example, whether the customers activities are consistent with the nature of its business, its
risk profile, its source of funds or its expected pattern of activity. The extent of ongoing
monitoring should be linked to the customers risk profile. This will require the activities of
higher risk customers to be subject to more frequent and more intensive monitoring.

Record-keeping and retention


5.32 Establishing an audit trail of the movement of assets is an important component of
investigating and tracking down money laundering schemes, and the maintenance of
appropriate records is an important step in creating an audit trail.
5.33 The GAML requires a licensed corporation to keep originals or copies of documents and a
record of data and information in relation to the following, among other things:
(a) Customers
(i) CDD (including identification and verification information of beneficial owners);
(ii) the purpose and intended nature of the business relationship with the customer;
(iii) forms concerning the customers account; and
(iv) all business correspondence with the customer and the beneficial owner of the
customer.
(b) Transactions
(i) the identity of the parties;
(ii) the nature, date, currency type and amount, and origin of funds (if known);
(iii) in what form the funds were offered or withdrawn (e.g. cash, cheque etc.);
(iv) the destination of funds;
(v) the form of instruction and authority; and
(vi) the type and number of any account involved in the transaction.
5.34 Customer documents and information should be kept throughout the business relationship and
for a period of 6 years after the end of the business relationship.

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5.35 Transaction documents and information should be kept for a period of 6 years after completion
of a transaction irrespective of whether the business relationship ends during the period.

Recognition and reporting of suspicious transactions


5.36 There should be adequate systems and procedures, such as transaction reports, to enable senior
management and the money laundering reporting officer to detect unusual or suspicious
activities promptly. What constitute suspicious activities will depend on the particular
circumstances. The criteria include their unusual nature compared with:
(a) the usual transactions put through the account; and
(b) the clients business or financial circumstances.

Procedures for disclosure as suggested by the JFIU


5.37 The obligation to report under the DTRPO, OSCO or UNATMO rests with the individual who
becomes suspicious of a person, transaction or property. Disclosures of suspicious
transactions under the DTRPO, OSCO or UNATMO should be made to the JFIU.
5.38 Once suspicion has arisen concerning a possible money laundering situation, the need for
disclosure should be considered and may require urgent discussions with senior management,
appropriate questioning of the customer, and a review of all information already held about
that customer. If suspicion remains and a decision is made to report the matter to the JFIU, it
should be done without delay, by telephone if necessary.
5.39 Licensed corporations or associated entities should maintain a record of all disclosures made
to the JFIU and include details such as the date of disclosure and the identity of the person
who made the disclosure. The JFIU will acknowledge receipt of a disclosure. If there is no
need for imminent action, the JFIU will usually give its consent for the licensed corporation
to continue to operate the account. The licensed corporations or associated entities, their
directors and staff must not inform or warn the client when information is disclosed to the
JFIU.

Education and training


5.40 Licensed corporations are required to give their staff appropriate training on money laundering
issues, and on a frequency sufficient to maintain their knowledge and competence. Staff
should be aware of:
(a) the obligations of both the licensed corporation and the individual, and the possible
consequence of failing to comply with these obligations under applicable legislation;
(b) the policies and procedures of the licensed corporation relating to anti-money laundering,
including the identification and reporting of suspicious transactions; and
(c) new and emerging ways that money laundering might be engaged in, to the extent such
information is needed by the staff to carry out their roles.

Examples of suspicious transactions


5.41 Chapter 7, GAML provides a list of situations that might give rise to suspicion of money
laundering activity, including those set out below. The list is not exhaustive and licensed
corporations need to be alert to their responsibilities under applicable legislation and
regulations.
(a) Customer-related
(i) customer requests for investment management services where the sources of their
funds are unclear or inconsistent with the customers financial background; and

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(ii) the opening of multiple accounts with the same beneficial owners or controlling
parties which are unusual.
(b) Trading-related
(i) buying and selling activities which are unusual or have no obvious purpose; and
(ii) frequent transactions in small amounts, purchased in cash and then sold in one
transaction with proceeds paid to a third party.
(c) Settlement/custody/transfers-related
(i) large or unusual settlements in cash or bearer form, or dealings only in cash or cash
equivalents;
(ii) holding of idle funds by a client, which are not used to trade, with the licensed
corporation; and
(iii) frequent fund transfers or cheque payments to or from unverified third parties or
those difficult to verify.
(d) Those involving employees
(i) changes in the life-style of an employee without reasonable cause, e.g. high spending
or not taking holidays;
(ii) unusual or unexpected increase in the sales performance of an employee; and
(iii) the use of forwarding addresses for clients, such as those of staff or persons
connected with staff.

International considerations
5.42 In addition to the considerations discussed above, licensed and registered persons will need to
be aware of the sanctions list published by the United Nations as they may not deal with clients
from countries on the sanctions list. See:
https://scsanctions.un.org/consolidated/.

Revision questions:

Question 9: To whom should a firm report suspected money laundering?


Answer 9: According to the DTRPO, the report should be made to an authorized officer, who
may be a police officer, a customs and excise officer or the JFIU, which has been
set up and is operated by the Hong Kong Police Force and the Customs and Excise
Department.
Question 10: Describe three suspicious transactions which might alert you to potential money
laundering activities.
Answer 10: Any 3 examples as stated in section 5.41.

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Topic summary
In this Topic we discussed the duties and responsibilities of the responsible officers and executive
officers, as well as their liabilities under the SFO and the NCO. The nine general principles of the
Code of Conduct and its detailed guidance on practices and standards were then examined, including
the know your client requirement and waiver for PIs.
We reviewed the principles and guidelines for proper internal controls, including some operational
control and risk management techniques provided in the ICG.
We then looked at additional Code of Conduct requirements specific to licensed or registered persons
dealing in securities listed or traded on the SEHK.
Finally, we discussed the legislation and guideline for the prevention of money laundering and
terrorist financing activities.

Checklist
Below is a checklist of the main points covered by this Topic. Candidates should use the list to test
their knowledge.
Every licensed corporation must have at least two responsible officers approved by the SFC. A
responsible officer is one who actively participates in or supervises the RAs of a licensed
corporation.
Every executive director of a licensed corporation is required to obtain the approval of the SFC
as a responsible officer. At least one of the responsible officers must be an executive director.
Provisions in the SFO concerning management liabilities.
Representations, information, invitations and advertisements should be accurate and not
misleading, false or deceptive.
Licensed or registered persons should not receive advantages such as money, gifts, employment,
services, favours and so on which would interfere with or prejudice their behaviour towards their
clients or employers (in the case of representatives) or be contrary to applicable ethical standards.
Licensed or registered persons should take reasonable steps to execute client orders promptly in
accordance with clients instructions and on the best available terms.
Executed client orders should be promptly and fairly allocated to the clients.
A licensed or registered person should have proper internal control procedures, sufficient
financial resources, competent staff, adequate supervision etc. to conduct its business activities
satisfactorily.
The true identity of clients, their financial position, investment experience and investment
objectives should be established and recorded.
The ultimate beneficiary and the person ultimately responsible for originating an order should
be identified if reasonably possible. In the case of a CIS, it is sufficient to identify the CIS and
the fund manager unless the ultimate beneficiary is giving the order, in which case he should be
identified.
A written client agreement should be entered into with a client before a licensed or registered
person provides services to that client.
The authority for a discretionary account must be in writing and should specify the person who
is authorized to operate the account, stating that the person is an employee or agent of the licensed
or registered person, if the authority is granted to such person.

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Risk disclosure statements should be included in client agreements for securities dealing, trading
in GEM stocks, authority to re-pledge clients securities collateral, authority to hold mail and
margin trading.
A licensed or registered person should provide prompt confirmation of transactions to its clients.
A licensed or registered person should handle client orders fairly and in the order in which they
are received. Client orders should be given priority over orders for the licensed or registered
person, its staff or agent.
Clients should be given priority over staff and the licensed or registered person in the allocation
of completed orders.
A licensed or registered person or its staff should not deal ahead of a client (front running) or
take advantage of price-sensitive information to deal for itself/themselves.
Conflicts of interest should be avoided and, if not, clients interests should be protected and
disclosure made to the client.
A licensed or registered person may only receive goods or services from a broker if they are of
demonstrable benefit to the client, best execution standards have been applied, the client has
given written consent, and the recipients soft-dollar practice has been disclosed to the client.
See the full list of acceptable goods and services and those which are forbidden (sections 2.42
and 2.43).
An analyst must adhere to high standards of ethical behaviour and integrity and have a reasonable
basis for analyses and recommendations.
If a licensed or registered persons staff are allowed to deal for their own accounts through
another licensed or registered person, duplicate trade confirmations and statements of account
should be provided to senior management of that licensed or registered person.
A licensed or registered person should ensure that complaints from clients are properly handled,
that steps are taken to investigate and respond promptly to the complaints, and that the client is
advised of any further steps available to him, including the right to refer the dispute to the FDRC.
A licensed or registered person should report to the SFC material breaches or suspected such
breaches of the law, rules, regulations and codes, insolvency situations and disciplinary actions
taken against it by any regulators or other professional or trade bodies.
Licensed or registered persons handling client assets should ensure that they are properly and
promptly accounted for and adequately safeguarded.
Licensed corporations are required under the Code of Conduct to provide additional disclosure
to their clients regarding the risk of client money being received or held outside Hong Kong.
Senior management of a licensed or registered person should know the business, its internal
control and risk management systems and procedures, and possess all relevant information
relating to its operations.
There are three classes of PIs, with different requirements applying to each class: Institutional
PIs, Corporate PIs, and Individual PIs.
It will always be necessary to ensure the suitability of a product for Individual PIs. However,
whether this is required for Corporate PIs will need to be assessed on a case-by-case basis.
There are specific conduct requirements which should be complied by a licensed or registered
person which operates ALPs for trading of securities that are listed or traded on an exchange.
The Code of Conduct requirements regarding electronic trading and ALP are included in Topic
5.

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The ICG lists eight key areas of internal controls: management and supervision, segregation of
duties and functions, personnel and training, information management, compliance, audit,
operational controls and risk management.
Senior management should establish and operate an effective management and organisational
structure which ensures that the business is conducted in a sound, efficient and effective manner.
Senior management must define clear reporting lines and authorisation limits, and ensure that
supervisory staff are suitably qualified and experienced.
Incompatible duties and functions should be segregated, particularly those that, when performed
by the same person, may provide opportunities for abuse or result in the overlooking of errors.
Policy making, supervisory, advisory, compliance and internal audit functions should not, where
practicable, be performed by staff with line operational duties.
A licensed or registered persons information management system, including electronic data
processing, should be adequate and operated in a secure and controlled environment.
The compliance function may cover the review of, for example, record keeping, client,
proprietary and staff dealings, and compliance with legal and regulatory requirements.
The audit function should independently examine, evaluate and report to senior management or
the audit committee on the adequacy, effectiveness and efficiency of the management, internal
controls and operations.
Operational controls should ensure the integrity of the intermediarys dealing practices and the
fair, honest and professional treatment of clients; and the safeguarding of the clients and
intermediarys assets.
Operational controls should ensure that any investment advice given for remuneration is
supported by a contractual advisory agreement, and that investment recommendations are made
after thorough analysis, are suitable for the client and properly documented; that proper
reconciliation of the records is carried out with external records and reports, and that errors,
omissions and discrepancies are followed up and the reconciliations reviewed by independent
senior staff.
Risk management procedures should limit to acceptable levels the exposure of the intermediary
to the risk of suffering loss as a result of client default or changing market conditions.
Operational controls should include procedures for passing orders to the dealing room, ensuring
client priority and, where practicable, assigning responsibility for allocating client orders to
independent senior staff.
Operational controls should where applicable, as when confidential price-sensitive information
is handled, include the setting up of Chinese walls to prevent leakage of this information to other
operating staff.
Types of common risk are credit, market, liquidity and operational risks.
A licensed or registered person which is an SEHK exchange participant should also observe the
requirements set out in Schedule 3 to the Code of Conduct.
A breach of the AMLOs requirements relating to CDD and record keeping is a criminal offence
that can incur penalties including imprisonment and a fine. It can also lead to the licensed
corporation or registered institution being subject to regulatory discipline.
The GAML specifies the need for awareness and vigilance and the setting up of a system to
report suspicious transactions, and requires licensed corporations to adopt a risk-based approach
in their CDD process.
The GAML and AMLO both require that customer records should be maintained for 6 years
following the end of the business relationship, and that transaction records should be kept for 6
years following the transaction.

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The GAML provides examples of suspicious circumstances that may indicate a possible money
laundering scheme.

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Topic 4: Dealing in securities traded on The Stock Exchange of
Hong Kong Limited
Table of contents
Topic overview 1
Learning outcomes 1
1 Market participants in Hong Kong securities market 2
Exchange Participants, licensed or registered persons and overseas participants 2
Hong Kong Exchanges and Clearing Limited 2
Exchanges, trading systems and clearing houses 2
2 Participantship and trading right 4
Participantship 4
Exchange Participants 4
Representatives and responsible officers 4
Trading rights of The Stock Exchange of Hong Kong Limited (SEHK) 5
3 Products traded on the SEHK 6
Equity securities 6
Debt securities 7
Unit trusts/mutual funds 7
Structured products 8
Characteristics of Hong Kong listed companies 9
4 Trading mechanism and rules 12
Automatic order matching and execution system 12
Trading mechanism 12
Quotation rules 14
Direct business (crossing of trades) rules 15
5 Trading halt, suspension, cancellation and withdrawal of listing 16
The SEHKs power to direct a trading halt or suspend dealings 16
Trading halt or suspension requested by the issuer 16
The Securities and Futures Commissions power to suspend dealings 16
Cancellation or withdrawal of listing 16
Rules on dealing in suspended securities 17
6 Clearing and settlement services 18
Central Clearing and Settlement System 18
Clearing services 19
Settlement services 19
Risk management 21
Clearing and settlement of OTC derivatives transactions 23
7 The SEHK disciplinary procedures 25
Situations calling for disciplinary action 25
Disciplinary powers 25
Disciplinary proceedings 25
8 Transaction costs 27
Brokerage (commission) 27
Transaction Levy and Investor Compensation Levy 27
Trading fee 27
Trading tariff 27
Ad valorem stamp duty 27
Transfer deed stamp duty 27
Transfer fee 27
Topic summary 28
Checklist 28
Topic overview
This Topic provides a review of dealing in securities traded on The Stock Exchange of Hong Kong
Limited (SEHK) except for options traded on the SEHK, which are covered in Topic 6.
We begin by providing an overview of the types of market participants in the Hong Kong securities
market, which includes Hong Kong Exchanges and Clearing Limited (HKEX), the SEHK and Hong
Kong Securities Clearing Company Limited (HKSCC). We then describe the exchange
participantship and trading right concepts and review the qualification of an exchange participant of
the SEHK (Exchange Participant).
There is then a general description of the products traded on the SEHK, before we take a look at the
characteristics of companies listed on the Main Board and the Growth Enterprise Market (GEM).
There follows a review of the SEHK trading mechanism and rules, including the third generation of
the Automatic Order Matching and Execution System (AMS/3), usual order types and the rules
regarding quotation and direct business.
Later, trading halt, suspension of trading on the SEHK, cancellation and withdrawal of listing are
considered and discussed SEHKs Rules of the Exchange about dealings in suspended securities.
Closely related to trading is the clearing and settlement process. We review the clearing house for
SEHK products, HKSCC, and its Central Clearing and Settlement System (CCASS). The criteria
for becoming a clearing participant in CCASS are discussed. The settlement method and other
important elements and concepts of the clearing and settlement processes, such as money settlement,
settlement instructions, risk management etc., are also discussed.
We then provide an overview of SEHK disciplinary procedures.
Finally, the general costs of trading for investors are outlined.

Learning outcomes
At the end of this Topic, candidates should be able to:
(a) describe market participants, HKEX, exchanges, clearing houses and their systems;
(b) explain the requirements governing SEHK participantship and trading rights;
(c) know the basics about products traded on the SEHK, including equity securities, debt securities,
unit trusts/mutual funds and structured products;
(d) know the characteristics of Hong Kong listed companies;
(e) describe the order execution system, order types and certain trading rules relating to dealing on
the SEHK;
(f) explain the events leading to possible trading halt, suspension and cancellation or withdrawal of
listing, and rules relating to dealing in suspended securities;
(g) describe HKSCC, the clearing house for securities transactions, and the criteria for becoming a
clearing participant in CCASS;
(h) describe and understand the clearing and settlement system, its methods and services;
(i) know the disciplinary procedures of the SEHK; and
(j) explain the categories and rates of transaction costs for an investor.

Paper 2 Version 2.4 4-1 Hong Kong Securities and Investment Institute
1 Market participants in Hong Kong securities market
1.1 Hong Kong market is one of the preferred locations in the Asian time zone for international
and domestic investors. The Securities and Futures Commission (SFC) and HKEX aim to
provide foreign investors with convenient access to the market, facilitating cross-border trades.

Exchange Participants, licensed or registered persons and


overseas participants
1.2 Market participants involved in the business of dealing in products traded on the SEHK
include:
(a) Exchange Participants, which are subject to the licensing requirements of the SFC as well
as the SEHK admission requirements;
(b) market participants which are not Exchange Participants but are licensed by or registered
with the SFC to carry out the regulated activity (RA) of dealing in securities. For
example, licensed corporations that are subsidiaries of (or controlled by) foreign firms
having a business presence in Hong Kong and which deal in products traded on the SEHK
through another Exchange Participant; and
(c) overseas market participants (which are subject to their own countries regulations for
dealing in securities) that do not have a physical presence in Hong Kong and which deal
in products traded on the SEHK through the above market participants.

Hong Kong Exchanges and Clearing Limited


1.3 HKEX is a company listed on the SEHK and is an exchange controller as defined in the
Securities and Futures Ordinance (SFO). HKEX controls various exchanges and clearing
houses in Hong Kong, including the SEHK, HKSCC and The SEHK Options Clearing House
Limited (SEOCH).
1.4 HKEX is responsible for ensuring an orderly and fair market in securities and futures
contracts. Rules and regulations have been made for these purposes by the SEHK and Hong
Kong Futures Exchange Limited (HKFE) and their clearing houses.
1.5 HKEX regulates listed companies, trading on the exchanges and the related clearing and
settlement functions. The regulation of intermediaries engaged in trading on the exchanges,
and their relationships with each other and their clients, are principally monitored by the SFC
directly. Accordingly, although the operating and other rules can be extensive, the regulatory
aspects of the operations of HKEX are limited in their scope.

Exchanges, trading systems and clearing houses


Exchanges
1.6 There are currently two exchanges:
(a) the SEHK, which provides for trading in securities; and
(b) HKFE, which provides for trading in futures contracts.
1.7 These were independent until 6 March 2000, when they were made subsidiaries of HKEX
under a scheme of arrangement. They continue to retain their trading and settlement structures,
and their operations are governed by separate sets of rules.

Trading systems
1.8 AMS/3 is the trading system currently used by the SEHK. The AMS/3 architecture allows for
a direct interface between brokers own systems and AMS/3 and eventually for straight-

Paper 2 Version 2.4 4-2 Hong Kong Securities and Investment Institute
through processing of client orders. AMS/3 processes equities, debt instruments, unit trusts,
exchange-traded funds and structured products (e.g. warrants).
1.9 The Hong Kong Futures Automated Trading System is an electronic screen-based trading
system used for trading in HKFE products as well as options traded on the SEHK.

Clearing houses
1.10 There are four clearing houses:
(a) HKSCC, a wholly owned subsidiary of HKEX, which is the clearing house for the cash
business and so securities settlement of the SEHK;
(b) The SEOCH, a wholly owned subsidiary of the SEHK, which clears the options business
of the SEHK;
(c) HKFE Clearing Corporation Limited (HKCC), a wholly owned subsidiary of HKEX,
which clears the futures and options business of HKFE; and
(d) OTC Clearing Hong Kong Limited (OTC Clear), a 75% owned subsidiary of HKEX,
which clears over-the-counter (OTC) derivatives transactions.
1.11 CCASS is operated by HKSCC for clearing and settlement of securities transactions on the
SEHK. HKEX introduced the Derivatives Clearing and Settlement System (DCASS) in
April 2004. DCASS provides a common platform for the clearing and settlement of all
derivatives products traded on the HKEX markets, including futures and options of HKFE,
and options traded on the SEHK.
1.12 OTC Clear is established for the purpose of providing clearing services for OTC derivatives.
It is a 75% owned subsidiary of HKEX with the remaining stake of 25% held by a consortium
of 12 financial institutions being its founding shareholders. It started operation in November
2013 when market participants may clear certain over-the-counter derivative transactions
through OTC Clear on a voluntary basis.
1.13 On 31 August 2016, the SFC designated OTC Clear as a central counterparty (CCP) in
respect of certain specified OTC derivative transactions subject to the mandatory clearing
obligation under the relevant new provisions of SFO and Securities and Futures (OTC
Derivative TransactionsClearing and Record Keeping Obligations and Designation of
Central Counterparties) Rules which started taking effect on 1 September 2016.

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2 Participantship and trading right
Participantship
2.1 Before March 2000, members or shareholders of the SEHK/HKFE were entitled to trade on
the respective exchanges. Upon merger and demutualisation, the two exchanges and three
clearing houses became the wholly owned subsidiaries of HKEX and participantship of the
exchanges and clearing houses was introduced. There are a number of groups of participants
within the structure of the various exchanges and clearing houses. Participantship of HKEX
is distinct from access to the trading facilities of the SEHK and HKFE and access to the
settlement facilities of HKSCC, the SEOCH and HKCC.
2.2 Those who wish to trade through the SEHK are required to hold trading rights and register as
Exchange Participants. With effect from 6 March 2010, trading rights are non-transferable and
will only be available from the SEHK for a fee, currently set at HK$500,000. Those wishing
to clear trades must become clearing participants of the respective clearing houses, HKSCC
and/or the SEOCH.
2.3 The various categories of participantship will require the payment of appropriate deposits and
admission fees to the exchanges and clearing houses.

Exchange Participants
2.4 The Rules of the Exchange define an Exchange Participant as a person who may trade on or
through the SEHK and whose name is entered in a register kept by the SEHK as a person who
has that right.
2.5 Exchange Participants should register with the SEHK as holding the necessary
participantships for the trading activities in which they intend to engage on the SEHK and, if
they wish to clear trades, should become participants of the relevant clearing houses, such as
HKSCC or SEOCH. They must comply with the Rules of the Exchange and the rules and
regulations of the clearing houses.
2.6 An Exchange Participant must always:
(a) be the holder of an SEHK trading right;
(b) be a licensed corporation under the SFO to carry on Type 1 RA;
(c) be a company limited by shares and incorporated in Hong Kong;
(d) be of good financial standing and integrity; and
(e) comply with the Securities and Futures (Financial Resources) Rules (FRR) and the
financial resources requirements of the Rules of the Exchange.

Representatives and responsible officers


2.7 Unless otherwise determined by the SEHK, all licensed representatives of an Exchange
Participant who have been approved by the SFC as responsible officers in relation to Type 1
RA shall be registered with the SEHK as responsible officers. Each responsible officer shall
undertake to comply with all applicable rules, regulations, procedures and guidelines. At all
times, an Exchange Participant shall have at least one executive director registered with the
SEHK as a responsible officer.
An Exchange Participant is responsible for the acts of its representatives acting on its behalf
in its business of dealing in securities, and shall ensure that they are competent and have
acquired the necessary skills and knowledge to carry out their responsibilities.

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Trading rights of The Stock Exchange of Hong Kong Limited
(SEHK)
2.8 The Rules of the Exchange define a stock exchange trading right as a right to trade on or
through the SEHK and to be entered as such in a register kept by the SEHK.
2.9 Any person who wishes to trade on or through the facilities of the SEHK is required to hold a
trading right of the SEHK. However, the holding of a trading right does not, of itself, permit
the holder actually to trade on or through the SEHK. In order to do this, it is also necessary
for the person to be registered as an Exchange Participant in accordance with the Rules of the
Exchange.
2.10 As mentioned in section 2.2 above, trading rights are non-transferable.
2.11 Each trading right of the SEHK (by virtue of participantship of the SEHK) entitles its holder
to connect to the trading system of the SEHK, whether via the trading terminal in the trading
hall and/or trading device(s) in the offices of the Exchange Participant.

Revision question:

Question 1: What are the requirements for a corporation that intends to be an Exchange
Participant?
Answer 1: The corporation is required to:

hold a trading right of the SEHK;


be a licensed corporation under the SFO to carry on Type 1 RA;
be a corporation limited by shares and incorporated in Hong Kong;
be of good financial standing and integrity; and
comply with the FRR and the financial resources requirements of the Rules of
the Exchange.

Paper 2 Version 2.4 4-5 Hong Kong Securities and Investment Institute
3 Products traded on the SEHK
3.1 The SEHK provides for trading in securities on two boards, the Main Board and GEM. The
Main Board is a market for capital formation by established companies with a profitable
operating track record. GEM is a relatively new market, established in November 1999, to
provide capital formation opportunities for growth companies from all industries and of all
sizes.
3.2 The SEHK administers listing matters as part of its responsibility to provide a fair, orderly and
efficient market for the trading of securities. Listing is the process by which securities issued
by a company (the issuer) are admitted for trading on a stock exchange. The SEHK has issued
two sets of Listing Rules, one which governs listings on the Main Board of The Stock
Exchange of Hong Kong Limited (i.e. Rules Governing the Listing of Securities on The
Stock Exchange of Hong Kong Limited) (Main Board Listing Rules or MBLR), and one
which governs listings on GEM (i.e. Rules Governing the Listing of Securities on the Growth
Enterprise Market of The Stock Exchange of Hong Kong Limited) (GEM Listing Rules or
GLR). The two sets of rules (collectively referred to as Listing Rules) include
requirements which have to be met before securities may be listed, and the ongoing obligations
of listed companies and their directors once a listing has been granted.
3.3 The Main Board and GEM cater for the different investment appetites of investors and offer
listing applicants a choice when going public. Investors who are averse to higher risk may
choose to invest in the more established companies listed on the Main Board.
3.4 The following are some common products traded on the SEHK.

Equity securities
3.5 Equity securities, generally referred to as shares, may be ordinary or preference shares. Most
of the equity securities listed on the SEHK are ordinary shares, and account for most of the
SEHKs turnover.

Securities traded under the Pilot Programme


3.6 In addition to the Main Board and GEM traded securities, the SEHK also admits some
securities listed on American stock exchanges for trading under the Pilot Programme.
3.7 Securities traded under the Pilot Programme have the following characteristics:
(a) they are listed on the NASDAQ or the American Stock Exchange;
(b) they may include a number of exchange traded funds;
(c) they have no public offerings in Hong Kong;
(d) they are not regulated as listings on the SEHKs Main Board or GEM; and
(e) they are admitted to the SEHK for trading only.
3.8 The trading of the Pilot Programme securities is regulated by Hong Kong laws and the Rules
of the Exchange. In particular, the securities are subject to the market manipulation provisions
of the SFO.
3.9 In general, the practice of suspension and resumption of trading will follow that of the home
market of the Pilot Programme securities, but the SFC and the SEHK retain the right to
suspend, halt trading in and delist any security.
3.10 A full list of the Pilot Programme securities is available on the HKEX website.

H shares and red chip shares


3.11 H shares and red chip shares are also traded on the SEHK.

Paper 2 Version 2.4 4-6 Hong Kong Securities and Investment Institute
3.12 H share companies are those incorporated in the Peoples Republic of China (mainland
China) and approved by the China Securities Regulatory Commission (CSRC) for listing
in Hong Kong. Shares of these mainland China enterprises are listed on the SEHK, subscribed
for and traded in Hong Kong dollars or other currencies, and referred to as H shares. After
finding its way into the Listing Rules, the term H shares has been accepted by and widely
used in the market. The letter H stands for Hong Kong.
3.13 A red chip company is one that has at least a 30% shareholding held in aggregate by mainland
China entities, and/or indirectly through companies controlled by them, with such entities
being the single largest shareholders in aggregate terms; or when the shareholding of the
company held in aggregate directly and/or indirectly by mainland China entities is below 30%
but is 20% or above and there is judged to be a strong influential presence of mainland China-
linked individuals on the companys board of directors.

GEM
3.14 GEM targets growth companies from all industries and of all sizes. The qualifications for
listing on GEM are in general lower than those for the Main Board. The objective is to
accommodate growth companies without a performing track record. However, there are other
requirements after listing which are additional to those of the Main Board. GEM operates on
the philosophy of buyer beware and let the market decide, and is based on a strong
disclosure regime. Companies listed on GEM and later which can fulfil certain qualifications
can be transferred to the Main Board directly.

Debt securities
3.15 Debt securities listed on the SEHK include bonds and notes which represent loans to an entity
(such as a government or a corporation) in which the entity promises to repay the bondholder
or note-holder the total amount borrowed. Repayments in most cases are made on maturity,
although some loans are repayable in instalments. Holders of bonds and notes are not owners
of an entity but its creditors.
3.16 In return for the loan, the entity will compensate the bondholder or note-holder with interest
payments (i.e. the coupon) during the life of the bond or note. The interest rate may be fixed
or floating.
3.17 Examples are Hong Kong Monetary Authority Exchange Fund Notes, The Hong Kong
Mortgage Corporation Limited FR Notes and The Govt of the HKSAR of the PRC iBonds.

Unit trusts/mutual funds


3.18 A unit trust or mutual fund invests contributions from investors in a portfolio of securities.
Units are issued to these investors.
3.19 The SFO defines a unit trust as any arrangement for the purpose of providing facilities for the
participation by persons, as beneficiaries under a trust, in profits or income arising from the
acquisition, holding, management or disposal of securities or any other property.

Exchange traded funds


3.20 Exchange traded funds (ETFs) are funds or unit investment trusts that hold portfolios of
securities designed generally to correspond to the price and yield performance of their
underlying portfolio of securities, with a theme and a creation and redemption facility, which
trade on the SEHK as a single security. ETFs offer investors an efficient way to obtain cost-
effective exposure to a wide range of underlying market themes.
3.21 Like other listed equity securities, investors can trade the ETFs listed on the SEHK during the
securities markets trading hours. Through the creation and redemption facility, large investors
and institutions can create ETFs in block-sized units (known as creation units) in cash or in

Paper 2 Version 2.4 4-7 Hong Kong Securities and Investment Institute
kind and redeem block-sized units of ETFs in return for securities approximating the
composition of the underlying portfolio.
3.22 The Hong Kong Tracker Fund is an ETF listed on the SEHK. It is designed to provide
investment results that closely correspond to the performance of the Hang Seng Index. Also,
some ETFs invest outside Hong Kong. For example, local investors can invest in the mainland
China stock markets through an A50 Fund on the Main Board.

Leveraged and inverse products


3.23 Leveraged and inverse products structured as ETFs listed and traded on the securities market
of HKEX are authorised by the SFC as collective investment schemes (CISs).
3.24 Leveraged products typically aim to deliver a daily return equivalent to a multiple of the
underlying index return that they track. Inverse products typically aim to deliver the opposite
of the daily return of the underlying index that they track. For example, if the underlying index
rises by 10% on a given day, a two-time (2x) leveraged product aims to deliver a 20% return
on that day. On the other hand, an inverse product should incur a 10% loss on that day.

Real Estate Investment Trust


3.25 A Real Estate Investment Trust (REIT) is a CIS focused in a portfolio of income-generating
properties such as shopping malls, offices, hotels and service apartments that aims to deliver
a source of recurrent income to investors. At least 90 per cent of its net income after tax is
paid to investors in the form of dividends at regular intervals. REITs must be authorised by
the SFC before they can be listed on the SEHK and are mainly regulated by the SFC. All
REITs listed on the SEHK must meet the general obligations and price-sensitive information
disclosure requirements under the Listing Rules, and deal with any enquiry from the SEHK
about unusual price/turnover movement.

Structured products
Equity warrants
3.26 Equity warrants carry the right to subscribe for equity securities of an issuer or any of its
subsidiaries at a pre-determined price. Equity warrants listed in Hong Kong are generally
American-style warrants which can be exercised at any time before or on maturity. European-
style warrants, on the other hand, may only be exercised on maturity. Equity warrants must
have a minimum term of one year and a maximum of five years from the date of issue or grant.
The issuer of the warrants is obliged to deliver the securities on full payment from the warrant
holder.

Derivative warrants
3.27 Derivative warrants are similar to equity warrants but are issued by a party (generally an
investment bank) that is independent of the issuer of the underlying securities and its
subsidiaries. The majority of derivative warrants in Hong Kong are settled in cash and they
may be call or put warrants. They may also be issued over assets other than equity securities
for example, currencies and commodities. Such warrants were first listed on the SEHK in
1989.

Callable bull/bear contracts


3.28 Callable bull/bear contracts (CBBCs) are structured products which are leveraged
investments tracking the performance of the underlying assets without requiring investors to
pay the full price required to own the actual assets. They are issued by a third party, usually
an investment bank, independent of HKEX and of the underlying assets. They are issued either
as bull or bear contracts, allowing investors to take bullish or bearish positions on the
underlying assets.

Paper 2 Version 2.4 4-8 Hong Kong Securities and Investment Institute
3.29 CBBCs are settled in cash only and may be issued with a lifespan of three months to five
years. When the price (as specified in the listing document) of the underlying assets reaches a
level (known as the call price) before the expiry of their lifespan, the CBBC will be called by
the issuers and the trading of that CBBC will be terminated immediately. The specified expiry
date from the listing document will no longer be valid.

Equity linked instruments


3.30 Equity linked instruments (ELIs) are structured products issued by banks and financial
institutions in many financial markets worldwide. They are marketed to retail and institutional
investors who want to earn a higher interest rate than that on an ordinary time deposit and
accept the risk of repayment in the form of the underlying shares or of losing some or all of
their investment. As in the case of other investments, ELI investors should familiarise
themselves with the product before making any investment decision.
3.31 When an investor purchases an ELI, he is indirectly writing an option on the underlying stock.
If the market moves as the investor expects, he earns a fixed return from his investment which
is derived mainly from the premium received on writing the option. If the market moves
against the investors view, he may lose some or all of his investment or receive shares worth
less than the initial investment.
3.32 To match their view of the underlying securities, investors may choose from three different
types of ELI bull, bear and range.

Characteristics of Hong Kong listed companies


3.33 The Listing Rules reflect currently acceptable standards in the marketplace and aim to ensure
and maintain investors confidence in the market, in particular, that:
(a) applicants are suitable for listing;
(b) the issue and marketing of securities is conducted in a fair and orderly manner and
investors are given sufficient information to enable them to make a properly informed
assessment of an issuer and the securities for which listing is sought;
(c) investors are kept fully informed by listed issuers, and any information which might
reasonably be expected to have a material effect on market activity in, and the prices of,
listed securities is disclosed immediately;
(d) all holders of listed securities are treated fairly and equally; and
(e) directors of a listed issuer act in the interests of its shareholders as a whole, particularly
where the public represents only a minority of the shareholders.

Main Board listing criteria


3.34 For an initial listing of securities on the Main Board, the following rules among others, apply:
(a) The issuer must be duly incorporated (MBLR 8.02).
(b) The issuer must not be a private company within the meaning of s. 11, new Companies
Ordinance (MBLR 8.03).
(c) Both the issuer and its business must, in the opinion of the SEHK, be suitable for listing
(MBLR 8.04) for example, an applicant with assets that are primarily cash or short-
dated securities (such as bonds, bills or notes with less than one year to maturity) would
not normally be regarded as suitable for listing, except where the issuer or group is solely
or mainly engaged in the securities brokerage business (MBLR 8.05C).
(d) The issuer must satisfy at least one of the following quantitative tests: profit test; market
capitalisation/revenue/cash flow test; or market capitalisation/revenue test (see section
3.35 below) (MBLR 8.05).

Paper 2 Version 2.4 4-9 Hong Kong Securities and Investment Institute
(e) A new applicant must have a trading record of at least the 3 preceding financial years
under substantially the same management, while ownership should be substantially the
same for at least the most recent financial year up until the time immediately before the
offering and/or placing becomes unconditional (MBLR 8.05(1), 8.05(2)(a)-(c) and
8.05(3)(a)-(c)). This continuous ownership and control requirement refers to ownership
and control of voting rights by a controlling shareholder or, where there is no controlling
shareholder, the single largest shareholder.
(f) In the case of a new applicant, the latest financial period reported on by the reporting
accountants must not have ended more than 6 months before the date of the listing
document (MBLR 8.06).
(g) There must be an adequate market in the securities that is, sufficient public interest in
the business of the issuer (MBLR 8.07).
(h) The minimum public float must be the higher of HK$50 million or 25% of the issuers
total number of issued shares. For issuers with an expected market capitalisation of over
HK$10 billion at the time of listing, the SEHK may accept a lower percentage of between
15% and 25% (MBLR 8.08(1)(a), (b) and (d)).
(i) There must be a sufficient spread of shareholders with a minimum of 300 shareholders
(MBLR 8.08(2)).
(j) Not more than 50% of the securities in public hands at the time of listing may be
beneficially owned by the 3 largest public shareholders (MBLR 8.08(3)), save for bonus
issue of options, warrants etc..
(k) Where any controlling shareholder or director of a new applicant has an interest in a
business apart from the applicants business which competes, or is likely to do so, this
fact must be disclosed (MBLR 8.10(1) and (2)).
(l) A new applicant applying for a primary listing on the SEHK must have a sufficient
management presence in Hong Kong, which will normally require at least 2 of its
executive directors to be ordinarily resident in Hong Kong, except as otherwise permitted
by the SEHK (MBLR 8.12).
(m) The securities for which listing is sought must be freely transferable. This may include
partly paid shares if their transferability is not unreasonably restricted (MBLR 8.13).
(n) The persons proposed to be directors must meet the requirements of MBLR Chapter 3
(MBLR 8.15).
(o) The issuer must employ an approved share registrar to maintain its register of members
in Hong Kong (MBLR 8.16).
3.35 The quantitative tests referred to above are as follows:
(a) Profit test
Profits attributable to shareholders for the most recent year must not be less than HK$20
million, and those for the two preceding years must not be, in aggregate, less than HK$30
million.
(b) Market capitalisation/revenue/cash flow test
The issuer must have a market capitalisation of at least HK$2 billion at the time of listing,
revenue of at least HK$500 million for the most recent audited financial year, and
positive cash flow from operating activities of at least HK$100 million in aggregate for
the three preceding financial years.
(c) Market capitalisation/revenue test
The issuer must have a market capitalisation of at least HK$4 billion at the time of listing,
and revenue of at least HK$500 million for the most recent audited financial year.

Paper 2 Version 2.4 4 - 10 Hong Kong Securities and Investment Institute


3.36 However, a number of the above criteria, including the quantitative tests, are subject to
important qualifications that it will be relevant in practice to understand.
3.37 The SEHK may accept a shorter trading record period and/or waive the profit or other financial
standards requirements in certain cases, as stated in the Main Board Listing Rules.

GEM listing criteria


3.38 The basic requirements for listing contained in the GEM Listing Rules are not the same as
those for the Main Board and the following summarises some key differences:
(a) A new applicant must have a trading record of at least 2 financial years with a positive
cash flow from operating activities in the ordinary and usual course of business (before
changes in working capital and taxes paid) of at least HK$20 million in total for the 2
financial years immediately before the issue of the listing document. (A shorter period
may be acceptable in the circumstances specified in GLR 11.14.)
(b) The applicant must have been under substantially the same management throughout the
2 full financial years immediately before the issue of the listing document and up until
the date of listing.
(c) Shorter periods of trading records, ownership and control, and management continuity
may be acceptable in respect of newly-formed project companies (such as a major
infrastructure project), natural resource exploitation companies, and in exceptional other
circumstances. However, the cash flow requirement of HK$20 million must still be met.
(d) The expected total market capitalisation at the time of listing must be at least HK$100
million.
(e) The equity securities in the hands of the public at the time of listing should be held among
at least 100 persons.

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4 Trading mechanism and rules
Automatic order matching and execution system
4.1 The trading rules discussed in this part of the study manual apply to on-exchange and not off-
exchange transactions.
4.2 Trading of securities on the SEHK is almost entirely conducted through AMS/3.
4.3 Auto matching is the core trading method in AMS/3, which is an order-driven system. In an
order-driven market, a buyer and a seller of shares each has an Exchange Participant acting
on their behalf. All transactions are concluded by automatic order matching, except the
following:
(a) transactions concluded by using the operation specified for odd-lot transactions;
(b) direct business transactions (cross trades);
(c) isolated trades entered into for the purpose of effecting a buy-in;
(d) orders exceeding the maximum order size limit; and
(e) transactions concluded outside AMS/3.
4.4 The system consists of 3 components:
(a) Trading terminal:
ET Trade Speed Stations (ETTSS) are the terminals, either installed in the SEHK
trading hall or in the offices of Exchange Participants.
(b) New Securities Trading Device (NSTD):
NSTD is a multi-workstations front-end trading device developed by an independent
software vendor. It is compatible to SEHKs core platforms, the Orion Market Data
(OMD-C) and Orion Central Gateway (OCG) and is offered to Exchange
Participants at standard terms and conditions under the brand name ET Trade Speed
Station.
(c) Broker-supplied system (BSS):
A BSS is a system developed by an Exchange Participant which allows trading
applications tailored to its needs. Every BSS must follow the open gateway specification
for BSSs set out by the SEHK.
4.5 An Exchange Participant may choose between using BSS or using ETTSS to connect to
AMS/3 through the OCG.

Trading mechanism
Trading sessions

Pre-opening Session
4.6 The maximum order size for automatch stocks is 3,000 board lots. There is no maximum
number of outstanding orders per broker ID, while the number of orders in each price queue
is 20,000. Orders are accumulated over a certain period of time and matched at a pre-defined
order matching period. Orders are matched in order type, price and time priority (at-auction
orders carry a higher matching priority), at the final Indicative Equilibrium Price (IEP).

Continuous Trading Session


4.7 The maximum order size for automatch stocks is 3,000 board lots. There is no maximum
number of outstanding orders per broker ID and the number of orders in each price queue is
20,000. Orders are continuously executed in strict price and time priority. An order entered
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into the system at an earlier time must be executed in full before an order at the same price
entered at a later time is executed.

Closing auction session


4.8 The closing auction session (CAS) is a session during which market participants interested
in trading at the closing price may input buy and sell orders. Then their orders interact with
each other to form a consensus closing price for each security and orders are executed at that
price.
4.9 The CAS is planned to be implemented by two phases. Phase 1 covers all the Hang Seng
Composite LargCap and MidCap Index constituent stocks, the H-shares which have
corresponding A shares listed in the exchanges in Mainland China and all ETFs. Phase 2 will
include all equity securities and funds not included in Phase 1. However, structured products
(i.e. derivative warrants and callable bull/bear contracts), equity warrants and debt securities
will still be excluded.
4.10 A reference price is determined by reference to several nominal prices during the continuous
trading session (CTS) of a trading day or the previous closing price (if there is no nominal
price). An order input during the CAS should not be with a price deviated more than 5% from
the said reference price.
4.11 Short selling is not implemented in Phase 1 and planned to be allowed in Phase 2 with
limitation.

Volatility control mechanism


4.12 Volatility control mechanism (VCM) refers to a mechanism that if the market tries to trade
any one of the prescribed stocks/contracts (see below) at a price of more than 10%/5% away
from its last traded price five minutes ago, there will be a five-minute cooling-off period on
the particular instrument. The instrument is still allowed for trading during the cooling-off
period but within certain price limits. Normal continuous trading will resume when the five-
minute cooling-off period ends and the instrument cannot be subject to the VCM again in the
same trading session. There is maximum one trigger per CTS and no VCM monitoring after
one trigger in each CTS.
4.13 In the securities market, the VCM is applicable to Hang Seng Index and Hang Seng China
Enterprises Index constituent stocks (currently there are 81 such stocks).
4.14 In the derivatives market, the VCM covers spot and next calendar month index futures
contracts with Hang Seng Index or Hang Seng China Enterprises Index as their underlying
index (currently eight futures contracts).
4.15 The VCM applies in CTS excluding first 15 minutes of morning and afternoon CTS and last
15 minutes of the afternoon CTS of the day. It does not applies in auction sessions which
include pre-opening session and CAS.

Order types

Pre-opening Session
4.16 AMS/3 only accepts at-auction and at-auction limit orders during the Pre-opening Session as
long as the order price input into AMS/3 does not deviate 9 times or more from the previous
closing price or the nominal price (as the case may be), if available.

At-auction order
4.17 An at-auction order is an order with no specified price and is entered into AMS/3 for execution
at the final IEP. It enjoys a higher order matching priority than an at-auction limit order and
will be matched in time priority at the final IEP. Any outstanding at-auction orders after the
end of the Pre-opening Session will be cancelled before the CTS starts.

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At-auction limit order
4.18 An at-auction limit order is an order with a specified price. Such an order with the specified
price at or more competitive than the final IEP (in the case of buying, the specified price is
equal to or higher than the final IEP, or in the case of selling it is equal to or lower than the
final IEP) may be matched at the final IEP subject to availability of eligible matching order(s)
on the opposite side. An at-auction limit order will be matched in price and time priority at the
final IEP. No such order will be matched at a price worse than the final IEP. Any outstanding
at-auction limit orders at the end of the Pre-opening Session will be carried forward to the
CTS and treated as limit orders provided that their specified price does not deviate 9 times or
more from the nominal price. Such orders will be put in the price queue of the input price.

CTS
4.19 AMS/3 only accepts limit, enhanced limit and special limit orders (with an option for an all-
or-nothing qualifier that confines the order to be either executed immediately in full or
rejected without being written into the central order book) during the CTS, as long as the order
price input into AMS/3 does not deviate 9 times or more from the nominal price, if available,
and follows the quotation rules (unless the restriction is waived).

Limit order
4.20 A limit order will allow matching only at the specified price. The sell order input price cannot
be made at a price below the best bid price, if available, whereas the buy order input cannot
be made at a price above the best ask price, if available. Any outstanding limit order will be
put in the price queue of the input price.

Enhanced limit order


4.21 An enhanced limit order will allow matching of up to 10 price queues (i.e. the best price queue
and up to the 10th queue at 9 spreads away) at a time provided that the traded price is not worse
than the input price. The sell order input price cannot be made at a price of 10 spreads (or
more) below the current bid price, whereas the buy order input price cannot be made at a price
of 10 spreads (or more) above the current ask price. Any outstanding enhanced limit order will
be treated as a limit order and put in the price queue of the input price.

Special limit order


4.22 A special limit order will allow matching of up to 10 price queues (i.e. the best price queue
and up to the 10th queue at 9 spreads away) at a time provided that the traded price is not worse
than the input price. A special limit order has no restriction on the input price as long as the
order input price is at or below the best bid price for a sell order or at or above the best ask
price for a buy order. Any outstanding special limit order will be cancelled and will not be
stored in AMS/3.

Quotation rules
4.23 The first bid or ask order entered into AMS/3 on each trading day is governed by the opening
quotation rule. The first bid order must be higher than or equal to the previous closing price
minus 24 spreads. The first ask order must be lower than or equal to the previous closing price
plus 24 spreads. The first order, whether it is a bid or ask, must not in any case deviate 9 times
or more from the previous closing price. Quotations for buy and sell orders other than the
opening quotations are governed by a different set of quotation rules and scale of spreads. In
particular, a buy or sell order cannot be made at a price that deviates 9 times or more from the
nominal price. However, quotation rules in general do not apply to at-auction limit orders,
except that a buy or sell at-auction limit order cannot be made at a price that deviates 9 times
or more from the nominal price.
4.24 The spread of a security depends on its share price:

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Price range (HK$) Spread (HK$)
For all securities other than those
specified by the SEHK and debt
securities:
0.01 - 0.25 0.001
>0.25 - 0.50 0.005
>0.50 - 10.00 0.010
>10.00 - 20.00 0.020
>20.00 - 100.00 0.050
>100.00 - 200.00 0.100
>200.00 - 500.00 0.200
>500.00 - 1,000.00 0.500
>1,000.00 - 2,000.00 1.000
>2,000.00 - 5,000.00 2.000
>5,000.00 - 9,995.00 5.000
Securities which are specified by the
SEHK and all debt securities:
0.50 - 9,999.95 0.050

4.25 The purpose of the quotation rules is to ensure that there is no sudden dramatic fluctuation in
the share price, for the maintenance of orderly trading in the market.

Direct business (crossing of trades) rules


4.26 Direct business means business transacted by an Exchange Participant who acts for both the
buyer and the seller, whether as principal or agent. The following sections review general rules
for direct business.
4.27 Every Exchange Participant conducting direct business transactions within the Pre-opening
Session, the trading hours and the CAS should input details of such transactions into the system
within the following time limits:
(a) immediately and in any case within 1 minute of the conclusion of direct business
transactions that are executed through an automated trading service provided by an
Exchange Participant; and
(b) 15 minutes after the conclusion of all other direct business transactions.
4.28 Direct business transactions conducted outside the Pre-opening Session, the trading hours and
the CAS must be reported within the first 15 minutes of trading at the next session.
4.29 Direct business transactions, once recorded by the system, cannot be cancelled by the
participant concerned.
4.30 The price of every direct business transaction must be within the range of:
(a) the lowest of 24 spreads below the previous closing price, the lowest bid and the lowest
ask price up to the time of the transaction on the day; and
(b) the highest of 24 spreads above the previous closing price, the highest bid and the highest
ask price up to the time of the transaction on the day.
4.31 The primary intention of the rules is the prompt and accurate reporting of direct business
transactions to ensure market transparency. Up-to-date information on the current trading
activity is necessary so that the SEHK can be aware of any unusual activity and, perhaps,
improper trading.

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5 Trading halt, suspension, cancellation and withdrawal of
listing
The SEHKs power to direct a trading halt or suspend dealings
5.1 Listing is always granted subject to the condition that the SEHK may, where it considers
necessary for the protection of the investor or maintenance of an orderly market, at any time
direct a trading halt (see Note below) or suspend dealings in any securities, whether or not
requested by the issuer.
Note: Trading halt means an interruption of trading in an issuers securities requested or
directed pending disclosure of information under the Main Board Listing Rules and
extending for no more than two trading days.
5.2 The SEHK may also direct a trading halt or suspend dealings where:
(a) an issuer fails to comply with the Listing Rules in a material respect;
(b) it considers that there are insufficient shares in the hands of the public;
(c) it considers that the issuer does not have a sufficient level of operations or sufficient assets
to warrant a continued listing; or
(d) it considers that the issuer is no longer suitable for listing.

Trading halt or suspension requested by the issuer


5.3 The issuer may also request the SEHK for a trading halt or suspension of trading in the issuers
securities, and such requests must be supported by specific reasons. In considering suspension,
the SEHK will have regard to its obligation to maintain an orderly and fair market for the
trading of all listed securities, and that listed securities should be continuously traded save in
exceptional circumstances.
5.4 In the interests of a fair and continuous market, the SEHK requires any trading halt or
suspension to be kept as short as possible.

The Securities and Futures Commissions power to suspend


dealings
5.5 It should also be noted that the SFC has the power to direct the SEHK to suspend dealings in
any securities under certain circumstances specified by the Securities and Futures (Stock
Market Listing) Rules.

Cancellation or withdrawal of listing


Continuing eligibility and cancellation of listing
5.6 An issuer must carry out a sufficient level of operations or have tangible assets of sufficient
value and/or intangible assets for which a sufficient potential value can be demonstrated to
warrant the continued listing of the issuers securities on the SEHK. An issuers listing may
also be cancelled if it fails to:
(a) take adequate action to restore its listing which has been suspended for a prolonged period;
or
(b) rectify matters, identified and notified by the SEHK as rendering the issuer unsuitable for
listing, within the specified period of time.

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Withdrawal of listing
5.7 In general, an issuer may not voluntarily withdraw its listing unless it has met the required
shareholders approval requirements set out in the Listing Rules. The requirements for
shareholders approval are more onerous for issuers which do not have an alternative listing
on another regulated, regularly operating, open stock exchange recognized for this purpose by
the SEHK.

Rules on dealing in suspended securities


5.8 Under the Rules of the Exchange, an Exchange Participant must not deal in suspended
securities except for the following dealings:
(a) where the suspension is due to the fact that the percentage of the securities held by the
public at all times has fallen below the prescribed minimum percentage as specified in
the relevant Listing Rules. Dealings in such suspended securities for the purpose of
facilitating the restoration of the prescribed minimum percentage must be reported to the
SEHK;
(b) the return of borrowed securities in which trading is suspended (without creating a new
securities borrowing position), or making payment in lieu of such return;
(c) where trading in a market-making security is suspended:
(i) the borrowing of shares of such security; or
(ii) the placing of an order for the creation of shares of such security in accordance with
the terms for the creation required by the issuer of shares of such market-maker
security
for the purpose of completing a market-maker short selling transaction concluded before
the suspension; and
(d) where trading in the securities is temporarily suspended for a period for the sole purpose
of the following activities:
(i) placing of such securities by or on behalf of the issuer of such securities under the
relevant Listing Rules or by an existing shareholder of such issuer; and
(ii) offer for subscription, offer for sale, rights issue and open offer of such
securities under the relevant Listing Rules.
5.9 Where dealing in a security has been suspended, the selling participant is required to report
any transactions that have been concluded before the suspension but not yet input into the
AMS/3. The report must be made within 15 minutes of the suspension by the selling
participant.

Revision question:

Question 2: Under what circumstances may the SEHK direct a trading halt or suspend dealings
in a particular stock?
Answer 2: The SEHK may direct a trading halt or suspend dealings of a particular stock where:
an issuer fails to comply with the Listing Rules in a material respect;
it considers that there are insufficient shares in the hands of the public;
it considers that the issuer does not have a sufficient level of operation or
sufficient assets to warrant a continued listing; or
it considers that the issuer is no longer suitable for listing.

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6 Clearing and settlement services
Central Clearing and Settlement System
6.1 HKSCC owns and operates CCASS and CCASS Depository for all eligible securities (see
section 6.6 below) traded on the SEHK. CCASS Depository means one or more securities
depositories for CCASS, providing safe-keeping facilities for eligible securities held in
CCASS as well as to cater for withdrawals and deposits of eligible securities by CCASS
participants. HKSCCs wholly-owned subsidiary, HKSCC Nominees Limited, acts as the
nominee for shares held in CCASS Depository.
6.2 HKSCC provides securities clearing and settlement services, money settlement services,
depository services, nominee services and electronic securities application services etc..
CCASS, a computerised book-entry clearing and settlement system for transactions in
securities traded on the SEHK, was first implemented in June 1992. It reduces scrip circulation
by immobilisation of share certificates delivered by participants to the depository. Settlement
is electronically recorded as increases or decreases in the stock account balances of participant,
without the physical movement of share certificates.
6.3 There are various categories of participants in CCASS, including Direct Clearing Participants
(DCPs), General Clearing Participants (GCPs) (collectively referred to as CCASS
Clearing Participants hereafter), Clearing Agency Participants, Custodian Participants, Stock
Lender Participants, Stock Pledgee Participants and Investor Participants (see section 6.22
below).

Direct Clearing Participantship


6.4 A DCP can only clear its own trades. An applicant for a Direct Clearing Participantship must:
(a) be an Exchange Participant;
(b) be a licensed corporation for Type 1 RA;
(c) undertake to sign a participant agreement, pay admission fees and contributions to the
guarantee fund and arrange indemnity insurance;
(d) provide, if required, assurances on the performance of its obligations, including liabilities
for defective securities deposited by it with the HKSCC; and
(e) obtain the agreement of its designated bank to comply with the requirement of HKSCC
for CCASS money settlement purposes.

General Clearing Participantship


6.5 A GCP can clear its own trades and provide third party clearing services to other Exchange
Participants which are not CCASS Clearing Participants. An applicant for a General Clearing
Participantship must:
(a) be a licensed corporation or registered institution for Type 1 RA;
(b) (in the case of a licensed corporation) be a limited company incorporated in Hong Kong,
have a minimum liquid capital of HK$300,000,000 or its required liquid capital under
the FRR, whichever is higher; or have paid-up share capital of not less than
HK$300,000,000 and liquid capital of not less than HK$100,000,000, or its required
liquid capital under the FRR, whichever is higher;
(c) (in the case of a registered institution) have a minimum credit rating of A3 or equivalent
or be a Hong Kong dollar note-issuing bank;
(d) demonstrate that it has the operational and financial capability to satisfy the requirements
of CCASS and to establish and operate a clearing business in securities; and
(e) undertake, if its application is successful, to:
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(i) sign a participant agreement;
(ii) pay admission fees and contributions to the guarantee fund;
(iii) arrange indemnity insurance;
(iv) provide, if required, assurance on the performance of its obligations, including
liabilities for defective securities deposited by it with HKSCC; and
(v) obtain the agreement of its designated bank to comply with the requirement of
HKSCC for CCASS money settlement purposes.

Clearing services
6.6 An eligible security means an issue of securities which is accepted by HKSCC as eligible for
deposit, clearing and settlement in CCASS.
6.7 CCASS clearing services determine the stock and money obligations of a CCASS Clearing
Participant trading on the SEHK.
6.8 On each trading day, trade data is automatically relayed from the SEHK trading system to
CCASS. There is no need for CCASS Clearing Participants to input or further confirm their
trade details in CCASS. They receive Provisional Clearing Statements of their stock and
money positions through their CCASS terminals shortly after 5:00pm (for the current days
SEHK trades) and 8:00pm (for the current days SEHK trades and exercised options trades)
on each trade day (T) for reconciliation with their internal records. Final Clearing
Statements are available to CCASS Clearing Participants shortly after 2:00pm on T+1 for
confirmation of settlement.
6.9 The method for working out the stock and money positions of a CCASS Clearing Participant
is called the Continuous Net Settlement (CNS) system, whereby its stock transactions in the
same security on the same day are offset against each other, resulting in a single net stock
position for the day. Through the legal process of novation, HKSCC guarantees settlement by
acting as the settlement counterparty to CCASS Clearing Participants and assuming the
settlement risk.

Settlement services
6.10 Settlement is recorded as follows:
(a) securities are credited or debited to CCASS Clearing Participants CCASS stock accounts
(securities settlement); and
(b) funds are recorded in the CCASS Clearing Participants money accounts (money
settlement).
6.11 CCASS stock accounts are separately distinguished in the CCASS, e.g. the No. 01 account is
the clearing account where a CCASS Clearing Participant maintains stocks for settlement, the
No. 02 account is meant for the handling of stock dividends, and Accounts 03 onwards are
designated accounts which may be used to hold safe custody stocks, house investments and
securities collateral. The Stock Collateral Control Account of a CCASS Clearing Participant
will have assigned to it the account number 20. The assigned account numbers of Stock
Segregated Accounts with Statement Service are from No. 21 onwards.
6.12 Safe custody securities must generally be transferred out of the No. 01 account to a designated
account within one day, unless they are required for settlement purposes.

Securities settlement SEHK trades


6.13 Almost all SEHK trades are settled on T+2 by electronic debit and credit entries to CCASS
Clearing Participants stock accounts.

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6.14 If a CCASS Clearing Participant does not have sufficient stock in its CCASS stock account to
settle its stock position by the end of T+2, HKSCC will execute a compulsory buy-in on T+3
to purchase the shares needed to close out the CCASS Clearing Participants outstanding short
position. The short CCASS Clearing Participant will be responsible for the cost of the shares
purchased and will be subject to a default fee.
6.15 However, HKSCC may grant an exemption from a buy-in if the CCASS Clearing Participant
is able to provide HKSCC with satisfactory evidence that grounds for exemption exist. The
following are some examples of such grounds:
(a) the CCASS Clearing Participant has deposited stock into the CCASS Depository, which
is unable to process the stock deposit prior to the final settlement run;
(b) there are defects in the relevant instruments of transfer (such as the use of outdated
instruments of transfer, the transferors signature not being in the correct place etc.)
provided that there is prima facie evidence that the transferor has signed on the instrument
of transfer;
(c) the securities are not credited to the clearing account of the CCASS Clearing Participant
for reasons beyond the control of the CCASS Clearing Participant such as typhoon,
black rainstorm, computer or electronic system failures etc.;
(d) where stock has been oversold because of a clerical or calculation error, and the CCASS
Clearing Participant has already bought back the oversold securities on T+1 and its
delivery obligation will be fully settled on T+3; and
(e) in respect of units or securities to be received from creation or redemption of units, the
CCASS Clearing Participant has an unconditional entitlement to receive sufficient units
or securities to cover the relevant short position on T+2.

Money settlement SEHK trades


6.16 The SEHK trades which are settled on T+2 through the CNS system are settled on a Delivery
Versus Payment basis, i.e. money settlement will only be effected after settlement of stock
positions in CCASS. Generally, money settlement by CCASS Clearing Participants through
their designated banks is confirmed at day end after the stocks have been delivered to them,
i.e. T+2. Securities for which payment has not been confirmed are put on hold and CCASS
Clearing Participants are not allowed to use or withdraw them. However, a CCASS Clearing
Participant can make a cash prepayment to HKSCC to make immediate use of the securities.
6.17 Each CCASS Clearing Participant must open an account at a bank approved by HKSCC, and
authorise HKSCC to debit or credit its account there. For settlement of transactions on a
Delivery Versus Payment basis, the money positions of a CCASS Clearing Participant on
settlement day for stocks traded will be set off against each other, and the net sum due from
or to the CCASS Clearing Participant will be settled by HKSCC issuing an instruction to the
CCASS Clearing Participants bank on settlement day. For cash prepayment on T+2, a CCASS
Clearing Participant may either input an instruction via a CCASS terminal or maintain a
standing instruction to authorise HKSCC to generate recurring Cash Prepayment Instructions
on behalf of the CCASS Clearing Participant on each settlement day.

Settlement isolated trades


6.18 An isolated trade is a trade which is designated by two counterparty Exchange Participants to
be settled under the Isolated Trades System (instead of the CNS system) or a trade which is
not accepted by HKSCC for settlement under the CNS system for risk management or other
reasons. Settlement of isolated trades is effected directly between the counterparty CCASS
Clearing Participants on a trade-for-trade basis.
6.19 HKSCC is not responsible for any default by CCASS Clearing Participants in respect of any
isolated trade. A CCASS Clearing Participant will itself have to pursue its counterparty

Paper 2 Version 2.4 4 - 20 Hong Kong Securities and Investment Institute


CCASS Clearing Participant in default. Money settlement can be made on a Free Of Payment
basis.

Settlement instructions
6.20 For transactions between CCASS participants (other than Investor Participants) to be settled
in CCASS other than SEHK trades, or isolated trades or investor settlement instruction (ISI)
transactions (see sections 6.22 and 6.23 below), each of the two CCASS participants must
input a settlement instruction (SI) into CCASS (containing the relevant details required by
HKSCC). SIs facilitate broker/custodian transactions, stock borrowing/lending transactions,
stock pledging transactions and portfolio movements. Settlement of SI transactions is
conducted on a trade-for-trade basis directly between the participants concerned.
6.21 The two counterparties are able to match their instructions through HKSCC facilities. These
may be against payment or free of payment, and may specify a future delivery date. On the
due date, HKSCC will deliver stock (and the money in case of against payment) in
accordance with the SI input and as authorised by each party.

Investor account with HKSCC


6.22 HKSCCs Investor Account Service allows individual and corporate investors to open direct
stock accounts in CCASS and become Investor Participants. Such an account is a depository
account for safekeeping of investors stocks that gives them legal protection and control over
their shareholdings.

Investor settlement instruction


6.23 ISIs facilitate transactions between CCASS Investor Participants and CCASS participants
other than Investor Participants. To move stock out of a direct account opened with HKSCC
by an investor as mentioned above, the investor may instruct the relevant CCASS participant
to enter an ISI. The investor then confirms the ISI through the CCASS phone system, the
CCASS Internet system, or in person by submitting a completed form.

Investor Stock Segregated Account


6.24 HKSCC also provides a Stock Segregated Account with Statement Service, which is a type of
CCASS stock segregated account of a CCASS Clearing Participant or Custodian Participant
that authorises HKSCC to furnish activity and/or monthly statements to an investor named by
it, and allow such investor to use the services available to the account.

Risk management
Marks
6.25 As settlement counterparty to CCASS Clearing Participants under the CNS system, HKSCC
is exposed to market risks as a result of unfavourable price fluctuations in respect of the
unsettled stock positions of CCASS Clearing Participants under the CNS system.
6.26 To monitor and control such risk exposure, HKSCC will mark-to-market the unsettled stock
positions of CCASS Clearing Participants under the CNS system and collect marks from
CCASS Clearing Participants. Mark-to-market involves the evaluation of HKSCCs risk
exposure of a CCASS Clearing Participant to HKSCC relating to the unsettled stock position
under the CNS system by reference to the extent to which the mark-to-market value of the
unsettled stock position has moved against its original value.
6.27 Marks will normally be collected in the form of cash. However, HKSCC may, in exceptional
cases, accept collateral securities provided by CCASS Clearing Participants as collateral for
marks obligations.
6.28 HKSCC has the right to collect marks from CCASS Clearing Participants for all unsettled
stock positions under the CNS system, whether or not due for settlement.
Paper 2 Version 2.4 4 - 21 Hong Kong Securities and Investment Institute
Margin

General
6.29 HKSCC is entitled from time to time (and at any time) to compute margin on all unsettled
stock positions (whether or not due for settlement) using the formula set forth in the
Operational Procedures of HKSCC in relation to CCASS or other appropriate methods and
assumptions as determined by HKSCC. Margin will be computed with reference to the
margining position of a CCASS Clearing Participant or Clearing Agency Participant (see Note
below) unless HKSCC specifies otherwise. Such margining positions will be determined by
HKSCC in accordance with the CCASS Operational Procedures.
Note: Clearing Agency Participant means one of the categories of participants admitted
to participate in CCASS as a Clearing Agency Participant. To become a Clearing
Agency Participant, an applicant must demonstrate that it has an established business
in operating a central securities clearing and settlement system and/or a central
securities depository.
6.30 Margin will normally be collected in the form of cash. However, HKSCC may, in exceptional
cases, accept collateral securities provided by CCASS Clearing Participants.

Intra-day margin
6.31 In addition to day-end margin collected from CCASS Clearing Participants on a daily basis,
HKSCC can also call for intra-day margin on unsettled stock positions from CCASS Clearing
Participants under any of the following circumstances:
(a) if sudden fluctuations of the securities market are apparent in HKSCCs review;
(b) where some other major markets remain open when the securities market operated by
the SEHK is closed on public holidays; or
(c) when HKSCC considers it appropriate under any other circumstances.

Collateral
6.32 HKSCC monitors its risk exposure to CCASS Clearing Participants on a continuous basis.
HKSCC may need to take additional risk management measures against a particular CCASS
Clearing Participant. For example, a CCASS Clearing Participants financial well-being may
be in question or its trading pattern may in HKSCCs view create excessive risks. In
appropriate cases, HKSCC will require a CCASS Clearing Participant to provide it with
collateral.
6.33 HKSCC may collect collateral based on HKSCCs assessment of its exposure on the risks
arising out of market contracts (see Note below) and defects in the securities of a CCASS
Clearing Participant. Normally, HKSCC will require CCASS Clearing Participants to provide
collateral in the form of cash or collateral securities, subject to the General Rules of CCASS
(including the CCASS Operational Procedures). The amount of collateral required to be
provided by a CCASS Clearing Participant will be decided by HKSCC, taking into account
HKSCCs exposure to it.
Note: A market contract is a contract between HKSCC and a CCASS Clearing Participant
arising as a result of novation.

Securities-on-hold
6.34 Since, under the current design of the CCASS money settlement process, payment by CCASS
Clearing Participants to HKSCC via their designated banks (as part of the CCASS money
settlement process) will only be confirmed good and irrevocable at day end after the securities
have been delivered to CCASS Clearing Participants under the CNS system in CCASS,
HKSCC faces significant risk exposure from the time of delivery of the securities in CCASS

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to the time when confirmation of good and irrevocable payment is issued by the designated
banks of CCASS Clearing Participants and the receiving bank of HKSCC.
6.35 To guard against this risk exposure, the General Rules of CCASS (including the CCASS
Operational Procedures) provide that HKSCC must be satisfied that:
(a) it has received payment in full for securities delivered by HKSCC to a CCASS Clearing
Participant under the CNS system on a settlement day; and
(b) such payment is good and irrevocable, or unless otherwise agreed by HKSCC, title and
property in such securities will not pass to the CCASS Clearing Participant.
Until then, CCASS Clearing Participants will not be allowed to use or withdraw some or all
of such securities, except as permitted by HKSCC.
6.36 CCASS Clearing Participants who wish to utilise any or all of the securities-on-hold covering
their outstanding payment obligations may pay same-day available funds to HKSCC to reduce
their monetary obligations and the equivalent discounted market value of the securities-on-
hold will then be released.

Evidence of securities available for settlement


6.37 For SEHK trades in securities which are subject to expiry (e.g. warrants) or which HKSCC
considers as high-risk securities and which are to be settled under the CNS system, the
delivering CCASS Clearing Participants must ensure that when such selling orders are placed
they have evidence readily available to show that, on or before the due date for settlement of
the market contracts, they have or will have the required quantity of securities in their stock
accounts in CCASS for settlement of the market contracts. The delivering CCASS Clearing
Participants must provide the evidence to HKSCC upon request.

Closing-out
6.38 If a CCASS Clearing Participant defaults, HKSCC may close out any or all unsettled
obligations of that CCASS Clearing Participant under the CNS system (whether or not they
are due for settlement).
6.39 The two main purposes of closing-out are:
(a) to enable HKSCC to crystallise its exposure to a CCASS Clearing Participant in default;
and
(b) to enable HKSCC to meet its obligations under the CNS system to other CCASS Clearing
Participants.
The end result of closing out all unsettled positions of a CCASS Clearing Participant under
the CNS system is that all obligations to deliver or receive securities will be replaced by sums
payable, and a net sum will become payable by or to the defaulting CCASS Clearing
Participant.

Clearing and settlement of OTC derivatives transactions


6.40 OTC Clear is established by HKEX and designated as a CCP for the purpose of providing
clearing and settlement services for OTC derivatives transactions.
6.41 OTC Clear has developed and implemented the clearing platform, OTC Clearing and
Settlement System (OCASS), to support the OTC clearing services. OCASS is an integrated
system which processes the trade novation and registration, valuation, collateral and margin
calculation, trade event management, market data storage and also the user interface for day-
to-day operation and reporting. OCASS has established interfaces with 3 Approved Trade
Registration Systems (ATRS), namely MarkitWire, DSMatch and HKTR-MC, to capture
OTC derivatives transactions. Clearing members can submit their trades for matching and
confirmation through any of the three ATRS. Once matched, trade data will be transmitted
directly to OCASS. Before OTC Clear accepts any trades for clearing a validation will be
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performed to ensure that the submitted trade satisfies all the product eligibility requirements
and sufficient collateral has been deposited with OTC Clear by the clearing member.
6.42 For those trades which are accepted for novation and recorded in OCASS, OTC Clear acts as
the CCP to both clearing members. The original trade between the clearing members is
substituted by two separate trades facing CCP.
6.43 For more detailed information about clearing and settlement of Hong Kong OTC derivatives
transactions, candidates may refer to web-site of HKEX (www.hkex.com.hk).

Revision questions:

Question 3: Describe the clearing and settlement functions of the CCASS.


Answer 3: On each trading day, trade data is automatically relayed from the SEHK trading
system to CCASS. There is no need for CCASS Clearing Participants to input or
further confirm their trade details in CCASS. The method for working out the stock
and money positions of a CCASS Clearing Participant is called the CNS system,
whereby its stock transactions in the same security on the same day are offset against
each other, resulting in a single net stock position for the day. Through the legal
process of novation, HKSCC guarantees settlement by acting as the settlement
counterparty to CCASS Clearing Participants and assuming the settlement risk.
Question 4: What is the settlement period for SEHK trades?
Answer 4: Almost all SEHK trades are settled on T+2 by electronic debit and credit entries to
CCASS Clearing Participants stock accounts.
Question 5: How is money settled for SEHK trades?
Answer 5: The SEHK trades which are settled on T+2 through the CNS system are settled on
a Delivery Versus Payment basis, i.e. money settlement will only be effected after
settlement of stock positions in CCASS. Money settlement of isolated trades can be
made on a Free Of Payment basis.

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7 The SEHK disciplinary procedures
7.1 Under Chapter 7, Rules of the Exchange, the SEHK has certain disciplinary powers that it can
enforce against an Exchange Participant for breaches of business conduct. An Exchange
Participant is held responsible for the acts of its responsible officers, directors, partners,
authorized persons, representatives, officers and employees. Disciplinary actions include
warning letters, fines and suspension of exchange participantship.
7.2 The front-line regulator of intermediaries, including Exchange Participants, is the SFC. The
SFC is responsible for all disciplinary matters relating to breaches of the SFO, the statutory
rules, regulations and codes of conduct. The SEHKs responsibility is limited to disciplinary
matters other than those within the purview of the SFC. Specifically, it is responsible for
disciplining trading, clearing and settlement offences and breaches of the Listing Rules.

Situations calling for disciplinary action


7.3 Here below are some situations where the board and the Chief Executive of the SEHK may
exercise their disciplinary powers against an Exchange Participant (for more details of the
situations calling for disciplinary action, please refer to Rule 723, Rules of the Exchange). If
an Exchange Participant:
(a) is or has been in breach of the Rules of the Exchange, as well as the statutory provisions
in the SFO and subsidiary legislation;
(b) fails to report promptly to the SFC and the SEHK any inability to comply with FRR
and/or financial requirements under the Rules of the Exchange;
(c) fails to carry out its legal obligations relating to securities;
(d) has been charged with or convicted of a criminal offence necessarily involving a finding of
fraud or dishonesty;
(e) is under investigation by the SFC where an auditor is appointed to investigate its affairs;
or
(f) is guilty of misconduct as defined in s. 193, SFO.

Disciplinary powers
7.4 The board of the SEHK has disciplinary powers and some of them are listed below (for more
details of these powers, please refer to Rule 702, Rules of the Exchange):
(a) to expel an Exchange Participant;
(b) to request an Exchange Participant to resign;
(c) to suspend an Exchange Participant from participantship;
(d) to impose a fine on an Exchange Participant;
(e) to censure an Exchange Participant;
(f) to suspend or revoke the registration of a responsible officer of an Exchange Participant;
or
(g) to suspend, withdraw or revoke an Exchange Participants right of access to the trading
system of the SEHK.

Disciplinary proceedings
7.5 The disciplinary proceedings are summarised below:
(a) The board of the SEHK may convene a meeting at any time to consider exercising its
disciplinary powers against an Exchange Participant. If the board is satisfied at the

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meeting that a prima facie case exists to call for such action against the Exchange
Participant, it will request the Exchange Participant to attend a meeting to explain its
conduct in the matter.
(b) The board of the SEHK may exercise any of its disciplinary powers against an Exchange
Participant if, at such meeting or any adjournment thereof, it is of the opinion, after
considering any explanation tendered by the Exchange Participant, that the case against
the Exchange Participant is substantiated. The board of the SEHK is also entitled to
exercise any of its disciplinary powers against the Exchange Participant concerned should
it fail to attend the hearing called for by the board.
(c) The board of the SEHK is under a duty to keep the SFC informed of any disciplinary
action against an Exchange Participant.
(d) The board of the SEHK has the power to suspend the Exchange Participant from trading
during the process. An Exchange Participant which is suspended shall not be entitled to deal
in securities or trade on or through the SEHK under any Stock Exchange trading right.
(e) If the disciplinary measure is taken by the Chief Executive of the SEHK, the Exchange
Participant has the right to appeal to the Disciplinary Committee within 14 days of
notification of the Chief Executives decision. The Disciplinary Committee shall deal with
and decide on the appeal in the same manner as if it were considering the exercise of its
disciplinary powers afresh.
(f) If an Exchange Participant is suspended from trading, it is under a duty to instruct and
appoint another Exchange Participant to carry out any instructions already received by it on
behalf of its clients prior to suspension and must immediately notify the SEHK in writing of
such appointment.
(g) If an Exchange Participant is expelled from the SEHK, it loses all rights to trade on the
SEHK.

Revision question:

Question 6: Who regulates the business conduct of Exchange Participants?


Answer 6: The front-line regulator of intermediaries, including Exchange Participants, is the
SFC which is responsible for all disciplinary matters relating to breaches of the SFO,
the statutory rules, regulations and codes of conduct. The SEHKs responsibility is
limited to disciplinary matters other than those within the purview of the SFC.
Specifically, it is responsible for disciplining trading, clearing and settlement
offences and breaches of the Listing Rules.

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8 Transaction costs
8.1 The following are costs to an investor for buying or selling securities on the SEHK.

Brokerage (commission)
8.2 HKEX has abolished minimum commissions chargeable on transactions on the SEHK since
1 April 2003. The brokerage of initial public offering transactions is currently set at 1% of the
application money.

Transaction Levy and Investor Compensation Levy


8.3 The SEHK charges two levies on behalf of the SFC on the value of each purchase or sale of
securities as follows (both the buyer and seller paying each of the two levies):
(a) a Transaction Levy of 0.0027% (rounded to the nearest cent), which is passed on to the
SFC for use in funding its operations; and
(b) an Investor Compensation Levy of 0.002% (rounded to the nearest cent), which is used
for the Investor Compensation Fund established by the SFC. However, since 19
December 2005, the payment of Investor Compensation Levy has been suspended by the
SFC.
There is no Transaction Levy or Investor Compensation Levy on the Pilot Program and
Exchange Traded Funds (ETFs) market maker transactions.

Trading fee
8.4 A trading fee of 0.005% per side of the consideration of a transaction (rounded to the nearest
cent) is payable to the SEHK. There is no trading fee on Pilot Program and ETFs market maker
transactions.

Trading tariff
8.5 A trading tariff of HK$0.50 is payable to the SEHK on each and every purchase or sale
transaction.

Ad valorem stamp duty


8.6 An ad valorem stamp duty is levied on each transaction at the rate of 0.1% (rounded up to the
nearest dollar) on the value of the transaction, on both the buyer and the seller. There is no
stamp duty on ETFs, derivative warrants, callable bull/bear contracts and options trading.

Transfer deed stamp duty


8.7 Irrespective of the quantity of shares traded, the Government levies a transfer deed stamp duty
of HK$5, payable by the registered holder of the share certificate(s), i.e. the seller, on each
new transfer deed.

Transfer fee
8.8 Irrespective of the quantity of shares traded, the registrar of each listed company levies a
transfer fee of HK$2.5 per share certificate from the registered holder, i.e. the buyer, for each
new certificate issued.
8.9 No charges are levied by HKSCC on investors if they settle with brokers or custodians outside
the CCASS. However, brokers or custodians have to pay fees for use of the clearing,
settlement, custody and nominee services offered by HKSCC. The decision on whether to pass
these fees on to investors will be totally at the discretion of the brokers or custodians.

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Topic summary
This Topic began with an overview of the types of market participants relating to the business of
dealing in SEHK products.
Next, it reviewed participantship in the SEHK, the trading right concept and the qualification of an
Exchange Participant. There was a general description of products traded on the SEHK, and the
characteristics of companies listed on the Main Board and GEM were reviewed.
The trading mechanism, including AMS/3 and certain trading rules of the SEHK, was then discussed.
Other trading issues, such as trading halt and suspension of trading and rules relating to dealing in
suspended securities, were also studied.
This was followed by discussion of clearing and settlement. The relevant clearing house, HKSCC, its
system, CCASS and the settlement method, CNS, were discussed. Money settlement, SIs and risk
management etc. were also discussed.
An overview of the SEHK disciplinary procedures followed, and finally the costs of trading for
investors were reviewed.

Checklist
Below is a checklist of the main points covered by this Topic. Candidates should use this list to test
their knowledge.
Market participants dealing in SEHK products include: (a) Exchange Participants, which are
subject to the licensing requirements of the SFC as well as the SEHK admission requirements;
(b) market participants which are not Exchange Participants but are licensed by or registered
with the SFC to carry out the RA of dealing in securities; and (c) overseas market participants
(subject to their own countries regulations for dealing in securities) that do not have a physical
presence in Hong Kong and which deal in products traded on the SEHK through the above
market participants.
HKEX is a company listed on the SEHK and is an exchange controller as defined in the SFO. It
controls various exchanges and clearing houses in Hong Kong, including the SEHK, HKSCC
and SEOCH.
HKEX regulates listed companies, trading on the SEHK and the related clearing and settlement
functions. The regulation of intermediaries engaged in trading on the exchanges, and their
relationships with each other and their clients, are principally monitored by the SFC directly.
Those who wish to trade through the SEHK are required to hold trading rights and register with
the SEHK as Exchange Participants.
An Exchange Participant must hold an SEHK trading right, be a licensed corporation to carry on
Type 1 RA, be a corporation limited by shares and incorporated in Hong Kong, be of good
financial standing and integrity and comply with the FRR and the financial resources
requirements of the Rules of the Exchange.
Unless otherwise determined by the SEHK, all licensed representatives of an Exchange
Participant who have been approved by the SFC as responsible officers in relation to Type 1 RA
shall be registered with the SEHK as responsible officers. Each responsible officer shall
undertake to comply with all applicable rules, regulations, procedures and guidelines. At all
times, an Exchange Participant shall have at least one executive director registered with the
SEHK as a responsible officer.
The products traded on the SEHK include equity securities, securities traded under the pilot
programme, debt securities, unit trusts/mutual funds (including ETFs and REITs), structured
products (including equity warrants, derivative warrants, CBBC and ELIs) etc..

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The products listed on the SEHK are subject to the Listing Rules, on both an initial and an
ongoing basis.
Basic requirements for listing on the Main Board and GEM.
Trading of securities on the SEHK is almost entirely conducted through AMS/3.
Auto matching is the core trading method in AMS/3, which is an order-driven system.
Exchange Participants may choose their approach to trade with AMS/3 trading terminals,
whereby they use traditional data entry and screen-based enquiries to gain access to the market
or opt for the open gateway approach, by which access to the market is via MWS or BSS.
There are a number of order types, including at-auction and at-auction limit orders, which are
accepted during the Pre-opening Session; limit orders, enhanced limit orders and special limit
orders, which are accepted during the CTS.
The purpose of the quotation rules is to ensure that there is no sudden dramatic fluctuation in the
share price, for the maintenance of orderly trading in the market.
Direct business (cross-trades) means business transacted by an Exchange Participant who acts
for both the buyer and the seller, whether as principal or agent.
Listing is always granted subject to the condition that the SEHK may, where it considers
necessary for the protection of the investor or maintenance of an orderly market, at any time
direct a trading halt or suspend dealings in any securities, whether or not requested by the issuer.
An Exchange Participant must not deal in suspended securities except as set out in the Rules of
the Exchange.
HKSCC owns and operates CCASS and CCASS Depository for all eligible securities traded on
the SEHK.
In addition to securities clearing and settlement services, HKSCC provides money settlement
services, depository services, common nominee services, electronic securities application
services etc..
Through the legal process of novation, HKSCC guarantees settlement by acting as the settlement
counterparty to CCASS Clearing Participants and assuming the settlement risk.
For settlement of transactions on a Delivery Versus Payment basis, the money positions of a
CCASS Clearing Participant on settlement day for stocks traded will be set off against each other,
and the net sum due from or to the CCASS Clearing Participant will be settled by HKSCC issuing
an instruction to the CCASS Clearing Participants bank on settlement day.
HKSCCs Investor Account Service allows individual and corporate investors to open direct
stock accounts in CCASS and become Investor Participants. HKSCC also provides a Stock
Segregated Account with Statement Service, which is a type of CCASS stock segregated account
of a CCASS Clearing Participant or Custodian Participant that authorises HKSCC to furnish
activity and/or monthly statements to an investor named by it, and allow such an investor to use
the services available to the account.
As settlement counterparty to CCASS Clearing Participants under the CNS system, HKSCC is
exposed to market risks as a result of unfavourable price fluctuations in respect of the unsettled
stock positions of CCASS Clearing Participants under the CNS system.
To monitor and control such risk exposure, HKSCC will mark-to-market the unsettled stock
positions of CCASS Clearing Participants under the CNS system and collect marks from
CCASS Clearing Participants, normally in the form of cash. However, HKSCC may, in
exceptional cases, accept collateral securities provided by CCASS Clearing Participants as
collateral for marks obligations.

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HKSCC has the right to collect marks from CCASS Clearing Participants for all unsettled stock
positions under the CNS system, whether or not due for settlement.
HKSCC monitors its risk exposure to CCASS Clearing Participants on a continuous basis.
HKSCC may need to take additional risk management measures against a particular CCASS
Clearing Participant. For example, a CCASS Clearing Participants financial well-being may be
in question or its trading pattern may in HKSCCs view create excessive risks. In appropriate
cases, HKSCC will require a CCASS Clearing Participant to provide it with collateral.
If a CCASS Clearing Participant defaults, HKSCC may close out any or all unsettled obligations
of that CCASS Clearing Participant under the CNS system (whether or not due for settlement).
OTC Clear is a CCP established by HKEX for the purpose of providing clearing and settlement
services for OTC derivatives transactions.
OTC Clear has developed and implemented the clearing platform, OCASS, to support the OTC
clearing services.
The board of the SEHK has disciplinary powers against Exchange Participants, the most severe
of which is expulsion.
The following are costs to an investor for buying and selling securities on the SEHK: brokerage
(commission), Transaction Levy and Investor Compensation Levy, trading fee, trading tariff, ad
valorem stamp duty, transfer deed stamp duty and transfer fee.

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Topic 5: Other securities activities
Table of contents
Topic overview 1
Learning outcomes 1
1 Approved introducing agent 3
Capital requirements 3
Other requirements 3
2 Securities margin financing 4
Definition of securities margin financing 4
Capital and financial resources requirements 4
Conduct requirements 5
Suggested risk management controls 7
3 Short selling 9
Legal and regulatory requirements 9
Procedural requirements for handling short-selling orders 10
Regulated short selling on The Stock Exchange of Hong Kong Limited (SEHK) 10
Short position reporting 11
4 Securities borrowing and lending 13
Definition of securities borrowing and lending 13
Rules of the SEHK 13
5 Advising on securities 14
Definition of advising on securities 14
Conduct requirements 14
6 Online trading and advising on securities 17
Introduction 17
Conduct requirements of electronic trading 17
Electronic public offerings 20
Advertisements on the Internet 21
7 Alternative liquidity pools 22
Management and supervision, access and operational controls 22
Adequacy of systems 23
Record keeping, reporting and notification obligations 23
8 Automated trading services 24
Introduction 24
Provisions addressing automated trading services in the Securities and Futures Ordinance
(SFO) 24
Guidelines for the Regulation of Automated Trading Services 25
9 Offers of securities 27
Introduction 27
Offers of listed securities: requirements of the Companies (Winding Up and Miscellaneous
Provisions) Ordinance 27
Offers of investments: requirements of Part IV, SFO 29
Authorization of collective investment schemes 30
Authorization and marketing of structured products 33
10 Cross-border trading 36
Mutual market access 36
General trading, clearing and settlement mechanism 36
Additional restrictions on Northbound trading 40
Short selling via the Northbound trading links 41
Updates to the mutual market access scheme 41
Topic summary 43
Checklist 43
Topic overview
This Topic commences with a view of the role of an approved introducing agent and related regulatory
issues, including its definition under the Securities and Futures Ordinance (SFO), the capital
requirement and the extent subsidiary regulation of the SFO and codes applying to them in general.
Next, regulatory considerations on securities margin financing (SMF) are discussed. These include
the definition of SMF under the SFO, regulatory requirements in relation to capital and financial
resources, conduct requirements including handling of client assets and margin client agreements and
suggested risk management controls applying to securities margin financiers.
Thirdly, short selling activities in Hong Kong are concerned. It starts with a summary of the general
requirements regarding short selling as provided by the SFO, including definition of short selling,
exclusions from the prohibition of short selling and procedural requirements for handling short-
selling orders. It follows the regulatory issues regarding regulated short selling activities. Further,
reporting requirements for short positions are discussed.
Fourthly, definition of securities borrowing and lending and the key relevant regulatory requirements
are briefly summarised.
Fifthly, advising on securities, which is a regulated activity (RA) under the SFO, is discussed. It
starts with the definition of advising on securities and the conduct requirements under the SFO.
Then, the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures
Commission (Code of Conduct) requirements regarding research analysts are reviewed.
Then, the regulatory issues governing online trading and advising on securities in Hong Kong,
including discussions of the relevant codes for electronic trading and guidelines for electronic public
offerings (ePOs) issued by the Securities and Futures Commission (SFC) and the SFOs
provisions in relation to advertisement for marketing financial products on the Internet.
In the seventh section, we review the Code of Conduct requirements for alternative liquidity pools
(ALPs).
We then discuss automated trading services in Hong Kong and how these activities are brought within
the regulatory ambit of the SFC.
Further, we consider the legislation governing offering of securities in Hong Kong, including the
prospectus requirements under the Companies (Winding Up and Miscellaneous Provisions)
Ordinance (CWUMPO) and Part IV of the SFO which provide a properly regulated means for
investment products such as collective investment schemes (CISs) and structured products to be
made available to investors.
In the final section, we review the regulatory aspects of the cross-border trading arrangement between
Mainland China and Hong Kong, including the eligible securities, trade quota, key rules for trading,
clearing and settlement and additional restrictions on Northbound trading.

Learning outcomes
At the end of this Topic, candidates should be able to:
(a) understand the function of an approved introducing agent and the regulatory requirements
applicable to it;
(b) know the definition, specific regulatory and conduct requirements for carrying on the activities
of securities margin financing, and be able to apply that knowledge;
(c) know the specific regulatory and conduct requirements for carrying on the activities of short
selling, and be able to apply that knowledge;
(d) know the specific regulatory and conduct requirements for carrying on the activities of stock
borrowing and lending, and be able to apply that knowledge;

Paper 2 Version 2.4 5-1 Hong Kong Securities and Investment Institute
(e) know the specific regulatory and conduct requirements for carrying on the activities of securities
advising in Hong Kong, and be able to apply that knowledge;
(f) know the related regulatory and conduct requirements for carrying on the activities of online
securities trading and advising, including electronic trading, ePO service and posting
advertisements on the Internet;
(g) know the specific regulatory and conduct requirements for operating ALPs;
(h) know the requirements governing automated trading services and the SFCs standards of practice
for providers of such services;
(i) know the CWUMPO provisions concerning offer of listed securities, SFO provisions concerning
offers of investments, including authorization of CISs and structured products and
advertisements for them; and
(j) know the arrangement and the characteristics of cross-border trading between Mainland China
and Hong Kong.

Paper 2 Version 2.4 5-2 Hong Kong Securities and Investment Institute
1 Approved introducing agent
1.1 Approved introducing agents form a sub-set of dealers in securities, not defined in the SFO
but specified under s. 58(4), Securities and Futures (Financial Resources) Rules (FRR) to
cover introducers of securities business to other securities dealers.
1.2 The SFC may approve a licensed corporation as an approved introducing agent if it can satisfy
the SFC that it only conducts the business of:
(a) receiving from a client offers for dealings in securities and passing on the offers in the
name of the client to an exchange participant of The Stock Exchange of Hong Kong
Limited (Exchange Participant), or another licensed dealer; or
(b) introducing a client who wishes to trade in securities to an Exchange Participant, or
another licensed dealer; and
(c) does not handle client assets and incurs no legal liability in respect of the introduced
business except for its own negligence, wilful default or fraud.

Capital requirements
1.3 In view of the limited risk borne by an approved introducing agent, it is allowed to maintain
a lower level of liquid capital (a minimum of HK$500,000) and is not required to maintain
paid-up share capital.

Other requirements
1.4 Since an approved introducing agent does not handle client assets, the subsidiary legislation
of the SFO governing handling of client securities and money do not apply. Neither is it
required to issue contract notes or receipts to a client, since it is normally the executing
intermediary who issues such documents. (The introducer has not entered into a contract with
its client.) It is, however, in its interest to clarify and confirm the arrangement in writing with
the executing intermediary.
1.5 An approved introducing agent may not be required to contribute to the Investor
Compensation Fund established under Part XII, SFO. The subsidiary legislation of the SFO
states that the SFC may grant exemption if the licensed corporation does not handle client
assets.
1.6 An approved introducing agent is, however, required to comply with statutory and code
obligations applicable to all licensed corporations.

Revision question:

Question 1: What is the definition of approved introducing agents?


Answer 1: Approved introducing agents is not defined in the SFO but created under s. 58(4),
FRR to cover introducers of securities business to other securities dealers.

Paper 2 Version 2.4 5-3 Hong Kong Securities and Investment Institute
2 Securities margin financing
Definition of securities margin financing
2.1 Securities margin financing (SMF) (Type 8 RA) is defined in Schedule 5, SFO as the
provision of financial accommodation in order to facilitate:
(a) the acquisition of securities listed on any stock market, whether in Hong Kong or
elsewhere; and
(b) (where applicable) the continued holding of such securities,
whether or not those securities are pledged as security for the accommodation.
2.2 Type 8 RA does not include provision of such accommodation:
(a) for underwriting, sub-underwriting and acquisition under a prospectus;
(b) by a person licensed for Type 1 RA to enable the licensee to engage in SMF for his clients;
(c) by a CIS, which is a corporation specified in the SFO, to finance investment in the CIS it
issues;
(d) by an authorized financial institution (AFI) to facilitate acquisitions or holdings of
securities by its clients;
(e) by an individual to a company in which he holds more than 10% of its issued shares, to
facilitate SMF; or
(f) by an intermediary who effects an introduction between a person and the intermediarys
related corporation to enable the corporation to provide SMF to that person.
2.3 It must be noted that a person licensed for Type 8 RA are subject to the sole business
requirement. Generally, any advance by a client in excess of the realisable value of the
securities collateral is an indication of the person licensed for Type 8 RA lending outside the
scope of what it is allowed to do.

Capital and financial resources requirements


2.4 A person licensed for Type 8 RA and a person licensed for Type 1 RA providing SMF
(licensed persons providing SMF) are required to comply with the applicable requirements
set out in the FRR, including:
(a) a minimum paid-up share capital requirement of HK$10 million;
(b) a minimum liquid capital requirement of HK$3 million, with the liquid capital greater
than the required liquid capital (which must be calculated in accordance with the
requirement of the FRR) at all times; and
(c) a requirement of applying haircut percentages as specified in the FRR on asset values of
stocks held by the licensed persons as collateral against margin loans.
Candidates should also refer to the detailed discussion of the FRR in section 1 of Topic 2.

Reporting requirements under the FRR


2.5 In accordance with the FRR, each of the licensed persons providing SMF is required to:
(a) disclose the particulars of the top 20 margin clients with the largest outstanding margin
loan balances in a specified form in the monthly returns to the SFC; and
(b) notify the SFC within one business day after it is aware that:
(i) the aggregate amounts it drawn on any loans, advances, credit facility or other
financial accommodation provided by its bankers exceeds the aggregate of the credit
limits;

Paper 2 Version 2.4 5-4 Hong Kong Securities and Investment Institute
(ii) it is unable to meet calls or demands for payment from any of its lenders, credit
providers or financial accommodation providers for three consecutive business days;
or
(iii) any of its lenders, credit providers or financial accommodation providers has
liquidated or will liquidate the security provided by the licensed person in order to
reduce the licensed persons outstanding loan.

Conduct requirements
Requirements of the Code of Conduct
2.6 Standards of business practice expected by the SFC of the licensed persons providing SMF
are stated in the Code of Conduct, including Schedule 5.

Margin lending policy


2.7 Licensed persons providing SMF should:
(a) have a prudent margin lending and margin call policy in writing and properly
communicated to its staff;
(b) assure that the margin client has the financial capacity to meet obligations arising from
the instructions the client gives or otherwise shall not accept the client instruction; and
(c) collect from their clients promptly any amount due as margin.
2.8 The responsibility for margin lending should be assigned to, where possible, a senior officer
or committee independent of the sales or trading function. A clear margin lending policy
should be developed, documented and communicated to all relevant staff and strictly enforced.
2.9 Such a policy should include at least these objectives:
(a) to ensure that there is a consistent risk management policy;
(b) to provide a basis so that the capital of the licensed person can be protected; and
(c) to ensure that there are adequate procedures for identification of risks, effective
monitoring and corrective action.
2.10 In particular, this policy should:
(a) ensure that exposure to individual margin clients or groups of related margin clients
(as defined in the FRR) is adequately secured; and
(b) avoid building up excessive exposure to:
(i) individual margin clients or groups of related margin clients; and
(ii) individual item of securities deposited by clients as collateral.
2.11 The SMF policy should address issues such as:
(a) the form of objective proof of net income or net worth to be used for setting credit limits
which should be strictly enforced and regularly reviewed;
(b) which securities are acceptable as collateral, and the different haircuts applicable to
collateral by taking into consideration their liquidity and volatility in prevailing market
conditions;
(c) the procedures to identify groups of related margin clients;
(d) the monitoring of changes in concentrated collateral positions and concentrated securities
margin loans;
(e) the triggering level for making the first and successive margin calls, including intra-day
calls;

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(f) the steps of giving warnings to clients with outstanding margin calls and when;
(g) the triggering level for stopping further advances to clients;
(h) the triggering level and the procedures for forced liquidation of a clients collateral to
ensure the best available terms to the client and reduce the licensed persons exposure to
that client to an acceptable level;
(i) the circumstances in which deviation from the policy may be approved by management;
(j) the management reports, especially exception reports, necessary to ensure efficient
monitoring over margin lending on an ongoing basis; and
(k) the keeping of records for ready establishment of the case history of margin calls for each
individual client.

Prudent bank borrowing


2.12 Every licensed person providing SMF should ensure that the aggregate of all outstanding bank
borrowings, overdrafts and advances etc. secured by securities collateral pledged or deposited
by margin clients remains prudent as compared to the aggregate of all outstanding margin
loans made to margin clients; and
2.13 Every licensed person providing SMF that repledges securities collateral should notify the
SFC in writing whenever for a continuous period of 2 weeks the aggregate outstanding balance
of borrowings drawn under its bank credit facilities equals or exceeds 80% of the total credit
limit of the bank credit facilities and such notification should be made within one business
day from such situation has happened.

Segregation of cash and margin accounts


2.14 Licensed persons providing SMF should segregate margin and cash client accounts to ensure
transactions and assets booked under a clients cash account is not commingled with those
booked under the clients margin account.

Margin client agreement


2.15 Licensed persons providing SMF should ensure that a written margin client agreement has
been entered into with a client before margin lending is provided to the client. Candidates may
refer to Topic 3 for the requirements that apply to client agreements, including margin client
agreements. Particularly, it should be specified in the margin client agreement that the account
is a margin account.
2.16 In case of a person licensed for Type 8 RA, the client agreement should also contain a
statement that:
(a) the licensed person is subject to the sole business requirement and clients of the licensed
person are not able to withdraw funds from the margin account unless they are for the
sole purpose of acquisition of listed securities and/or continued holding of those
securities; and
(b) only for the purpose of collection margin calls or outstanding debts that the licensed
person may effect dealing in securities for or on behalf of the client.

Risk disclosure statement


2.17 Candidates should refer to Topic 4 for the requirements of providing risk disclosure statements
to clients during the account opening, including the relevant risk disclosure statements for
margin trading and providing an authority to repledge clients securities collateral.

Information for clients


2.18 Each licensed persons providing SMF should inform margin clients:

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(a) inform margin clients clearly in writing of its margin lending and margin call policy as it
affects them; and
(b) inform margin clients, upon opening of the margin accounts, that it has the practice of
repledging securities collateral.
2.19 In the written notice given to any client for renewal of the clients standing authority for
repledging the clients securities collateral (see s. 2.21 below), a risk disclosure statement as
specified in Schedule 1 to the Code of Conduct concerning the risk of such authority should
be included.

Requirements of Contract Notes Rules and Client Securities Rules

Requirements of Contract Notes Rules


2.20 Requirements of the Contract Notes Rules include that:
(a) the contract notes and monthly statements of each margin account should be indicated as
a margin account; and
(b) each statement of account of margin clients should contain details of all financial
accommodation provided to the client, including the nature, credit limit and expiry date
of the accommodation, and the basis of interest calculations; and the quantity, market
value, margin value and margin ratio of securities collateral held at the end of the day or
month.

Requirements of Client Securities Rules


2.21 According to the Securities and Futures (Client Securities) Rules (Client Securities Rules),
licensed persons providing SMF need to obtain clients written standing authority before they
pool and repledge client securities collaterals. The standing authority has to be renewed on an
annual basis. The renewal may be obtained by the following way: the licensed persons gives
the client a written notice at least 14 days prior to the expiry date, reminding the client of the
impending expiry and informing the client that the standing authority would be renewed on
the same terms for an equivalent period or for a period not exceeding 12 months, unless the
client objects. It is a deemed renewal procedure. The client should be given a written
confirmation of the renewal within a week after the expiry date.
2.22 The aggregate market value of the repledged securities collateral cannot exceed 140% of the
licensed persons aggregate margin loans.

Suggested risk management controls


2.23 Risks faced by a licensed corporation conducting SMF include credit, market, liquidity and
operational risks.
2.24 The risk management controls suggested by the Management, Supervision and Internal
Control Guidelines for Persons Licensed by or Registered with the Securities and Futures
Commission include that:
(a) risk management staff should closely monitor the firms credit exposure in relation to
clients, including pre-settlement credit exposures and settlement risk. Where credit is
extended to clients for margin trading, appropriate haircuts must be made to the market
value of the securities pledged.
(b) the margin policy should cover the acceptability of different types of margin, the
respective rates applicable, when additional margin may be called, and the intermediarys
options if a margin call is not met by the client.
(c) management should set and enforce concentration limits for particular products, markets
and business counterparties.

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(d) management should establish default procedures to alert liquidity management staff to
potential problems and to provide them with time to take appropriate action to minimize
the impact of client or counterparty liquidity problems.

Revision questions:

Question 2: State three issues that the margin lending policy should address to in accordance
with the Code of Conduct.
Answer 2: Any three stated in section 2.11.
Question 3: Is there any limit on repledging client securities collateral?
Answer 3: Yes. The limit is 140%.
Question 4: State three risk management controls for SMF activities.
Answer 4: Any three stated in section 2.24.

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3 Short selling
Legal and regulatory requirements
3.1 The general rule regarding short selling under s. 170, SFO is that a person shall not sell
securities at or through a recognized stock market unless at the time he sells them, he or his
principal has (or he believes he or his principal has) a presently exercisable and unconditional
right to vest the securities in the buyer.
The final condition above means that the seller must have the right to have the securities vested
in him or transferred in accordance with his directions. This is primarily designed to cover
stock borrowing and lending arrangements (see section 4 of this Topic).
3.2 Where securities have been charged or pledged to secure a loan, a person may still be regarded
as having an unconditional right to the vesting of securities, depending on the particular
circumstances of the charge or pledge.
3.3 A short sale which satisfies the above conditions is a permitted short sale, and is called a
covered short sale. Where the above conditions are not satisfied, the sale is called a naked
short sale.
3.4 Contravention of the short selling prohibition is an offence.

Presently exercisable and unconditional right


3.5 The Guidance Note on Short Selling Reporting and Stock Lending Record Keeping
Requirements gives examples of circumstances where the SFC accepts that a seller has a
presently exercisable and unconditional right to vest the securities in the purchaser of them
even though the seller does not actually have the securities at the time of placing the sale order.
Some of the examples are as follows:
(a) The seller has bought the securities before he places a sale order for them. Even though
the securities may not have been delivered to him before he places the sale order, the sale
order is an ordinary sale (i.e. conducting day trades where securities are bought first and
then sold does not violate s. 170(1), SFO).
(b) The sellers sale is covered by a hold notice (notice by a lender that he is holding stock
available to lend to the seller for a specified period) or a blanket assurance (from a
lender to the seller that he has sufficient stock available to lend to the seller for a specified
period).
(c) The seller who owns options or other convertible instruments has given irrevocable
instructions to convert the instruments and receive the underlying securities before the
sale of the underlying securities.
(d) The seller has stock out on loan which he has the right to recall under a stock borrowing
and lending arrangement.

Exclusions from the prohibition


3.6 The SFO provides that the following short sellers or short sales are permitted:
(a) a person who acts in good faith, believes and has reasonable grounds to believe that he
or the intermediary for whom he acts as representative has the right to pass on the
securities as mentioned above;
(b) Exchange Participants dealing in odd lots in the normal course of their business;
(c) a sale of underlying securities relating to an options contract traded on a recognized stock
market; and
(d) a sale permitted under rules prescribed under s. 397, SFO.

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3.7 Under the Securities and Futures (Short Selling and Securities Borrowing and Lending
(Miscellaneous)) Rules, the following transactions are exempted from the general prohibition
on short sales in s. 170, SFO:
(a) sales of specified instruments by a market maker appointed by the Hong Kong Monetary
Authority (HKMA) or its agent; and
(b) sales of a listed security by a securities market maker in performing market-making or
liquidity-providing activities in respect of such a security, where the securities market
maker acquires the right to pass on the title to the purchaser before the end of the next
trading day.

Procedural requirements for handling short-selling orders


3.8 There are provisions under the SFO regarding of handling short selling orders. They include:
(a) the provision of documentary assurances to the intermediary who is executing the order
that the conditions in section 3.1 above are satisfied (see Note below); and
(b) the requirement for Exchange Participants and their representatives that they must
indicate short sales to their counterparties when passing a short selling order and inputting
it into a recognized stock market.
Note: The Securities and Futures (Short Selling and Securities Borrowing and Lending
(Miscellaneous)) Rules provide that oral assurance is adequate for the following
situation: a person selling as a principal provides his agent (which may be a
licensed corporation or registered institution) with an oral assurance that the
counterparty to the securities borrowing and lending agreement in question
has the securities to lend to him and the agent records such oral assurance in
the form of a tape recording or record the required particulars of the order
on a time-stamped record at the time when the agent receives the short selling
order.

Regulated short selling on The Stock Exchange of Hong Kong


Limited (SEHK)
3.9 Regulated short selling is defined in Schedule 1, SFO and in the Eleventh Schedule of the
Rules of the Exchange of The Stock Exchange of Hong Kong Limited (SEHK) to mean the
sale of a security in respect of which the seller, or a person for whose benefit or on whose
behalf the sale is made, has a currently exercisable and unconditional right to vest the security
in the purchaser by virtue of:
(a) having under an securities borrowing and lending (SBL) agreement:
(i) borrowed the security; or
(ii) obtained a confirmation from the counterparty to the agreement that the counterparty
has the security available to lend to him;
(b) a title to other security which is convertible into or exchangeable for the security to which
the sale relates;
(c) an option to acquire the security to which the sale relates;
(d) rights or warrants to subscribe for and receive the security to which the sale relates; or
(e) having entered into with another person an agreement or an arrangement of a description
prescribed by rules made under s. 397, SFO.
In relation to (b), (c), (d) or (e) above, this does not include a sale where the seller (or the
person for whose benefit or on whose behalf the sale is made) has, at the time of placing the

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order for the sale, issued unconditional instructions to obtain the security to which the sale
relates.
3.10 General practical points relating to short selling on the SEHK are:
(a) it may be undertaken only in securities designated by the SEHK, of which there is
currently a large number;
(b) Exchange Participants must indicate short sell orders when inputting the orders to the
trading system;
(c) Exchange Participants must make stock borrowing arrangements for settlement before
the short sale; and
(d) a short sale cannot be made below the best current ask price (the tick rule). Details of and
exceptions to the short-selling rules of the SEHK will not be discussed in this study
manual.
3.11 As already noted above, naked short selling on the exchange is an offence under the SFO. The
Rules of the Exchange also prohibit it. A sale is not a naked short sale if any one of the
conditions in section 3.9 above is fulfilled. If there is a stock borrowing and lending agreement
involved, documentary assurances must be given and the sale identified as a short sale at each
step in the order chain, and the sell order must be entered as a short sale in the trading system
of the SEHK, when the tick rule will be applied automatically by the system. The SEHK has
power to change these requirements only in relation to the tick rule.

Short position reporting


3.12 The Short Position Reporting Rules require a market participant who has a reportable short
position in any specified shares at the close of trading on a reporting day to report the
reportable short position. Specified shares refer to shares in a corporation, or interests in a CIS,
which are listed or admitted to trading on the SEHK and specified in Schedule 1, Short Positon
Reporting Rules e.g. constituent stocks of the Hang Seng Index and the Hang Seng China
Enterprises Index.
3.13 The reportable short position in any specified shares, except specified shares which are
interests in a CIS, is a net short position value that is equal to or more than the threshold
specified as the lower of:
(a) HK$30 million; and
(b) 0.02% of the value of the total number of the specified shares issued by the corporation
in concerned.
The reportable short position in any specified shares which are interests in a CIS is a net short
position value that is equal to or more than HK$30 million.
3.14 For the purpose of determining a net short position value, if the closing price of any specified
shares is in a foreign currency, it must be converted into Hong Kong dollar at a specified rate
of exchange for that foreign currency.
3.15 The Short Position Reporting Rules require the report of the reportable short position to be
made to the SFC within 2 business days after the reporting day which is normally the last
trading day of each week (but see section 3.16 below).
3.16 The Short Position Reporting Rules also empower the SFC to change the reporting frequency
from weekly to daily. The SFC may publish a daily reporting requirement notice if it believes
that circumstances which threaten or may threaten the financial stability of Hong Kong exist.
In this case, the reporting day in relation to a person is the day on which the person has a
reportable short position in any specified shares to which the notice relates at the close of
trading on each trading day of the SEHK. The person must make the reporting to the SFC
within one business day after the reporting day.

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3.17 To assist market participants in complying with the Short Position Reporting Rules, the SFC
has issued the Guidance Note on Short Position Reporting that explains how certain aspects
of the rules operate.

Revision questions:

Question 5: Under what condition(s) may a short sale not be regarded as a naked short sale?
Answer 5: A short sale is not a naked short sale if any one of the conditions stated in section
3.9 is fulfilled.
Question 6: What is a reportable short position?
Answer 6: A reportable short position is a net short position value that is equal to or more than
the threshold specified as the lower of:
HK$30 million; and
0.02% of the value of the total number of the specified shares issued by the
corporation concerned.

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4 Securities borrowing and lending
Definition of securities borrowing and lending
4.1 SBL is defined under Schedule 1, SFO. It refers to the activity whereby a person borrows or
lends securities on the condition that the borrower undertakes to return securities of the same
description on a future date, or pay the equivalent value of the securities as it is on that date
to the lender. It includes a stock borrowing as defined in the Stamp Duty Ordinance for the
purposes of exempting such transactions from stamp duty.
Note: As noted earlier, regulated short selling is usually supported by SBL arrangements.
This is a useful mechanism through which considerable volumes of securities (which
might otherwise be kept in an immobile state) held by various custodian institutions,
such as banks and fund custodians, may be made available to assist in the flow of
trading in the markets, at a profit to the holders of the securities.

Rules of the SEHK


4.2 The SEHKs regulations on SBL are contained in the Rules of the Exchange and Sixth
Schedule, Rules of the Exchange.
4.3 An Exchange Participant engaged in SBL must:
(a) collect collateral of at least 100% of the value of securities loaned or 105% if the
borrowing is for short selling; and
(b) mark to market (i.e. adjust the value of the securities according to the latest market price)
all securities borrowings at least daily against the previous days closing price.
4.4 The borrowing and lending of Hong Kong stocks is exempted from stamp duty, subject to
certain criteria.
4.5 Exchange Participants are required to maintain ledgers recording stock borrowing and lending
transactions, which should be made available to the Inland Revenue Department to enable it
to satisfy itself that the requirements for exemption from stamp duty applicable to genuine
SBL transactions are properly applied.

Revision question:

Question 7: How do regulated stock borrowing and lending activities make benefits to securities
market?
Answer 7: Stock borrowing and lending activities provides a useful mechanism through which
considerable volumes of securities (which might otherwise be kept in an immobile
state) held by various custodian institutions, such as banks and fund custodians, may
be made available to assist in the flow of trading in the markets, at a profit to the
holders of the securities.

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5 Advising on securities
Definition of advising on securities
5.1 There are two activities defined in Schedule 5, SFO as constituting advising on securities
(Type 4 RA). They are:
(a) the giving of advice; or
(b) the issuing of analyses or reports, for the purposes of facilitating the recipients to make
decisions on the acquisition or disposal of securities.
5.2 They include advice or decision on:
(a) whether;
(b) which;
(c) the time at which; or
(d) the terms or conditions on which
securities are/should be acquired or disposed of. However, the advice that falls within the
meaning of advising on corporate finance or providing credit rating services is excluded.
5.3 Persons holding licences to advise on securities are comparable in number to dealers in
securities, so they form a significant group.
5.4 Persons exempted from requiring a licence to advise on securities generally include:
(a) solicitors, counsel, professional accountants, trust companies and persons licensed to
carry out asset management who give such advice wholly incidental to their professions;
(b) financial journalists and broadcasters who give investment advice or issue analyses or
reports on investments to the public on subscription or otherwise;
(c) corporations giving such advice or issuing such analyses or reports solely to their wholly
owned subsidiaries or holding companies holding all their issued shares or other wholly
owned subsidiaries of the holding company; and
(d) persons licensed to deal in securities and give such advice wholly incidental to the
carrying on of such dealing activity.

Conduct requirements
5.5 Persons licensed for Type 4 RA must ensure that all reports issued are neither misleading nor
deceptive. It is an offence to make any fraudulent or reckless misrepresentation to induce a
person to buy or sell securities (s. 107, SFO). The person making the statement may be liable
to pay compensation to the other person for any damage that person may suffer, as this is a
civil wrong (s. 108, SFO). References should be made to sections 9.42 to 9.47 of this Topic
for further discussions of ss. 107 and 108, SFO.
5.6 The following are considered to be forms of misconduct under ss. 277 and 298, SFO:
(a) if a person recklessly or intentionally discloses or disseminates, in Hong Kong or
elsewhere, false or misleading information, including the omission of material
information; and
(b) if the information is likely to induce another person to subscribe, buy or sell securities,
or maintain, increase, reduce or stabilize the share price in Hong Kong.
5.7 In recent years, there has been an increased focus on the influence of research on traded
securities and the ethical standards adopted by firms (i.e. intermediaries and their group of
companies) and analysts (i.e. individuals) that are preparing and issuing such research. Of

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particular concern is that commercial or investment interests of a firm or an analyst may create
potential conflicts of interest which affect the research recommendations that are made.
5.8 The Code of Conduct addresses firms and analysts that issue investment research, or have an
influence, on securities traded in Hong Kong. It has now been extended to cover securities to
be issued by a new listing applicant (including a real estate investment trust) which will be
traded in Hong Kong. It requires firms to establish mechanisms, including policies and
procedures, to ensure that analysts are held to high standards of integrity and ethical behaviour.
The approach taken in paragraph 16 is to set out a number of principles that the SFC considers
of fundamental importance, which are then expanded upon.

Trading, financial and business interests


5.9 Investment research and recommendations should not be prejudiced by the trading activities
and financial or business interests of the firm or the analyst. Where (i) an analyst is an officer
of, or has any financial interest in, the company or new listing applicant which is the subject
of the report, or (ii) the firm has specified financial or business relationships with the company
or new listing applicant which is the subject of the research report (see paragraph 16.5 of the
Code of Conduct for details), appropriate disclosures should be made (see section 5.16 below).
5.10 Appropriate written policies and control procedures should be established covering dealings
by analysts and their associates (i.e. a spouse, minor children and certain trust arrangements)
and should include limitations on dealing by analysts:
(a) which are contrary to their outstanding recommendation; or
(b) 30 days before and 3 business days after the issue of the research.
Where an analyst has dealt within the 30-day period, the research should be withheld.
5.11 Firms should not make any assurances to a listed company or a new listing applicant about
providing favourable reports (or changing its coverage or rating) on the company or new
listing applicant, with a view to influencing a business relationship with the company or new
listing applicant.
5.12 Firms which act as a manager, sponsor or underwriter of a public offering should not issue
research during the quiet period (see Note below) unless issuing research on the company
or new listing applicant is part of its normal course of business.
Note: The quiet period is the 40 days immediately following pricing of an initial public
offering (IPO) or the 10 days immediately following pricing of a secondary market
offering.

Reporting lines, compensation and compliance system


5.13 Reporting lines and other firm-wide compliance procedures should be established that
eliminate, avoid or manage actual or potential conflicts of interest.
5.14 Such procedures include:
(a) not allowing an investment banking function to pre-approve research;
(b) not directly linking an analysts remuneration to investment banking transactions;
(c) not allowing research analysts to solicit investment banking business (i.e. analysts should
not participate in sales pitches and deal roadshows); and
(d) not providing research analysts preparing a research report on a new listing applicant with
any material information that is:
(i) not reasonably expected to be included in the prospectus; or
(ii) not publicly available.

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Outside influence
5.15 The undue influence of securities issuers, institutional investors and other outside parties on
analysts should be eliminated or managed. Where compensation (or other benefits) relating to
the research is provided by the company or new listing applicant which is the subject of the
research (or a third party), that fact should be disclosed.

Disclosures
5.16 Disclosures of actual or potential conflicts of interest should be complete, timely, clear,
concise, specific and prominent and they should be made in the research report itself.

Reasonable basis
5.17 An analyst should have a reasonable basis for his analyses and recommendations.

Mass media
5.18 Where an analyst appears in a personal capacity in the mass media to make commentaries or
recommendations, the provisions of paragraph 16 continue to apply. Accordingly, should the
analyst have any interest in the company which is the subject of his comments, he should
disclose that fact. An analyst will not be held responsible if the relevant disclosure has been
made to the media but such disclosure is not reported on by the media.

Revision question:

Question 8: What limitations are imposed on dealing by an analyst under the Code of Conduct?
Answer 8: An analyst should not deal in any securities:
contrary to his outstanding recommendation; or
within 30 days before and 3 business days after the issue of the research.
Where an analyst has dealt within the 30-day period, the research should be
withheld.

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6 Online trading and advising on securities
Introduction
6.1 Online trading and advising on securities generally refers to providing services for dealing in
and/or advising on securities through the Internet or other electronic means, including
telephones, wireless access, hand-held electronic devices (e.g. smart phones, tablets etc.) and
proprietary electronic systems (e.g. automatic teller machines ATMs, stand-alone computer
systems). By the virtue of advacing electronic means, there are electronic public offerings and
advertisements on the Internet for marketing financial products.
6.2 The SFCs codes and guidelines relating to electronic trading and electronic public offerings,
and the SFOs provisions relating to advertisements on the Internet for marketing financial
products will be discussed below.

Conduct requirements of electronic trading


6.3 Paragraph 18 and Schedule 7 of the Code of Conduct set out the conduct requirements of
electronic trading (See Note below). A licensed or registered person engaging in electronic
trading of securities that are listed or traded on an exchange is subject to these requirements.
Note: Electronic trading refers to the trading of securities and futures contracts
electronically and includes internet trading, direct market access and algorithmic
trading.

Responsibility for orders


6.4 A licensed or registered person is responsible for:
(a) the settlement and financial obligations of orders sent to the market through its electronic
trading system; and
(b) the implementation of policies, procedures and controls to supervise the orders in
compliance with applicable regulatory requirements.

Management and supervision


6.5 A licensed or registered person should effectively manage and adequately supervise the design
and operation of the electronic trading system it uses or provides to clients for use. Examples
of measures include that:
(a) written internal policies and procedures on the operation of the system should be
established and implemented by the licensed or registered person;
(b) at least one responsible officer or executive officer should be responsible for the overall
management and supervision of the system; and
(c) adequate qualified staff, technology and financial resources should be assigned to the
design and operation of the system.
On 29 January 2016, the SFC and the Polices Cyber Security and Technology Crime Bureau
jointly issued suggested control measures for safeguarding against unauthorised activities
committed in online client account. Brokers are also reminded to take appropriate steps to
raise the awareness of their clients on the security precautions they need to take in using the
system. The circular is available in the SFCs web-site:
http://www.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=16EC3.

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Adequacy of system
6.6 A licensed or registered person should ensure the integrity of the electronic trading system it
uses or provides to clients for use. To ensure the reliability, security and capacity of the system,
the following controls should be adopted:
(a) effective controls should be in place to immediately prevent the system from generating
and sending orders to the market and cancel any unexecuted orders that are in the market;
(b) the system should be tested before deployment and regularly reviewed, and any material
service interruption should be promptly reported to the SFC;
(c) appropriate security controls should be employed to avoid the system from being abused
and such controls should at least include:
(i) reliable authentication or validation techniques to ensure that the access or the use
of the system is restricted to persons approved to use the system on a need-to-have
basis;
(ii) effective techniques to protect the confidentiality and integrity of information stored
in the system and passed between internal and external networks; and
(iii) operating controls to prevent and detect unauthorized intrusion, security breach and
security attack;
(d) a licensed or registered person should monitor the capacity usage of the electronic trading
system and determine and keep a record of the spare capacity planned;
(e) the capacity of the system should be regularly stress tested and the findings of the stress
tests should be documented; and
(f) there should be contingency arrangements to handle client order instructions that exceed
the capacity of which the system can handle and to ensure alternative means of order
execution are available to clients.

Record keeping
6.7 Proper records of the following should be kept:
(a) the design and development (including any testing, reviews, modifications, upgrades or
rectifications) of the electronic trading system;
(b) comprehensive documentation of the risk management controls of the system for a period
of not less than 2 years after the system ceased to be used; and
(c) audit logs on the activities and incident reports for all material system delays or failures
of the system for a period not less than 2 years.

Specific requirements on internet trading and DMA

Risk management
6.8 A licensed or registered person that provides internet trading or direct market access (DMA)
services (see Note below) must ensure that all the client orders are transmitted to its
infrastructure. Also, all these client orders must be subject to the following:
(a) appropriate automated pre-trade risk management controls that could:
(i) prevent entries that exceed trading or credit limits prescribed for each client or
propriety account; and
(ii) alert the users of potential erroneous orders entries and prevent the entry of
erroneous orders; and
(b) regular post-trade monitoring to identify any manipulative or abusive order instructions
and transactions.

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Note: DMA refers to the access to a market provided to a client through a licensed or
registered persons identifier (other than those initiated by way of internet trading)
under which the client transmits orders, directly or indirectly, to the markets trade
matching system for execution

Minimum client requirements for DMA services


6.9 A licensed or registered person should establish minimum client requirements for its DMA
services. Each client should be assessed as to whether it meets the requirements before being
granted the DMA service. These requirements should include:
(a) the client has in place appropriate arrangements to ensure that its users are proficient and
competent in using the system for the DMA services;
(b) the client understands and is able to comply with applicable regulatory requirements; and
(c) the client has adopted adequate arrangements to monitor the orders entered through the
DMA services.
6.10 A licensed or registered person should regularly evaluate the minimum client requirements in
accordance with current market conditions and whether the client using its DMA services
continues to meet the minimum client requirements.

Algorithmic trading system and trading algorithms

Qualification
6.11 Effective policies and procedures should be established and implemented to ensure that there
are suitably qualified persons involved in the design and development of, or approved to use
its algorithmic trading system (See Note below) and trading algorithm. Where necessary,
training should be provided to those persons.
Note: Algorithmic trading system is a system through which algorithmic trading (i.e.
computer generated trading activities created by a predetermined set of rules aimed
at delivering specific execution outcomes) is conducted. It includes a system designed
and developed in-house or by a third party service provider.

Testing
6.12 A licensed or registered person should ensure adequate testing of the algorithmic trading
system and trading algorithms it uses or provides to clients for use, and any subsequent
developments and modifications before deployment to ensure that:
(a) the system and trading algorithms will operate as designed;
(b) foreseeable extreme market circumstances and the characteristics of different trading
sessions have been taken into consideration in their design and development; and
(c) the operation of a fair and orderly market would not be interfered with.
6.13 The algorithmic trading system and trading algorithms should be reviewed and tested
regularly and no less than annually, for the algorithmic trading systems ability to handle
sizable trading volume and for the trading algorithms ability to execute orders without
interfering with the operation of a fair and orderly market.
Note: A licensed or registered person should perform appropriate due diligence if an
algorithmic trading system or a trading algorithm is provided to a licensed or
registered person by a third party.

Risk management
6.14 There should be reasonably designed controls in place to ensure:
(a) the integrity of its algorithmic trading system and trading algorithms; and

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(b) its algorithmic trading system and trading algorithms operate in the interest of the
integrity of the market, such as monitoring and prevention of passing to the market for
execution order instructions which may be erroneous or interfere with the operation of a
fair and orderly market.

Electronic public offerings


Guidelines for Electronic Public Offerings
6.15 The Guidelines for Electronic Public Offerings provide guidance to persons who offer ePO
services. An ePO takes place where the internet or other electronic means (e.g. electronic
trading mechanisms such as hand-held or wireless trading devices) are used to display or
provide access to prospectuses, application forms and/or to collect applications or application
instructions from the public during an IPO or a follow-on offering.

Issuer-driven ePO
6.16 In an issuer-driven ePO, the issuer decides to offer an ePO mechanism through intermediaries
who are eligible service providers (ESPs), usually involving the provision of an electronic
prospectus by the issuer to ESPs, the electronic collection of application information from
applicants by ESPs, and the electronic collection and transmission of application data from
ESPs to receiving banks or share registrars.
6.17 In an issuer-driven ePO, responsibility for the coordination, capacity of back-end systems,
testing, contingency planning, decision-making etc. of all aspects of the ePO falls on the issuer,
the sponsor and the share registrar. If the issuer decides to use an issuer-driven ePO, it should
invite suitable intermediaries to provide ePO services and/or facilities. The issuer should
prepare the prospectus in electronic form and in a format that cannot be tampered with. In
addition, the issuer should provide ESPs with detailed instructions, a timetable and other
information relevant to their role in the ePO before the ePO begins. The availability of the
ePO and a list of the participating ESPs should be set out in the prospectus, application form
and any formal notice or announcement detailing the application procedures for the public
offering. Issuers and sponsors should have a contingency plan to deal with emergency
situations relating to the ePO, and ensure that there is a central point for coordination of all
parties involved in the ePO.
6.18 The ESP is responsible for the compliance and system integrity of the ePOs front-end
processes, including those concerned with collection and handling of applications and the
electronic interface of its website. Only ESPs (i.e. those who have passed the data conformity
tests organized by the Federation of Share Registrars) are eligible to take part in an issuer-
driven ePO where the back-end of the ePO includes the electronic transmission of data from
the intermediary to a receiving bank and share registrar.

Registrant-driven ePO
6.19 In a registrant-driven ePO, an intermediary may collect applications from its clients
electronically or manually and the applications may be delivered to the issuer or the receiving
bank either in traditional paper-based form or in any other way specified by the issuer, with
the issuer having little or no additional role. In a registrant-driven ePO, the issuer has little or
no responsibility towards the intermediary and the need for coordinating the back-end of the
ePO does not arise.
6.20 In such ePOs, the intermediarys responsibilities are largely identical to those in issuer-driven
ePOs. In all cases, the consent of the issuer is necessary.

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Advertisements on the Internet
6.21 The issuing of advertisements or other documents relating to securities, investment
arrangements and investment advising services via the Internet are within the control of s. 103,
SFO, which requires them to be approved by the SFC, unless they fall within the specified
exemptions. Advertisements not targeted at Hong Kong residents do not need to be submitted
for the SFCs approval. Advertisements offering advisory services or the management of client
portfolios in return for remuneration if targeted at Hong Kong residents will not be allowed
unless such advertisements are the subject of exemption under the relevant ordinance. Where
such advertisements are dispatched over the Internet, they may trigger licensing or registration
requirements.
6.22 The SFC has set some criteria for determining whether advertisements are targeted at Hong
Kong residents and therefore requiring its approval:
(a) whether the materials are targeted using push technology (the technology spams,
broadcasts or directs information) at Hong Kong residents; and
(b) whether the materials are presented in a way that indicates that the advertisements are so
aimed.
6.23 Advertisements will not be considered to be targeted at Hong Kong residents provided that:
(a) the broadcast includes a prominent disclaimer that the products or services are not
available to Hong Kong residents, or lists the countries where they are available (which
should exclude Hong Kong); and
(b) reasonable steps are taken to ensure that the products or services are not provided to Hong
Kong residents, such as by checks on telephone numbers, addresses or the use of blockage
devices.

Revision questions:

Question 9: What are the appropriate security controls for avoiding an electronic trading system
from being abused?
Answer 9: The security controls should include:
reliable authentication or validation techniques to ensure that the access or the
use of the system is restricted to persons approved to use the system on a need-
to-have basis;
effective techniques to protect the confidentiality and integrity of information
stored in the system and passed between internal and external networks; and
operating controls to prevent and detect unauthorized intrusion, security breach
and security attack.
Question 10: What are the minimum client requirements for DMA services?
Answer 10: The minimum requirements should include:
the client has in place appropriate arrangements to ensure that its users are
proficient and competent in using the system for the DMA services;
the client understands and is able to comply with applicable regulatory
requirements; and
the client has adopted adequate arrangements to monitor the orders entered
through the DMA services.

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7 Alternative liquidity pools
7.1 ALP means an electronic system, whether designed and developed in-house or by a third
party service provider, operated by a licensed or registered person through which the
crossing/matching of orders involving securities listed or traded on exchanges (see Note below)
is conducted with no pre-trade transparency.
Note: ALPs are allowed to transact Hong Kong listed securities and overseas listed securities.
7.2 Paragraph 19 and Schedule 8 of Code of Conduct apply to a licensed or registered person who
operates an ALP (ALP operator) or routes client orders to an ALP for execution. The
requirements are discussed below.

Management and supervision, access and operational controls


Management and supervision
7.3 An ALP operator should effectively manage and adequately supervise the design,
development, deployment and operation of its ALP (the ALP).
7.4 An ALP operator should establish and implement written internal policies and procedures to
ensure that:
(a) there is at least one responsible officer or executive officer responsible for the overall
management and supervision of the ALP;
(b) managerial and supervisory controls that are designed to manage the risks associated
with the operation of the ALP are in place;
(c) a formalized governance process with input from risk and compliance functions is set up;
and
(d) there are clearly identified reporting lines with supervisory and reporting responsibilities
assigned to appropriate staff members.
7.5 Regular reviews should be conducted to ensure that the internal policies and procedures are
in line with regulatory developments and changing market conditions. Deficiencies identified
should be promptly remedied.

Access to and operation of ALPs


7.6 An ALP operator:
(a) should establish and implement measures to ensure that only qualified investors (see
Note 1 below) are accepted to be users of the ALP and only orders placed or originated
by a qualified investor are routed to the ALP on behalf of clients;
(b) may allow transactions to be placed into and transacted in the ALP as such times as it
considers appropriate;
(c) should ensure that orders which are not proprietary orders (see Note 2 below) have
priority over proprietary orders when such orders are being transacted at the same price,
irrespective of the time when the orders are placed;
(d) is required to prepare and revise/update as necessary ALP Guidelines (see Note 3
below) for the purpose of providing sufficiently comprehensive information to the users
to ensure that they are fully informed of the operation of the ALP and ensure the ALP
Guidelines have been brought to the attention of the person placing or originating the
order; and
(e) should permit the users to opt out of matching or crossing their orders in the ALP.

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Note 1: A qualified investor means a professional investor who is (i) an Institutional
Professional Investor as discussed in sections 2.63(a) and 2.64 of Topic 3; or (ii) a
Corporate Professional Investor as discussed in sections 2.63(b) and 2.65 of Topic
3 except those corporations that act solely as investment holding companies and are
wholly owned by an Individual Professional Investor (which is discussed in sections
2.63(c) and 2.66 of Topic 3).
Note 2: A propriety order means an order which are for (i) the account of the ALP operator,
trading as principal; (ii) the account of a company within the same group of
companies as the ALP operator, trading as principal; (iii) any account in which the
entities mentioned above in (i) or (ii) has an interest; or (iv) the account of any
employee or agent of the entities mentioned above in (i) or (ii).
Note 3: A copy of the ALP Guidelines should be provided to the SFC upon their publication
on the ALP operators website. Revised and updated ALP Guidelines, with the
amendments being identified and explanation for such amendments, should be (i)
published on the ALP operators website and circulated to the users of the ALP as
soon as practicably after the revision and updating; and (ii) provided to the SFC
upon the publication.

Risk management
7.7 An ALP operator should have controls that are reasonably designed to ensure the integrity of
the trading methodology and that the trading methodology operates in the interest of
preserving market integrity.

Adequacy of systems
7.8 An ALP operator should ensure the ALPs integrity including the controls, reliability, security
and capacity of the ALP and have appropriate contingency measures in place in case of failure.
7.9 An ALP system should have security control to restrict the level of visibility of trading
information that is available to the staff of the ALP operators, including:
(a) restricting the access of staff members to trading information in the ALP only to the
extent necessary to enable the ALP to operate satisfactorily and efficiently;
(b) keeping the SFC informed as to the identity of each such staff members being permitted
to access to the ALP and the information he/she has access and the basis for permission
to such access;
(c) maintaining a log that records the details of accesses by staff members; and
(d) having measures in place to ensure that any person responsible for originating proprietary
orders in the ALP does not have access to any trading and transaction information in the
ALP.

Record keeping, reporting and notification obligations


7.10 An ALP operator should keep, or cause to be kept, proper records concerning the design,
development, deployment and operation of the ALP.
7.11 An ALP operator should have procedures to ensure:
(a) information of transactions conducted on the ALP is properly reported or made available
to the users, exchanges, the SFC and other regulators; and
(b) the SFC is kept informed of any change in relation to the operation of the ALP and any
breach arising out of its operation.

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8 Automated trading services
Introduction
8.1 Automated trading services (ATS) in Hong Kong are used to describe any automated system
that provides, by means of electronic facilities, a trading or clearing mechanism for securities,
futures contracts and OTC derivatives other than the operations of a recognized exchange
company or a recognized clearing house (at the moment this would only cover the SEHK,
Hong Kong Futures Exchange Limited and their related clearing houses). The services
provided include, for example:
(a) trade confirmation and matching systems provided by brokers; and
(b) full trading and settlement systems for non-local securities, futures contracts and OTC
derivatives.

Provisions addressing automated trading services in the Securities


and Futures Ordinance (SFO)
8.2 The provision of ATS is covered in two places in the SFO. First, a person may be authorized
under s. 95(2) (i.e. Part III), SFO to provide ATS similar to the services provided by a
recognized exchange or recognized clearing house.
8.3 Second, a person may be licensed, or in the case of an AFI, may be registered to provide ATS
as a RA, under Part V, SFO. In these cases, all the provisions of the SFO and subsidiary
legislation, codes and guidelines applicable to licensed persons and registered persons will
apply wherever appropriate.

Licensing of ATS under Part V, SFO or authorization under Part III, SFO
8.4 The SFC will decide which route an ATS provider should be directed to take. The legal
provisions enable the SFC to make a choice.

Licensing under Part V, SFO


8.5 Generally, the SFC intends that ATS providers who also provide traditional dealer services
(such as agency broking, principal trading, market making and holding clients securities or
funds) should apply under Part V, SFO, to be licensed for all relevant RAs, including providing
ATS.

Authorization under Part III, SFO


8.6 The SFC expects that there may be a wide variety of ATS falling within the scope of
authorization of ATS under Part III, SFO. They will be considered on a case-by-case basis.
Examples of such authorization may include:
(a) an ATS provider does not provide traditional dealer services as mentioned in section 8.5
above;
(b) an ATS provider whose nature of business is that of a market operator or which does not
handle client securities and funds;
(c) an AFI wishes to provide an electronic trading system for securities; or
(d) an exchange outside Hong Kong wishing to provide ATS in Hong Kong by placing
dedicated terminals in Hong Kong or providing technical specifications and support
services to enable institutions in Hong Kong to make computer-to-computer connections
to the overseas exchanges systems.

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Guidelines for the Regulation of Automated Trading Services
8.7 The guidelines summarize the legislative framework and set out the principles, procedures
and standards in relation to authorization, registration and licensing of persons by the SFC for
providing ATS.

Principles for the regulation of ATS

General
8.8 In addition to the general regulatory objectives in the SFO, the guidelines highlight the
standards of practice that ATS providers are expected to meet to the satisfaction of the SFC.
The breadth of each of the principles set out below offers ATS providers assistance in
determining what the SFC will demand of them in practice.
8.9 Generally, ATS providers licensed under Part V or authorized as an overseas exchange, will
satisfy these requirements by virtue of their existing regulation. However, where other ATS
providers are regulated under Part III, the SFC will look at cases on an individual basis.
8.10 In addition, the SFC has made it clear that when considering the appropriate level of regulation
that regulation will be proportionate to the function performed and the risks associated with
the ATS operation in particular, the market participants affected, the impact on retail
investors and systemic risk. The SFC will also consider international standards and best
practices.
8.11 The SFC has identified 9 core standards of practice which the ATS service provider should
maintain:
(a) Standard 1: Financial resources
An ATS provider should have sufficient financial resources for the proper performance
of its operations, functions and obligations.
(b) Standard 2: Risk management
An ATS provider should prudently manage risks associated with its businesses and
operations.
(c) Standard 3: System integrity
An ATS provider should achieve a high degree of reliability, availability and security in
respect of its systems, data and networks by setting up and maintaining electronic
facilities. An ATS provider should also incorporate adequate capacity and contingency
arrangements.
(d) Standard 4: Governance
The governance arrangement should be robust, well-defined and transparent, in order for
an ATS provider to properly oversee its management and manage the decision-making
process.
(e) Standard 5: Access and participation
To permit fair and open access, an ATS provider should have objective, risk-based and
transparent criteria for participation.
(f) Standard 6: Transparency
An ATS provider should provide appropriate transparency in relation to its ATS
operations, products, and transactional information, including where relevant: its
arrangements for order processing and transaction execution, or for clearing and
settlement (as applicable); the list of products that may be traded or cleared through its
facilities; and its rules and operational requirements.

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(g) Standard 7: Surveillance
An ATS provider, a regulatory authority (including potentially the SFC), or another
competent person should conduct proper surveillance of activity conducted via the ATS.
Such surveillance should be consistent with relevant market regulation practices in Hong
Kong and internationally.
(h) Standard 8: Record keeping
An ATS provider should keep full records of its ATS operations, including proper audit
trails of activity conducted via the ATS.
(i) Standard 9: Reporting
An ATS provider should keep the regulatory authorities informed of its ATS operations
and of any material changes to those operations.

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9 Offers of securities
Introduction
9.1 Offers of securities (including initial public offers of securities, or IPOs) fall within the
scope of Type 1 and Type 4 RAs.
9.2 This section will deal with the statutory regulatory framework governing offers of securities,
particularly in relation to the following:
(a) the prospectus requirements of CWUMPO that are involved as part of offer of securities;
and
(b) the offer and distribution of shares, units and other interests in CISs and structured
products covered under Part IV of the SFO.
Note: The new Companies Ordinance (Cap. 622 Laws of Hong Kong) came into force on 3
March 2014. It covers all the areas regulated under the old Companies Ordinances
(i.e. Cap. 32 Laws of Hong Kong), except the prospectus regime and the winding-up
and insolvency provisions. These two regimes remain under the old Companies
Ordinance which has been renamed the Companies (Winding Up and Miscellaneous
Provisions) Ordinance.

Offers of listed securities: requirements of the Companies (Winding


Up and Miscellaneous Provisions) Ordinance
9.3 Offers to the public in Hong Kong of securities by a company incorporated in or outside Hong
Kong must be in compliance with, or be exempted from, the prospectus requirements of the
CWUMPO. A prospectus is defined in the CWUMPO as any prospectus, notice, circular,
brochure, advertisement or other document:
(a) offering any shares of a company to the public for subscription or purchase for cash or
other consideration; or
(b) calculated to invite offers by the public to subscribe for or purchase for cash or other
consideration any shares of a company.
9.4 Part II and Part XII of the CWUMPO, respectively, contain provisions regarding prospectuses
issued by companies incorporated in or outside Hong Kong.
9.5 However, certain offers excluded from the prospectus requirements are set out in the
Seventeenth Schedule, CWUMPO and include, for example, an offer to persons defined as
professional investors for the purposes of the SFO.

Companies incorporated in Hong Kong


9.6 Section 38D, CWUMPO prohibits a prospectus from being issued by or on behalf of a
company unless the prospectus complies with the CWUMPOs requirements and a copy has
been registered by the Hong Kong Registrar of Companies. Under s. 38(1), CWUMPO, every
prospectus, unless exempted under s. 38A, CWUMPO, must be written in English with a
Chinese translation (or vice versa) and must state the matters set out in Part I of the Third
Schedule, CWUMPO.
9.7 In addition, s. 38(3), CWUMPO prohibits the issue of an application form without a
prospectus that meets the requirements of s. 38, unless such form was issued either in
connection with a bona fide invitation to a person to enter into an underwriting agreement or
where such shares were not being offered to the public. A breach of this requirement results
in liability to a fine.

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9.8 The s. 38 requirements do not apply to the issue of a prospectus to existing holders of shares
(e.g. rights issues) or to the issue of a prospectus or application form relating to shares of the
same class as those previously issued and that are listed on the SEHK.
9.9 Section 41, CWUMPO provides that, where a company allots, or agrees to allot, any shares
of the company with a view to any or all such shares being offered for sale to the public, any
document where such offer is made is deemed to be a prospectus issued by the company.

Companies incorporated outside Hong Kong


9.10 Companies incorporated outside Hong Kong but seeking a listing on the SEHK will need to
be registered under and be bound by Part XVI, new Companies Ordinance. They will be
subject to the same prospectus requirements as discussed above.

Certificates of exemption
9.11 The SFC may issue a certificate of exemption to exempt compliance in relation to
requirements of the Third Schedule, CWUMPO if it considers that the exemption will not
prejudice the interest of the investing public and compliance with any or all of those
requirements would be irrelevant or unduly burdensome.
9.12 In September 2000 the SFC and Hong Kong Exchanges and Clearing Limited (HKEX)
issued a joint press release announcing the relaxation of the requirements relating to dual-
language prospectuses and listing documents of new applicants for listing on the Main Board
and Growth Enterprise Market. Consequently, the English- and Chinese-language versions of
the prospectus/listing document may be distributed separately from each other provided that
both are available at each place where the distribution of such documents takes place (i.e.
branches of the receiving bank and offices of the underwriting syndicate).

Requirements of the Third Schedule to the CWUMPO


9.13 Part I of the Third Schedule, CWUMPO sets out the requirements for the content of
prospectuses offering subscription shares. Key paragraphs under the Third Schedule include,
among others:
(a) a general description of the business of the company (paragraph 1);
(b) sufficient particulars and information to enable a reasonable person to form a valid and
justifiable opinion of the financial condition and profitability of the company at the time
of issue of the prospectus (paragraph 3);
(c) the names, descriptions and addresses of directors and proposed directors (paragraph 6);
(d) the number of shares issued within the preceding 2 years as fully or partly paid up
otherwise than in cash (and the consideration for such issue) (paragraph 11);
(e) voting rights, capital and dividend rights, where the companys share capital is divided
into different classes of share (paragraph 20); and
(f) a statement of the gross trading income or sales turnover of the company for the
preceding 3 years, including a breakdown of the more important trading activities
(paragraph 27).
9.14 Part II of the Third Schedule, CWUMPO sets out the various reports to be included in
prospectuses, such as:
(a) an auditors report with respect to profits/losses and assets/liabilities of the company and
any guarantor corporation (and separately or together for subsidiaries of such
company/guarantor corporation) for, and any dividends paid during, the preceding 3 years
(paragraph 31);

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(b) where the proceeds, or part of the proceeds, are to be applied directly or indirectly in the
purchase of any business, a report by accountants of the profits/losses of that business for
each of the preceding 3 years, together with the assets/liabilities of that business at the
date of its last accounts (paragraph 32);
(c) where the proceeds, or part of the proceeds, are to be applied directly or indirectly to the
acquisition by the company of another corporate entity that will result in its becoming a
subsidiary of the company, a report by accountants of the profits/losses of that corporate
entity for the each of the preceding 3 years, together with the assets/liabilities of that
corporate entity at the date of its last accounts (paragraph 33); and
(d) where a companys most recent accounts disclose that either more than 10% of the
companys assets or not less than HK$3 million in value comprises the companys
interests in land or buildings, to prepare a valuation report (paragraph 34). (Where a
company has obtained more than one valuation report within the 6 months preceding the
prospectus date, all other such reports must be included in the prospectus.)

Civil and criminal liability for misstatements in the prospectus


9.15 Section 40, CWUMPO provides that, subject to some exemptions, directors and promoters of
an issuer of shares and any person that has authorized the issue of a prospectus that contains
untrue statements will incur a civil liability to pay compensation to investors who have
subscribed on the basis of the prospectus.
9.16 It should be noted that an expert (e.g. a reporting accountant or valuer) who has given consent
to the inclusion of a report in the prospectus is not thereby deemed to have authorized the
issue of the prospectus, except in relation to an untrue statement in his report.
9.17 In addition, any person authorizing the issue of a prospectus that contains misstatements incurs
criminal liability under s. 40A, CWUMPO, unless he can prove that the statement was
immaterial or that he had reasonable grounds to believe, and believed up to the date of issue,
that the statement was true.

Offers of investments: requirements of Part IV, SFO


9.18 The core aspects to Part IV are:
(a) Under s. 103, SFO, it is an offence to make an offer of investments to the public unless
the circumstances of the offer are in accordance with the permitted routes of so doing (for
example, an offer made under a registered prospectus is permitted).
(b) Section 104, SFO empowers the SFC to grant authorization to (and to impose conditions
on) CISs (commonly referred to as mutual funds or unit trusts), thereby enabling the
CISs to be marketed to the public.
(c) Section 104A, SFO empowers the SFC to grant authorization to (and to impose
conditions on) structured products, thereby enabling them to be marketed to the public.
(d) Section 105, SFO empowers the SFC to authorize the issue of (and to impose conditions
on) advertisements and other documents that contain an offer to the public.
9.19 As will be clear from the above, Part IV is an important means by which a properly regulated
environment is established for the products which can be made available to investors. In this
way, the powers given to the SFC encourage the development of reputable and well-structured
investment products in the Hong Kong market and seek to eliminate dubious products and
schemes.
9.20 The following sections expand on the powers given to the SFC under Part IV, SFO. These
powers include the power to authorize CISs and structured products for offer to the public as
well as advertisements and other documents that contain an offer to the public. The following
sections will first deals with the SFCs powers under the SFO, and the latter part will review

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the regulatory codes issued by the SFC concerning how such powers will be exercised, i.e.
such codes set out the SFCs specific requirements for granting authorization.

Authorization of collective investment schemes


Definition of CIS
9.21 The term collective investment scheme is given a lengthy definition in Schedule 1, SFO.
There are 3 aspects to the definition:
(a) what is positively defined as a CIS;
(b) what is excluded; and
(c) what is prescribed by the Financial Secretary (under s. 393, SFO).
9.22 The key elements of what constitutes a CIS are:
(a) an arrangement in respect of a property under which the management of the property is
not subject to the day-to-day control of the schemes participants, and either:
(i) the property is managed as a whole by or for the person operating the arrangement;
or
(ii) the participants contributions and accruing profits or income are pooled; and
(b) the purpose of the arrangement is to enable the participants to receive profits, income or
other payments or returns from the property or dealings relating to it.
9.23 Exclusions from the definition of a CIS include:
(a) arrangements where the participants and the operator of the arrangement belong to the
same group of companies;
(b) franchise arrangements; and
(c) arrangements where a solicitor acting in his professional capacity holds money from
clients during the course of his work.
9.24 The arrangements defined as CISs may be extended by the Financial Secretary using the
powers granted under s. 393, SFO.
9.25 The intention is to make the definition flexible, to ensure, where necessary, that any new
products are properly regulated.

Authorization of CIS
9.26 There are only two circumstances in which a CIS may be offered or marketed to the public in
Hong Kong: it must be either (i) structured as a company which is listed on the SEHK, or (ii)
authorized by the SFC. The authorization route is by far the most common approach taken,
and is the one considered in this section.
9.27 The SFC derives its powers in this regard from Part IV, SFO, which regulates the offering (and
advertising) of investments in Hong Kong.
9.28 Section 104, SFO states that, on an application to the SFC, the SFC may, where it considers
appropriate, authorize any CIS. There are two important qualifications to this authority.
9.29 First, the SFC may grant authorization subject to any other conditions it considers
appropriate. The SFC is also given the power to refuse to authorize applications and to
withdraw authorizations.
9.30 Second, the SFO requires that there must be an individual approved by the SFC to receive
notices and decisions served by the SFC relating to an authorized CIS. Contact details relating
to that person must be provided to the SFC. The SFC has powers to approve the contact person
or to withdraw the approval.

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9.31 The specific requirements of the SFC for authorization of CISs are set out in the Code on Unit
Trusts and Mutual Funds.
9.32 It should also be noted that other CISs not offered to the public may still be subject to the
regulation of the SFC via the licensing or registration regime.

Advertisements
9.33 Advertisements, invitations and documents which contain an invitation to the public
(Advertisements) in respect of certain matters may only be issued if they are authorized by
the SFC, or come under an appropriate exemption. A breach of this provision is an offence.
9.34 These provisions are set out in s. 103(1), SFO, which is concerned with advertisements either:
(a) to enter into or offer to enter into:
(i) an agreement to acquire, dispose of, subscribe for or underwrite securities; or
(ii) a regulated investment agreement (see Note below), or an agreement to acquire,
dispose of, subscribe for or underwrite any other structured product; or
(b) to acquire an interest in or participate in, or offer to acquire an interest in or participate
in, a CIS.
Note: It refers to any agreement which provides to a party to the agreement a profit, income
or other returns calculated by reference to changes in the value of any property (but
excluding an interest in a CIS).
9.35 The SFC may authorize Advertisements pursuant to s. 105(1), SFO. It may grant authorization
subject to any conditions it considers appropriate. It is also a condition that an individual has
been approved by the SFC to receive SFC notices and decisions relating to the Advertisements
in question, and that the SFC has been notified of such persons contact information.
9.36 There are several exemptions provided for in s. 103, SFO, which permit the issue of certain
documents and the acts of special groups, including the following:
(a) prospectuses complying with the CWUMPO;
(b) listing documents and certain other offer documents in relation to securities traded on a
recognized stock market;
(c) Advertisements issued by certain licensed corporations (see section 9.37 below for an
example);
(d) Advertisements in respect of securities or interests in CISs intended to be disposed of
only to professional investors;
(e) sellers or publishers of newspapers and other publications containing such advertisements;
and
(f) conduits or live broadcasters issuing such prohibited material in the ordinary course of
their business.
9.37 The SFC has provided a specific exemption from the SFCs authorization requirement in the
case of Advertisements in respect of securities (except for unlisted securities that are
structured products and unauthorized CISs) which are made by or on behalf of an intermediary
licensed or registered for Type 1, Type 4 or Type 6 RA.
9.38 It should also be noted that Advertisements to invest in an authorized CIS must comply with
the Advertising Guidelines Applicable to CISs Authorized under the Product Codes.

Advertising or offering CISs on the Internet


9.39 The SFC has issued the CIS Internet Guidance Note, which, inter alia, requires hard copies of
all CIS Internet advertisements to be submitted to the SFC for authorization. Where hyperlinks

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are provided, reasonable efforts should be made to ascertain that such links do not lead to
websites containing CIS advertisements targeting the public in Hong Kong and which have
not been authorized by the SFC. A hyperlink to an unauthorized CIS advertisement could
constitute an offence under the SFO.
9.40 The CIS Internet Guidance Note requires that authorized CISs must issue an up-to-date
prospectus whose paper version has been approved by the SFC. The prospectus should contain
the information necessary for investors to make an informed judgement of the proposed
investment. In general, an electronic prospectus should be made available in an online offering
of a CIS and in the same way the electronic application form is made available to investors.
More details are contained in the CIS Internet Guidance Note.

Misrepresentations
9.41 Advertisements are also subject to the provisions of the SFO concerning misrepresentation,
which provide for both civil remedies and criminal sanctions. The provisions are set out below,
and in reviewing them, it should be noted that:
(a) the misrepresentation provisions are not restricted to Advertisements to the public but are
of more general application; and
(b) actions may be taken in respect of both civil remedies and criminal sanctions.
9.42 Under s. 107, SFO, it is a criminal offence punishable by fine and/or imprisonment for a
person to make any fraudulent or reckless misrepresentation for the purpose of inducing
another person to:
(a) enter into or offer to enter into (i) an agreement to acquire, dispose of, subscribe for or
underwrite securities, or (ii) a regulated investment agreement or an agreement to acquire,
dispose of, subscribe for or underwrite any other structured product; or
(b) acquire an interest in or participate in, or offer to acquire an interest in or participate in,
a CIS.
See s. 107, SFO for definitions of fraudulent and reckless misrepresentation and also section
9.45 below.
9.43 The civil remedies for misrepresentation are established under s. 108, SFO, which is similar
to s. 107, SFO but in addition, covers negligent misrepresentation. Section 108, SFO provides
that where a person makes any fraudulent, reckless or negligent misrepresentation which
induces another person to:
(a) enter into or offer to enter into (i) an agreement to acquire, dispose of, subscribe for or
underwrite securities, or (ii) a regulated investment agreement or an agreement to acquire,
dispose of, subscribe for or underwrite any other structured product; or
(b) acquire an interest or to participate in, or offer to acquire an interest in or to participate
in, a CIS;
that person making the misrepresentation will be liable to pay compensation by way of
damages in respect of any pecuniary loss incurred by the other person as a result of relying on
the misrepresentation. A court may grant an injunction in addition to or as a substitute for
damages.
9.44 The liability to civil remedies is extended to every director of a company which has made a
misrepresentation, except to the extent it is proved that a director did not authorize the making
of that misrepresentation.
9.45 These different types of misrepresentation are defined in the SFO as follows:
(a) A fraudulent misrepresentation is any statement which is known to the person making the
misrepresentation, at the time it is made, to be false, misleading or deceptive.

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(b) A reckless misrepresentation is any statement which, at the time it is made, is false,
misleading or deceptive, and is made recklessly.
(c) A negligent misrepresentation is any statement which, at the time it is made, is false,
misleading or deceptive, and is made without reasonable care having been taken to ensure
its accuracy.
It should be noted that each of these definitions is extended to cover promises, forecasts and
material omissions.
9.46 The provisions of ss. 107 and 108, SFO also apply to persons that are excluded from the
licensing or registration requirements. For example, journalists are exempt from the licensing
or registration requirements for the publication of their investment advice. If there is evidence
showing that a journalist has made false or misleading statements, the SFC may prosecute the
journalist concerned.
9.47 Certain exemptions and riders are set out in other subsections of s. 108, SFO.

Authorization and marketing of structured products


Definition of structured product
9.48 The term structured product is given a lengthy definition in Schedule 1, SFO. The definition
of the term follows the same approach taken with CISs and identifies:
(a) what is positively defined as a structured product;
(b) what is excluded; and
(c) what is prescribed by the Financial Secretary (under s. 392, SFO).
9.49 The term structured product is defined to mean:
(a) a regulated investment agreement; and
(b) any instrument under which the return or amount due or the method of settlement is
determined by reference to either:
(i) changes in the price, value or level of other financial products (including securities,
commodities, indices, property, interest rates or currency exchange rates or futures
contracts); or
(ii) the occurrence or non-occurrence of specified events (other than events relating to
the issuer or guarantor of the instrument).
9.50 The arrangements defined as structured products may also be extended by the Financial
Secretary using the powers granted under s. 392, SFO.
9.51 There are several specific exclusions from the definition of a structured product, including
CISs, convertible debentures, and subscription warrants. The SFC has also provided a specific
exemption from the SFCs authorization requirement for certain structured products e.g.
currency-linked instruments and interest rate-linked instruments issued by AFIs.
9.52 It is also important to understand that although not all structured products are regarded as
securities as defined in the SFO, a structured product will be regarded as a security for the
purposes of the SFOs regulatory requirements if it is the subject of an offer to the public
which is authorized or required to be authorized under s. 105(1), SFO. Where a structured
product is regarded as a security, the licensing and registration regime will therefore apply.

Authorization of structured products


9.53 In general, structured products offered or marketed to the public in Hong Kong must be
authorized by the SFC (see Note below). Certain types of structured products may also be
listed on the SEHK, and those products will additionally need to comply with the applicable

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Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited
(Listing Rules). The authorization requirements are introduced below. The Listing Rule
requirements applying to listed structured products are outside the scope of this manual.
Note: A number of exemptions apply, including to certain types of products (see also section
9.51 above) and for offers to professional investors. However, further details of those
exemptions are outside the scope of this Manual.
9.54 Section 104A, SFO states that, on an application to the SFC, the SFC may, where it considers
it appropriate, authorize any structured product. There are two important qualifications to this
authority.
9.55 First, the SFC may grant authorization subject to any other conditions it considers
appropriate. The SFC is also given the power to refuse to authorize applications and to
withdraw authorizations.
9.56 Second, the SFO requires that there must be an individual approved by the SFC to receive
notices and decisions served by the SFC relating to an authorized structured product. In
practice the SFC requires such individual to be licensed or registered in respect of Type 1
(dealing in securities) or Type 4 (advising on securities) RA. Contact details relating to that
person must be provided to the SFC. The SFC has powers to approve the contact person or to
withdraw approval.
9.57 Where the SFC refuses to authorize a structured product, or refuses to approve an individual
as an authorized person, it must give reasons. The SFO also provides that the SFC may refuse
to authorize a structured product if the SFC is not satisfied that the authorization would be in
the interest of the investing public.
9.58 The specific requirements of the SFC for authorization of structured products are set out in
the Code on Unlisted Structured Investment Products (SIP Code).

Advertisements and misrepresentations


9.59 Structured products are subject to the same requirements under the SFO as for CISs in relation
to both advertisements (see sections 9.33 to 9.38 above) and misrepresentations (see sections
9.41 to 9.47 above).
9.60 It should also be noted that Advertisements to invest in an authorized structured product will
need to comply with the advertising guidelines set out in Appendix D to the SIP Code.

Marketing listed structured products


9.61 The SFC has also established specific guidelines related to the marketing of listed structured
products, such as warrants, through its Guidelines on Marketing Materials for Listed
Structured Products (Structured Products Guidelines). These provide guidance on the
expected content of marketing materials circulated and distributed to the public to disseminate
information on listed structured products with the intention or effect of promoting such
products.
9.62 The Structured Products Guidelines do not have the force of law, but a failure to comply with
them will reflect adversely on the fitness and properness of licensed or registered persons.
9.63 As a general principle, marketing materials relating to listed structured products should not be
false, biased, misleading or deceptive, and should include appropriate risk warnings.
Marketing materials are defined broadly and must be identified as such. In addition, the
Structured Products Guidelines provide guidance in relation to:
(a) contents of the marketing materials;
(b) explanation of risks of the underlying investment in the structured products as well as of
the structured products themselves;

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(c) presentation of a balanced view of the structured product, including potential gains and
losses; and
(d) legibility and prominence of required information.

Revision question:

Question 11: Under what circumstances may a CIS may be offered or marketed to the public in
Hong Kong?
Answer 11: There are only two such circumstances: it must be either (i) structured as a company
which is listed on the SEHK, or (ii) authorized by the SFC.

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10 Cross-border trading
Mutual market access
10.1 The mutual market access scheme establishes trading links between the Mainland China and
Hong Kong exchanges through the Shanghai-Hong Kong Stock Connect (Shanghai Connect)
and Shenzhen-Hong Kong Stock Connect (Shenzhen Connect) respectively launched in
November 2014 and December 2016 (together, the Stock Connects).
10.2 The Stock Connects allow investors in Mainland China to trade eligible securities listed on
the SEHK via the so-called Southbound trading links, and investors in Hong Kong to trade
eligible securities listed on the Shanghai Stock Exchange (SSE) and the Shenzhen Stock
Exchange (SZSE) via the so-called Northbound trading links.
10.3 Establishing mutual market access is an important step in developing capital market
connectivity between Mainland China and Hong Kong, the internationalisation of Mainland
Chinas capital markets, and the internationalisation of the Renminbi (RMB).
10.4 A principle of the Stock Connects is that home market rules and laws will apply to all trades.
While orders are placed through local securities firms, trading and clearing occurs subject to
the rules and procedures of the market where trading and clearing takes place, i.e. Shanghai
or Shenzhen in the case of the Northbound trading links, and Hong Kong in the case of the
Southbound trading links. Trading and clearing participants/members are regulated by the
rules and laws of the markets where they operate.
10.5 The Stock Connects are the subject of a memorandum of understanding (MOU) between
the SFC and the China Securities Regulatory Commission (CSRC) concerning cross-border
regulatory and enforcement concerns. The MOU addresses the sharing of information
concerning, and conducting joint investigations in relation to, suspected improper activities
including disclosure of false information, insider dealing and market manipulation.
10.6 The Stock Connects have no effect on the existing arrangements concerning the regulation of
each market, its listed companies, or intermediaries. Companies listed on the SEHK remain
subject to the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong
Limited (Listing Rules) (dual listed companies remain subject to regulation by their primary
regulator), and licensed corporations and registered institutions in Hong Kong participating in
Shanghai Connect or Shenzhen Connect remain subject to the regulatory oversight of the SFC
and HKMA respectively.
10.7 Trading via each of the Stock Connects may be suspended at any time by either of the relevant
exchanges participating in each trading link, either generally or in respect of specific securities,
where it considers a suspension necessary for ensuring a fair and orderly market. However,
any such suspension must be subject to the prior approval of the relevant regulator (SFC in
respect of SEHK, CSRC in respect of SSE/SZSE).

General trading, clearing and settlement mechanism


Investors
10.8 As regards the Northbound trading links, all Hong Kong persons and overseas investors who
are able to trade on the SEHK are able to participate. However, as noted below, during the
initial launch of Shenzhen Connect only institutional professional investors are permitted to
trade in stocks listed on ChiNext Board of SZSE.
10.9 As regards the Southbound trading links, the only Mainland China persons able to participate
are:
(a) institutional investors; and
(b) individual investors satisfying the eligibility criteria (presently being that an individual

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investor must hold at least RMB500,000 in his securities and cash accounts).

Eligible securities
10.10 Only eligible securities may be traded through the Stock Connects, as set out below. It is
expected that the range of securities able to be traded via the Stock Connects will develop
over time.

Northbound trading
10.11 Eligible securities for Northbound trading via Shanghai Connect are:
(a) constituent stocks of the SSE 180 Index:
(b) constituent stocks of the SSE 380 Index; and
(c) SSE listed A shares with a dual listing of H shares on the SEHK.
In each case provided the security is traded in RMB and the security has not been placed under
risk alert (see Note to next section) by the SSE.
10.12 Eligible securities for Northbound trading via Shenzhen Connect are:
(a) all the constituent stocks of the SZSE Component Index;
(b) the SZSE Small/Mid Cap Innovation Index which have a market capitalisation of not less
than RMB 6 billion;
(c) all the SZSE-listed A shares which have corresponding H shares listed on SEHK; and
(d) stocks listed on ChiNext Board of SZSE however, these are initially only open to
institutional professional investors.
In each case provided the security is traded in RMB and the security has not been placed under
risk alert by the SZSE.
Note: Securities placed under risk alert are either in a delisting process or at risk of being
subject to delisting, or are otherwise unstable due to financial or other reasons or
expose investors to undue risk.

Southbound trading
10.13 The following are eligible securities forSouthbound trading under both the Shanghai Connect
and the Shenzhen Connect:
(a) constituent stocks of the Hang Seng Composite LargeCap Index;
(b) constituent stocks of the Hang Seng Composite MidCap Index; and
(c) all H shares where the issuers have a dual listing with A shares listed on the SSE.
10.14 In addition, the following additional securities are eligible under the Shenzhen Connect for
Southbound trading:
(a) constituent stocks of the Hang Seng Composite SmallCap Index that have a market
capitalisation of not less than HKD 5 billion; and
(b) all H shares where the issuers have a dual listing with A shares listed on the SZSE.
10.15 However, securities traded on SEHK are not regarded as eligible securities if:
(a) the security is not traded in Hong Kong dollars;
(b) the security is an H share and the issuer of it has corresponding shares listed and traded
on any exchange in Mainland China other than SSE/SZSE; or
(c) the security is an H share and the issuer of it has corresponding A shares listed on either
SSE or SZSE that are placed under risk alert.

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10.16 In both Northbound and Southbound trading links, where a stock was eligible for trading due
to being a constituent stock in an index but ceases to be a part of the index, only sell orders
and no further buy orders will be permitted.
10.17 More complicated eligibility rules apply to the shares of companies with dual H share and A
share listings where one or both of those classes is newly admitted to listing or one of their
share classes is subject to suspension on the relevant exchange.

Trade quota
10.18 Trading under both the Northbound and Southbound trading links is subject to a daily quota
of the maximum amount by value that can be traded on that trading day. The Northbound daily
trading link quota for each of the Shanghai Connect and the Shenzhen Connect is RMB13
billion. The Southbound daily trading link quota for each of the Shanghai Connect and the
Shenzhen Connect is RMB10.5 billion. The daily quota is expected to be expanded as the
scheme develops.
10.19 The daily quota is calculated on a net buy basis. Sell trades effectively increase the amount
of available quota. Investors are always allowed to sell their cross-border securities,
irrespective of the daily quota balance. Buy trades are subject to there being available daily
quota.

Trading, clearing and settlement


10.20 Exchange participants/members of each of the three exchanges, SEHK, SSE and SZSE, and
clearing participants/members of each clearing house for each exchange, Hong Kong
Securities Clearing Company Limited (HKSCC) for SEHK and China Securities Depository
and Clearing Corporation Limited (ChinaClear) for SSE/SZSE, may participate in the Stock
Connects subject to their meeting specified eligibility criteria including: information
technology capability, risk management, client documentation and other requirements. SEHK
exchange participants that register to participate are known as China Connect Exchange
Participants (CCEPs). HKSCC clearing participants that register to participate are known
as China Connect Clearing Participants (CCCPs).
10.21 Trading under both the Northbound and Southbound trading links is undertaken through the
subsidiaries established by each exchange (Exchange Subsidiary) and local securities firms.
These local securities firms must be exchange participants/members of the relevant exchange
who have successfully applied to participate in the relevant Stock Connects and who have
signed an undertaking with the corresponding Exchange Subsidiary (being the one where the
local securities firm is located). In each case, orders are subject to matching and execution on
the relevant exchange platform, i.e. the SSE/SZSE platform for Northbound trades, and the
SEHKs Automatic Order Matching and Execution System platform for Southbound trades.
10.22 Risk management of clearing participants was discussed in Topic 4. Essentially the same
considerations apply to CCCPs save that, in relation to their activities under the Stock
Connects, marks and collateral are calculated and applied in relation to unsettled Northbound
stock positions, and are required to be provided in the form of cash in RMB unless HKSCC
otherwise approves. In addition, a Mainland settlement deposit and a Mainland security
deposit are required to be paid in an amount determined by HKSCC, and these deposits are
also normally required to be made in the form of cash in RMB.
10.23 As regards Northbound orders:
(a) an SEHK participant must be registered as a CCEP in order to execute the orders via the
relevant trading links;
(b) CCCPs must use the clearing and settlement facilities provided for each trading link to
clear and settle the trades;
(c) HKSCC, acting through its Mainland incorporated subsidiary, acts as a participant of

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ChinaClear;
(d) settlement obligations of the CCCPs are undertaken by HKSCC (as are other depository,
nomine and related services).
Note: A list of registered participants is published on the HKEX website. As at the end of 2016
the number of CCEPs and CCCPs are in excess of 140 each.
10.24 As regards Southbound orders received in the Mainland, ChinaClears Hong Kong based
subsidiary acts as a Special Participant of HKSCC to undertake essentially the same functions,
obligations and risk management provisions as other HKSCC participants and, accordingly,
settlement obligations of the investor are undertaken by ChinaClear. However, as for all SEHK
trades, HKSCC remains the central clearing party.
10.25 Currently, investors will only be able to trade on the other market through the Stock Connects
on days where both markets are open for trading and banking services are available in both
markets on the corresponding settlement days.
10.26 Southbound executed trades are settled on the usual T+2 basis as for other trades executed on
the SEHK. However, Northbound executed trades are settled on the trade day for securities
settlement and on a T+1 basis for money settlement. (See pre-trade checking in sections 10.27
and 10.28 below.)

Pre-trade checking for Northbound trades


Standard pre-trade check
10.27 The pre-trade check requirements reflect the practices in respect of local orders undertaken on
the SSE/SZSE. Eligible securities can only be sold via the Northbound trading links if they
have been deposited with the relevant exchange participants (which act as selling brokers) not
later than the end of the trading day prior to the intended date of sale. If the shares are kept in
accounts with custodians or other exchange participants that are not the intended selling
brokers, investors must transfer the shares to the exchange participants acting as selling
brokers prior to the intended date of sale. Eligible A shares acquired by Hong Kong and
overseas investors via the Stock Connects will be held in HKSCCs omnibus stock account
maintained with ChinaClear. SSE/SZSE will verify the sell orders received via the relevant
Stock Connects in respect of the eligible A shares against HKSCCs account balance as at the
end of the last trading day. Sell orders will be rejected if they are excess of the shareholding
as recorded in HKSCCs account in the relevant stock.

Enhanced pre-trade check


10.28 An enhanced pre-trade checking model may optionally be used. An investor whose
shareholdings are maintained with a Custodian Participant of HKSCC or a General Clearing
Participant of HKSCC which is not an exchange participant, is permitted to open a special
segregated account (SPSA) with Central Clearing and Settlement System (CCASS) to
which a unique investor identification number is attached. CCASS takes a snapshot of an
investors holding in the SPSA and copies such holding to the system conducting the pre-trade
checking by referring to the unique investor identification number input with a sell order for
the investor. An investor holding securities in an SPSA is able to place sell orders by providing
to the exchange participant (which act as the selling broker) its investor identification number
and the order can be executed if there are sufficient shares in the SPSA. This means that shares
only need to be transferred to the investors account maintained with the exchange participant
following the sell order being executed and matched. Under the standard pre-trade check, this
would need to occur prior to the sell order being placed.

Custodian of Northbound traded securities


10.29 Shares that have been traded under the Northbound trading links are held by HKSCC for the
account of its participants in an omnibus account maintained with ChinaClear. These shares

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are uncertificated and are recorded in computerized form in CCASS and physical deposit or
physical withdrawal of them is not available.

Default
10.30 Neither HKSCC nor ChinaClear participates in each others mutualized risk management
pools (e.g. the guarantee fund of HKSCC) that are normally contributed by their home market
clearing participants. ChinaClear is not required to contribute to the HKSCC Guarantee Fund
and will not be required to share any default loss of CCCPs. The Guarantee Fund contributions
of CCCPs will not be utilized to offset close-out loss in the event of ChinaClears default.
10.31 When an event of default of a CCCP in Northbound trade (i.e. eligible SSE and/or SZSE
securities) positions occurs, HKSCC may declare the CCCP as a defaulter and the positions
of the defaulting CCCP, including positions in Hong Kong shares, SSE and SZSE securities,
will be closed out by authorized brokers appointed by HKSCC. If there is net closing-out loss
which is unable to be fully covered by the defaulting CCCPs collateral, the guarantee fund
will be utilized in accordance with applicable rules.
10.32 If ChinaClear defaults in relation to a Northbound trade, HKSCC would in good faith seek
recovery of the outstanding stocks and monies from ChinaClear through available legal
channels and through ChinaClears liquidation process. HKSCC will in turn distribute the
stocks and monies recovered to CCCPs on a pro-rata basis.

Additional restrictions on Northbound trading


10.33 A number of restrictions apply specifically to the Northbound trading links that do not apply
to the Southbound trading links, primarily because of differences in trading practices on the
SSE/SZSE or because of applicable laws in the Mainland.
10.34 Margin trading is permitted:
(a) only on shares that the SSE/SZSE has specified as eligible for margin trading; and
(b) only for CCEPs and exchange participants who are registered with SEHK to conduct
Northbound trading through CCEPs for the account of their clients.
Note: The SSE/SZSE may suspend further margin trading after the margin trading indicator
for the stock reaches 25%. When the margin trading indicator drops below 20%, it
will allow margin trading to resume.
10.35 Stock borrowing and lending (SBL) is permitted only:
(a) for covered short selling activities undertaken through the Northbound trading link (an
investor borrows Northbound trading link eligible securities and sells them on SSE or
SZSE) here the SBL agreement cannot be for a period longer than one calendar month;
or
(b) for meeting pre-trade checking requirements (such as when an investor cannot transfer
sufficient quantity of the Northbound trading link eligible securities he intends to sell to
his selling broker for pre-trade checking) here the SBL agreement cannot be for a period
longer than one day (i.e. roll-over is not allowed).
10.36 SBL is also subject to additional restrictions set by the relevant exchange. Only certain types
of persons, as determined by SSE or SZSE, may act as stock lenders. All SBL activities must
be reported to the SEHK.
Note: Securities that are not eligible for both buy and sell orders (see sections 10.18 and
10.19 on trade quotas above) may not be subject to stock borrowing and lending for
the purpose of covered short selling.
10.37 Day trading is not permitted, i.e. shares bought cannot be sold before settlement and so cannot
be sold on the same trading day.

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10.38 The Mainland China imposes two limits on foreign (i.e. non-Mainland China) ownership of
listed companies: no single foreign investor can own more than 10% of a listed companys
issued shares and total foreign investors ownership of a listed company cannot exceed 30%
of its total issued shares. HKEX will publish a notification on its website where the SSE/SZSE
have informed it that these limits are being approached. Foreign investors will be requested
to sell the shares if the 30% threshold is exceeded.
10.39 The Mainland China also has disclosure rules for persons whose holding reaches 5% of a
companys shares that may impact on the ability of that persons to trade during specified
periods.

Short selling via the Northbound trading links


10.40 Covered short selling of eligible securities is permitted for Northbound trading, but only on
those securities that have been specified by the SSE or SZSE these are published on the
HKEX website. Each CCEP needs to ask its client to confirm whether an order is a short
selling order or has established effective procedures that require the client placing a short sell
order to identify it as such. CCEPs handling short selling orders on specified securities will
also need to observe the relevant restrictions and requirements including the following:
(a) a CCEP needs to undertake pre-trade checking to ensure the borrowed securities are in
its clearing account with CCASS by the commencement of trading that day;
(b) the relevant order must comply with restrictions on (i) the number of securities that can
short sold on a given trading day and (ii) the price at which a short sale order may be
input into the trading system (see Notes below). HKEX publishes on its website each
trading day the number of securities available for short selling - the list is updated every
fifteen minutes during the trading day; and
(c) exchange participants must submit reports to the SEHK on the open short position of
securities (i.e. total number of shares of a specified security that have been short sold
through the Stock Connects less the total number of shares borrowed for the purpose of
short selling that have been returned to the relevant stock lender).
Note 1: The number of shares that may be short sold may not exceed 1% on the number of
shares of that short selling security held by all investors through the CCASS as at the
commencement of that trading day and should not accumulate more than 5% in any
period of ten consecutive trading days.
Note 2: A short selling order must not be input at a price lower than the most recent execution
price or the previous closing price (if there have been no executed trades) for that
short selling security.
10.41 Each of SSE and SZSE may suspend the short selling activities of an A share listed on its
market when the total open short positions in that A share reaches 25% of the stocks listed
and tradable shares, and may resume short selling activities when the A shares total open
short position drops below 20%.
10.42 As with Southbound trading, naked short selling is not permitted to be undertaken in respect
of Northbound trading.
Note: Short selling undertaken by Mainland China persons via the Southbound trading links
is subject to the local rules applicable to investors and intermediaries in Mainland
China and so is outside the scope of the syllabus of this manual.

Updates to the mutual market access scheme


10.43 The Stock Connects have been established as a scalable arrangement and are expected to
develop overtime. This is expected to include an expansion of the quotas but may also include
a widening of the securities eligible for the trading links. The SFC and the CSRC have reached

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a consensus to include Exchange Traded Funds as eligible securities under the mutual market
access scheme in due course. SSE B shares and other types of listed securities such as warrants
and bonds which are not presently included as eligible securities may be included in future.
The eligibility criteria for Mainland China persons eligible to participate may also change over
time. The Stock Connects are also restricted to secondary market trading and there have been
some discussion as to whether primary market activities such as initial public offerings might
be able to be supported in the future.

Revision questions:

Question 12: Are all Mainland China persons able to participate in the Southbound trading links?
Answer 12: No, only institutional investors and any individual investors who hold RMB500,000
or more in his securities and cash accounts.
Question 13: What is the Northbound daily trading link quota of Shanghai Connect and the
Shenzhen Connect?
Answer 13: The Northbound daily trading link quota for each of the Shanghai Connect and the
Shenzhen Connect is RMB13 billion.

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Topic summary
In this Topic, we began with the discussion about the legal and/or regulatory requirements for
approved introducing agents, SMF, short selling, securities borrowing and lending activities and
advising on securities.
With the evolution of information technology, carrying out securities related activities via electronic
means are becoming popular. Regulatory guidelines for online securities trading and advising
activities, operation of ALPs and the legislative framework governing ATS in Hong Kong were then
reviewed.
We further looked at offers of securities, including (a) the statutory requirements under CWUMPO
and SFO in relation to offers to buy or sell securities; (b) laws and regulation regarding authorization
of CISs and structured products; and (c) guidelines regarding marketing of structured products.
Finally, we reviewed the regulatory aspects of the cross-border trading arrangement between
Mainland China and Hong Kong.

Checklist
Below is a checklist of the main points covered by this Topic. Candidates should use this list to test
their knowledge.
Approved introducing agents form a sub-set of dealers in securities, not defined in the SFO but
specified under FRR to cover introducers of securities business to other securities dealers. An
approved introducing agent does not handle client assets and incurs no legal liability in respect
of the introduced business.
SMF is defined as the provision of financial accommodation in order to facilitate the acquisition
of securities listed on any stock market and, where applicable, the continued holding of such
securities.
Standards of business practice expected by the SFC of the licensed persons providing SMF are
stated in the Code of Conduct.
Licensed persons providing SMF should segregate margin and cash client accounts to ensure
transactions and assets booked under a clients cash account is not commingled with those
booked under the clients margin account.
Licensed persons providing SMF need to obtain clients written standing authority before they
pool and repledge client securities collaterals.
Licensed persons providing SMF should ensure that a written margin client agreement has been
entered into with a client before margin lending is provided to the client.
Under s. 170, SFO, a person shall not sell securities at or through a recognized stock market
unless at the time he sells them, he or his principal has (or he believes he or his principal has) a
presently exercisable and unconditional right to vest the securities in the buyer.
Regulated short selling means the sale of a security in respect of which the seller, or a person for
whose benefit or on whose behalf the sale is made, has a currently exercisable and unconditional
right to vest the security in the purchaser.
Exchange Participants must indicate short orders when inputting the orders to the trading system.
SBL refers to the activity whereby a person borrows or lends securities on the condition that the
borrower undertakes to return securities of the same description on a future date, or pay the
equivalent value of the securities as it is on that date to the lender. It includes a stock borrowing
as defined in the Stamp Duty Ordinance for the purposes of exempting such transactions from
stamp duty.

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An analyst must adhere to high standards of ethical behaviour and integrity and have a reasonable
basis for analyses and recommendations.
A firm issuing research reports must implement appropriate mechanisms to avoid potential
conflicts of interest.
A licensed or registered person is responsible for the settlement and financial obligations of
orders sent to the market through its electronic trading system and the implementation of policies,
procedures and controls to supervise the orders in compliance with applicable regulatory
requirements.
A licensed or registered person should effectively manage and adequately supervise the design
and operation, ensure the integrity, monitor the capacity usage, and have proper records on the
design and development, comprehensive documentation of the risk management controls and
audit logs on the activities and incident reports of the electronic trading system it uses or provides
to clients for use.
ALP means an electronic system operated by a licensed or registered person through which the
crossing/matching of orders involving securities listed or traded on exchanges is conducted with
no pre-trade transparency.
An ALP operator should effectively manage and adequately supervise the design, development,
deployment and operation of the ALP.
An ALP operator should observe the conduct requirements concerning the access to and
operation of the ALP, ensure the integrity of the ALP methodology operates in the interest of
preserving market integrity, ensure the adequacy of the ALP system, keep proper records
concerning the design and operation of the ALP and make proper reports or notification to its
users, exchanges, the SFC and other regulators.
The issuing of advertisements or other documents relating to securities, investment arrangements
and investment advising services via the Internet requires the SFCs approval if they are targeted
at Hong Kong residents.
The provision of ATS is covered in two places in the SFO. A person may be authorized under s.
95(2), SFO to provide ATS similar to the services provided by a recognized exchange or
recognized clearing house, or may be licensed (or in the case of an AFI, may be registered) to
provide ATS as a RA, under Part V, SFO.
The Guidelines for the Regulation of ATS set out the principles, procedures and standards for
the regulation of ATS.
CWUMPO requirements relating to prospectus for offer of securities.
Features of CISs are that they are arrangements in respect of property under which the
management of the property is not subject to the day-to-day control of the schemes participants,
and the property is managed as a whole by or for the person operating the arrangement, the
participants contributions and accruing profits or income are pooled, and the purpose of the
arrangement is to enable the participants to receive profits, income or other payments or returns
from the property or dealings relating to it.
There are only two circumstances in which a CIS may be offered or marketed to the public in
Hong Kong: it must be either (i) structured as a company which is listed on the SEHK, or (ii)
authorized by the SFC. The authorization route is by far the most common approach taken.
Advertisements, invitations and documents which contain an invitation to the public in respect
of certain matters may only be issued if they are authorized by the SFC, or come under an
appropriate exemption. A breach of this provision is an offence.
It is an offence for a person to make a fraudulent or reckless misrepresentation for the purposes
of inducing another person to participate in CISs or structured products and, if a person does

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make a fraudulent, reckless or negligent representation for such a purpose, he may be liable to
the other person for any loss suffered as a result of relying on the misrepresentation.
Marketing materials relating to listed structured products should not be false, biased, misleading
or deceptive, and should include appropriate risk warnings.
The Stock Connects allow investors in Mainland China to trade eligible securities listed on the
SEHK via the so-called Southbound trading links, and investors in Hong Kong to trade eligible
securities listed on the SSE and SZSE via the so called Northbound trading links.
Only eligible shares may be traded through the Stock Connects.
Trading under both the Northbound and Southbound trading links via the Stock Connects is
subject to daily quota of the maximum amount by value that can be traded. The daily quota is
calculated on a net buy basis.
Northbound trades are subject to pre-trade check that eligible securities can only be sold if they
have been deposited with the relevant exchange participants which act as selling brokers or have
opened a SPSA with CCASS and have sufficient shares in the SPSA.
As with Southbound trading, naked short selling is not permitted to be undertaken in respect of
Northbound trading. Covered short selling of eligible securities is permitted for Northbound
trading.

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[Blank Page]
Topic 6: Exchange traded options and over-the-counter
derivatives
Table of contents
Topic overview 1
Learning outcomes 1
A Exchange traded options 3
1 Introduction 3
Options traded on The Stock Exchange of Hong Kong Limited (SEHK) 3
The trading and clearing and settlement systems 4
2 Participant types and access rights 6
Options Exchange Participant 6
Options Trading Exchange Participant 6
Options Broker Exchange Participant 6
Termination of participantship 7
The SEHK Options Clearing House Participant 7
Market makers 8
Access to Hong Kong Futures Automated Trading System 9
3 Trades monitoring, position limits and reporting requirements 11
Trades monitoring 11
Position limits and reporting requirements 12
4 Clearing and margin 14
Client margin calculations 14
Collection of premiums and collateral 14
Default by clients 15
Intra-day margin 15
5 Settlement 16
Exercise of options 16
Payment to clearing house 16
B Over-the-counter (OTC) derivatives 18
6 Licensing 18
Fit and proper 19
Risks of OTC derivatives trading 20
Risk management policies and procedures 21
Oversight by senior management 22
Independent credit risk management 22
Adequate resources 23
Progress of the developing new OTCD regime 23
7 Ongoing requirements 25
Systems 25
Risk reduction techniques 25
Valuations and exposures 25
Monitoring of financial performance 26
Topic summary 27
Checklist 27
[Blank Page]
Topic overview
This Topic covers regulatory considerations in regard to the trading and settlement of options on
stocks traded on The Stock Exchange of Hong Kong Limited (SEHK), as well as a brief discussion
of the regulatory aspects of trading in over-the-counter (OTC) derivatives.
Part A of the Topic applies to options on stocks traded on the SEHK which are generally referred to
as Traded Options. It begins with a brief introduction of options in general, the applicable exchange
and clearing house rules and the trading and clearing systems for Traded Options.
Next, we consider the participant types and access rights to trade and clear Traded Options on the
SEHK and The SEHK Options Clearing House Limited (SEOCH) respectively, and discuss the
relevant requirements of the SEHK and the SEOCH.
We also consider the monitoring of trades (the requirements regarding identity of clients, restrictions
on client business and handling of error trades, etc.) followed by a review of positions and reporting
requirements.
We then review clearing and margins including client margin calculations, collection of collateral,
defaults by clients and intra-day margin calls.
In the final section of Part A, we have a discussion on settlement in particular, option exercises and
payments to the SEOCH.
Part B covers regulatory considerations for OTC derivatives business.
As a result of decisions taken by the Group of Twenty and Financial Stability Board (including Hong
Kong), Hong Kong is in the process of implementing a new legislative and regulatory framework for
OTC derivatives transactions. Amongst others, two new regulated activities (RAs) will be
introduced and the scope of two existing RAs will be expanded to cover activities in OTC derivatives.
The discussion here addresses the existing framework and candidates should have a general
awareness of the progress of the development and implementation of the new framework.
In the context of the existing framework, we look at the regulatory considerations of these
requirements under two main headings licensing and on-going requirements. First, we consider the
requirements of the fit and proper in regard to off-exchange business and then move to particular
matters of risk management policies and procedures. Next, we address the requirements for oversight
by senior management, the need for independent credit risk management, and the basics of ensuring
that an intermediary has adequate resources under the circumstances.
In the final section we turn to an intermediarys ongoing requirements and take a brief look at the risk
reduction techniques that are expected to be in place. Following that, we examine the need for and
attention to be paid to valuations and pricing. Finally, we look at the requirements for monitoring
financial performance in the OTC derivatives business.

Learning outcomes
At the end of the Topic, candidates should be able to:
Part A: Exchange traded options
(a) explain the nature of the RA of dealing in Traded Options in Hong Kong and how it is structured;
(b) understand the various classes of participantships in relation to Traded Options business and the
requirements applicable to their activities;
(c) understand the role of market makers in the trading of Traded Options and the rules they have to
comply with;
(d) understand the rules relating to the various classes of SEOCH participantships and to the clearing
system;

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(e) know the capital, margin and other contribution requirements and the imposition of trading and
other limits; and
(f) understand the exercise and settlement procedures for Traded Options;

Part B: OTC derivatives


(g) appreciate the fit and proper test as applied to OTC derivatives business;
(h) understand the risk management requirements;
(i) understand the relationship between these matters and the intermediarys internal organisation;
(j) appreciate the additional system requirements for OTC derivatives business; and
(k) appreciate the obligation to monitor financial performance requirements in OTC derivatives
business.

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A Exchange traded options
1 Introduction
1.1 An option gives the holder the right, but not an obligation:
(a) to buy or sell a security, commodity or other underlying instrument; or
(b) otherwise, to exercise the right and obtain the benefits that are related to favourable
movements in an underlying measure such as an interest rate.
1.2 It is called an option (in contrast to a futures contract or a forward), as the holder may or may
not exercise the option, as he chooses. Options are usually for a specific period and for a
specific exercise price.
1.3 Options are written by one person (the writer) and issued at a price (the premium) to
another person (the holder). The option may subsequently be traded on the market (e.g. the
SEHK) for a varying price (the premium) dictated by market forces. Options have the
following characteristics:
(a) The writer incurs obligations that remain outstanding for the life of the option; such an
obligation may be for an unlimited amount.
(b) The loss of the holder is limited to the premium he pays. This is because, in the worst
case, if the movement against which his benefit is measured is adverse, the holder may
decide to abandon the option at its expiry date and will then lose the amount of the
premium he paid to purchase the option.
1.4 Derivatives are defined (under the context of market misconduct) in s. 245, Part XIII and s.
285, Part XIV, Securities and Futures Ordinance (SFO), in relation to listed securities
(whether or not the derivatives themselves are listed), to mean:
(a) rights, options or interests in, or in respect of, listed securities;
Note: These are also securities per the definition of securities.
(b) contracts for the purposes of making a profit or avoiding a loss, by reference to the price
of listed securities or rights, options or interests in listed securities;
(c) rights, options or interests in respect of (a) or (b); and
(d) instruments or other documents creating, acknowledging or evidencing any rights,
options or interests or any contracts referred to in (a), (b) or (c).
1.5 Options are normally considered as derivatives, and it might therefore seem more logical to
study them with other derivatives such as futures. However, Traded Options are traded on the
SEHK. Dealing in Traded Options is Type 1 RA under the licensing regime and is studied
under the operations of the SEHK; while options on futures contracts, which are traded on
Hong Kong Futures Exchange Limited (HKFE), are covered in the study of the Type 2 RA
of trading in futures contracts. This is one of the anomalies of the Hong Kong market, as it
might appear to contradict the customary references to the SEHK as the cash market and
HKFE as the derivatives market. Traded Options are classified as securities under the SFO.
This Topic does not include discussion about options on futures contracts, which are defined
by the SFO as futures contracts.

Options traded on The Stock Exchange of Hong Kong Limited


(SEHK)
1.6 As mentioned above, options on stocks are traded on the SEHK and generally referred to as
Traded Options. There are two types of options traded on the SEHK, call options and put
options.

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1.7 A call option is a contract which gives the holder the right but not the obligation to buy a fixed
number of shares of a specified stock, the underlying, at a fixed price, the exercise price,
at any time on or before a specified date.
1.8 A put option is a contract which gives the holder the right but not the obligation to sell a fixed
number of shares of a specified stock at a fixed price at any time on or before a specified date.
1.9 Options traded on the SEHK are so-called American-style options because they are
exercisable at any time during their outstanding life; this contrasts with European-style options,
which are only exercisable on the expiry date.
1.10 Traded Options are written on actively traded stocks which are listed on the SEHK.
1.11 The primary legislative and regulatory framework covering Type 1 RA is addressed in
previous topics of this study manual. In addition, the following are rules promulgated by the
SEHK governing trading of Traded Options business:
(a) Options Trading Rules of the Stock Exchange (Options Trading Rules);
(b) Operational Trading Procedures for Options Trading Exchange Participants of the Stock
Exchange (Options Trading Procedures);
(c) HKATS Trading Procedures;
(d) Options Clearing Rules of SEOCH (SEOCH Rules);
(e) Operational Clearing Procedures for Options Trading Exchange Participants of SEOCH;
and
(f) General Rules of CCASS (CCASS Rules).

The trading and clearing and settlement systems


Trading system
1.12 Traded Options are traded electronically through Hong Kong Futures Automated Trading
System (HKATS), which is a transaction-based network system. Trading on HKATS can be
conducted through HKATS workstations located at the premises of the Options Exchange
Participants. Alternatively, Options Exchange Participants may develop their own application
software to connect to HKATS. The system displays current market information and
automatically matches buy/sell orders based on price/time priority.
1.13 With HKATS, orders are placed electronically into the Central Orderbook. The system
automatically matches the corresponding buy or sell orders in real time based on price/time
priority. The executed trade is reported back to the trader, who can then confirm the trade
immediately with his client. At the same time, information on the Traded Options trades is
electronically transmitted to the SEOCH for registration, clearing and settlement.
1.14 There is a pre-market opening period. The main objective of the pre-market opening
mechanism is to establish an opening price before the market opens so as to prevent large
price fluctuations and manipulation at the opening.
Clearing and settlement system
1.15 The Derivatives Clearing and Settlement System (DCASS) is the common platform for the
clearing and settlement of Traded Options traded on the SEHK and products traded on HKFE,
including index futures and options, single stock futures and options. SEOCH maintains for
each SEOCH participant different types of clearing accounts in DCASS.
1.16 From the initial recording of a matched trade in DCASS, the process flow is to the SEOCH,
which is responsible for clearing the options. The SEOCH monitors risks (determines the
margin to be collected, monitors the size of the Reserve Fund, carries out surveillance,
including the review of position ratios and/or position limits, etc.) and acts as the clearing
house. The SEOCH is the counterparty for all trades and the guarantor of performance in

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respect of money settlement and stock delivery.
1.17 The SEOCH participants enter exercise instructions for house or client positions using
DCASS terminals. The SEOCH performs assignment and novation and the resultant stock
transactions are passed to Central Clearing and Settlement System (CCASS) for settlement.
Through the legal process of novation, Hong Kong Securities Clearing Company Limited
guarantees settlement by acting as the settlement counterparty to CCASS clearing participants
and assuming the settlement risk.
Note: Novation refers to the legal change of counterparty in a contractual transaction.

Revision question:

Question 1: What is the trading system for Traded Options?


Answer 1: HKATS.

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2 Participant types and access rights
2.1 In order to conduct any Traded Options business for clients, an Exchange Participant must be
admitted and registered by the SEHK as an Options Exchange Participant under one of the
following categories:
(a) Options Trading Exchange Participant (Trading Participant); or
(b) Options Broker Exchange Participant (Broker Participant).
A Trading Participant may apply to the SEHK for permission to make a market in a particular
option class. Please see sections 2.15 to 2.20 of this Topic for details.
2.2 All trading of Traded Options must be carried out on HKATS via an Trading Participants
connection, except otherwise authorized by the SEHK.

Options Exchange Participant


2.3 Each Options Exchange Participant (which includes Trading Participants and Broker
Participants) shall at all times:
(a) adhere strictly to, and be bound by, the Options Trading Rules and the Options Trading
Procedures and any conditions attached to its approval as an Options Exchange
Participant; and
(b) comply with all matters, such as decisions, directives and guidelines, in relation to the
above rules and procedures, as well as the SEOCH Rules and the CCASS Rules which
may affect it to the extent they are applicable.

Options Trading Exchange Participant


2.4 A Trading Participant must:
(a) be an Exchange Participant (hence, it must be licensed by the SFC to conduct Type 1 RA);
(b) be a participant of the SEOCH or have entered into a clearing agreement with a SEOCH
General Clearing Participant (General Clearing Participant) to the effect that the
General Clearing Participant undertakes to clear for the participant all its options trades
carried out through the SEHK;
(c) have installed at one or more registered business addresses such computer equipment and
software as may be specified by the SEHK and the options systems operator for gaining
access to HKATS, and ensure that such computer equipment is operated and maintained
in accordance with SEHK requirements; and
(d) have in place, to the satisfaction of the SEHK, staff and internal operating and security
procedures necessary, amongst other things, to enable it always to have access to HKATS
for the purpose of conducting its Traded Options business and where applicable for
processing instructions from its clients and for providing professional services to its
clients.

Options Broker Exchange Participant


2.5 A Broker Participant must:
(a) be an Exchange Participant (hence, it must be licensed by the SFC to conduct Type 1 RA);
(b) have in place, exclusively with one Trading Participant which is a SEOCH Direct
Clearing Participant or a General Clearing Participant, an options broking agreement; and
(c) have in place, to the satisfaction of the SEHK, staff, computer equipment and internal
operating and security procedures necessary, amongst other things, to enable it always to

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have access to updated price information regarding Traded Options for the purpose of
conducting its Traded Options business and, where applicable, for processing instructions
from its clients and providing professional services to its clients.

Register
2.6 The SEHK maintains a register of Options Exchange Participants containing the full name
and address of each Options Exchange Participant together with the date of its admission, the
category of options exchange participantship under which it is registered, and such other
information as is required. The register is open for public inspection on payment of a
prescribed fee and also through Hong Kong Exchanges and Clearing Limited website.

Termination of participantship
2.7 Where an Options Exchange Participant resigns his participantship, which must be by giving
written notice to the SEHK, the SEHK may still give directions and order other actions as it
sees fit, including requiring the Options Exchange Participant to close, give-up or allow the
expiration of contracts to which it is a party.
2.8 The resignation will only take effect when no open positions of that Options Exchange
Participant remain, all his delivery obligations have been met, all his obligations to the SEHK
and SEOCH, as applicable, have been fulfilled, and the SEHK notifies the Options Exchange
Participant that its participantship is cancelled according to the Options Trading Rules.

The SEHK Options Clearing House Participant


2.9 There are two categories of SEOCH participants, each of which has different function:
(a) a Direct Clearing Participant can register and clear trades for its own and clients accounts;
and
(b) a General Clearing Participant can register and clear trades for its own account, its clients
accounts and other Trading Participants own and clients accounts.
2.10 Each SEOCH participant must, among other things:
(a) be in good standing as a Trading Participant and be in compliance with the Options
Trading Rules;
(b) have adequate personnel, back office systems and computer hardware and software to the
satisfaction of SEOCH;
(c) have liquid capital of not less than the higher of:
(i) its required liquid capital under the Securities and Futures (Financial Resources)
Rules; or
(ii) HK$20 million if a General Clearing Participant or HK$5 million if a Direct
Clearing Participant; and
(d) deliver collateral to SEOCH for its initial contribution to the Reserve Fund: HK$5 million
if a General Clearing Participant or HK$1.5 million if a Direct Clearing Participant.
2.11 A General Clearing Participant must also contribute to the Reserve Fund HK$1.5 million in
respect of each clearing agreement entered into with Trading Participants from the fourth
agreement onwards.
2.12 The SEOCH maintains for each SEOCH participant different types of clearing accounts in
DCASS. These accounts are registered under the name of the SEOCH participant.
2.13 SEOCH also maintains for each SEOCH participant different types of clearing accounts in the
Common Collateral Management System, a common sub-system of DCASS for recording
collateral movement transactions between that SEOCH participant and SEOCH.

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2.14 SEOCH participants can make enquiries and carry out various types of rectification on trades
executed during the day via DCASS terminals. They can also give-up trades they have
executed during the day to other SEOCH participants, or confirm taking up trades from other
SEOCH participants via their DCASS terminals.

Market makers
2.15 In order to promote liquidity, the SEHK operates a market-maker mechanism in Traded
Options market. A Trading Participant may apply to the SEHK for permission to make a
market in a particular option class, whether as a Regular Market Maker or a Primary Market
Maker. Before such permission is granted, the SEHK may require the participant to
demonstrate to the satisfaction of the SEHK that it is suitably qualified to make a market in
the options contracts in respect of which it applies to be a market maker. The SEHK may
consider the financial standing, trading record, personnel, computer equipment and internal
security procedures of the applicant. The SEHK keeps a register of all such approved market
makers, including the option classes in which they act as market makers.

Regular Market Makers


2.16 The following rules apply to Regular Market Makers:
(a) Each Regular Market Maker is entitled to enter quotes into HKATS on receipt of quote
requests or according to the obligation to provide continuous quotes.
(b) Subject to compliance with Options Trading Rules, each Regular Market Maker will be
permitted to enter a number of quotes simultaneously into HKATS. This is important for
Regular Market Makers, since, for any change in the price of an underlying instrument,
they will often need to adjust immediately all the option series prices in their charge;
otherwise, arbitrage opportunities could arise, causing them to be exposed to losses.
(c) Each Regular Market Maker must, on receipt of a quote request for an option series in an
option class for which he holds a current Regular Market Maker permit, to enter a quote
into HKATS for at least a prescribed minimum number of option contracts (lots), the
quote to be held for a prescribed minimum period of time.
(d) A bid and offer spread no greater than the maximum specified by the SEHK must also
form part of such a quote by the Regular Market Maker.
(e) Each Regular Market Maker must be available to respond to quote requests or provide
continuous quotes on all trading days during the period for which its permit is granted,
unless specifically exempted by the SEHK.
(f) The SEHK may prescribe such regulations as set out in the Second Schedule of the
Options Trading Rules from time to time as it think fit. Regular Market Makers are also
required to comply with such regulations.

Primary Market Makers


2.17 The following rules apply to Primary Market Makers:
(a) Each Primary Market Maker must enter quotes into the HKATS on receipt of quote
requests and to provide continuous quotes in accordance with the terms and conditions
of its appointment letter.
(b) A Primary Market Maker must:
(i) on receipt of a quote request for an option series in an option class for which it is
registered as a Primary Market Maker:
enter a quote into the HKATS for at least such minimum number of Traded
Options contracts;

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hold the quote for such minimum period of time; and
respond within such period of time after receipt of the quote request, as may be
specified in its appointment letter; and
(ii) provide continuous quotes for the assigned option series in an option class for which
it is registered as a Primary Market Maker for such minimum number of options
contracts and with such maximum bid and offer spread as may be specified in its
appointment letter.
(c) Primary Market Makers must respond to no less than a certain percentage of quote
requests and provide continuous quotes for no less than a certain percentage of trading
hours as may, in each case, be specified in its appointment letter.
(d) Each Primary Market Maker must be available to respond to quote requests and provide
continuous quotes on all trading days during the period for which its permit is granted,
unless specifically exempted by the SEHK.
(e) The SEHK may from time to time prescribe additional requirements, obligations,
restrictions and conditions which must be complied with by a Primary Market Maker, by
giving written notice to it to amend its appointment letter.

Rights of market makers


2.18 A market maker is entitled to fee discounts for those option classes where it is a market maker
and where such trades are allocated to its house account.

Records of hedging activities


2.19 A market maker is also required to maintain as part of its records, and make available for the
SEHKs inspection, certain information on the portfolio it carries solely for hedging its market
making activities.

Suspensions and revocations


2.20 The SEHK has a number of rights to suspend or revoke a market makers permit. For example,:
(a) the SEHK has the right to suspend market making obligations on declaring unusual
market conditions, such as when volume in an options class deviates from the normal
operation of such options class; or
(b) a Regular Market Makers failure to respond to at least 50% of quote requests per option
class in two consecutive months may lead to the SEHK revoking the market maker permit
unless it can demonstrate reasonable grounds for such failure.
It is not necessary for this Topic that responsible officers know all the circumstances in which
the SEHK can exercise these rights.

Access to Hong Kong Futures Automated Trading System


2.21 All trading of Traded Options must be carried out on HKATS via a Trading Participant.
Equipment and software which are required for connection to HKATS shall be specified by
the SEHK from time to time. The Trading Participant should install all applicable software
specified by the SEHK in the latest version.
2.22 Unauthorized access to HKATS is protected by means of username-password control. When
a user attempts to log on, HKATS will check to see if that username is registered by checking
in the central database of the host system. The username must also match with the password.
Failure to comply with any one of the above conditions will result in access being denied. It
is the duty of every Trading Participant and its registered HKATS users to keep confidential
the password or passwords allocated to it or them.

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2.23 A Trading Participant must ensure that all persons having access to HKATS through its
connection, or any connection granted through the Trading Participant, exercise due care in
operating HKATS and that HKATS is operated, and orders and give-up instructions are
entered, amended or cancelled, in accordance with the procedures and guidelines of the SEHK.
2.24 Each Trading Participant must implement procedures to ensure that no person who logs on to
and uses HKATS at any of its registered business addresses will:
(a) use HKATS for any illegal purpose or for any purpose other than the execution and
clearing of Traded Options or such other purposes as the SEHK may prescribe from time
to time;
(b) use HKATS other than in such manner as the SEHK may prescribe from time to time;
(c) sell or otherwise impart or disclose any information (whether in digital form or otherwise)
obtained through or from HKATS to any third party or in any way use such information
other than in the ordinary course of traded options business of such Trading Participant;
(d) in any way interfere, tamper with or interrupt the normal operation, or damage the
integrity, of HKATS; or
(e) attempt to gain access to the computer facilities of HKATS or the computer files of any
other Trading Participant or to extract any information from HKATS save as permitted
pursuant to the Options Trading Rules and the Options Trading Procedures.
2.25 A Trading Participant will be fully responsible and liable for any unstable condition,
breakdown or damage to HKATS or the Trading Participants HKATS work-stations as a
result of any unauthorized usage of HKATS by the Trading Participant or as a result of any
non-compliance by its authorized persons with Options Trading Rules.

Revision questions:

Question 2: What are the categories of SEOCH participants and their difference?
Answer 2: The two categories of SEOCH participants are Direct Clearing Participants and
General Clearing Participants. A Direct Clearing Participant can register and clear
its own and clients accounts. A General Clearing Participant can register and clear
its own account, its clients accounts and other Options Trading Participants own
and clients accounts.
Question 3: What conditions must be met to become a market maker?
Answer 3: A Trading Participant may apply to the SEHK for permission to make a market in a
particular option class. Before such permission is granted, the SEHK may require
the participant to demonstrate to its satisfaction that it is suitably qualified to make
a market in the options contracts in respect of which it applies to be a market maker.
The SEHK may consider the financial standing, trading record, personnel, computer
equipment and internal security procedures of the applicant.

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3 Trades monitoring, position limits and reporting requirements
Trades monitoring
Options broking agreement
3.1 Only a Trading Participant is entitled to access the options system. A Broker Participant is not
permitted to have system access rights but is entitled to conduct Traded Options business for
the account of its clients by entering into options broking agreements with a Trading
Participant and corresponding client contracts with its clients, in each case acting as principal.
3.2 To reiterate and for the avoidance of doubt:
(a) a Broker Participant can only be a party to one options broking agreement at any one
time. The SEHK may impose limits on the number of agreements into which a Trading
Participant may enter; and
(b) a Broker Participant who has entered into an agreement with a Trading Participant will
be a client of the latter for the purposes of the various rules and procedures relevant to
Traded Options business.
3.3 Every Trading Participant must monitor the ability of each Broker Participant with whom he
has entered into an options broking agreement to satisfy promptly all demands for SEOCH
collateral in respect of margin, or demands for premium, settlement amount and/or delivery
obligations. A Trading Participant must promptly notify the SEHK of any failure by any such
Broker Participant to meet such demands or obligations, identifying the Broker Participant
concerned.

Disclosure of clients information


3.4 An Options Exchange Participant must be able to comply with the requirements regarding the
identity of a client in accordance with the Code of Conduct for Persons Licensed by or
Registered with the SFC (Code of Conduct) and the Client Identity Guidance Note to
disclose all information regarding the identity of a client to the SEHK or its designated staff
on the request of the SEHK. Such information includes the identity, address and contact details
of the person or entity ultimately responsible for originating the instruction in relation to a
transaction and the instruction given and the person or entity that stands to gain the
commercial or economic benefit of the transaction and/or to bear its commercial or economic
risk.

Restrictions on client business


3.5 A Broker Participant can effect any Traded Options business for its own account or for the
account of an affiliate. The Broker Participant should identify whether the instruction is for a
client of the omnibus account or for the Broker Participants own account when it gives
instructions to a Trading Participant. The Trading Participant should not accept an instruction
from a Broker Participant if the latter cannot identify whether the instruction is for a client of
the omnibus account or the Broker Participants own account.

Client contracts
3.6 Before providing services to a client in relation to Traded Options contracts, an Options
Exchange Participant or other licensed or registered persons engaging in Traded Options
business should enter into an options client agreement as required by the Code of Conduct.

Error trades, give-ups and take ups


3.7 If a Trading Participant becomes aware that an order specification entered into HKATS is
incorrect on the trading day before it is matched on HKATS, the Trading Participant must
correct the order specification on HKATS before market close on that trading day or during

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trading hours, or the Pre-Trading Period on the following trading day and thereafter. No
Trading Participant can use this specific HKATS function unless the incorrect order
specification was genuinely entered by mistake. The SEHK may demand evidence to justify
the use of this HKATS function, including requiring the Trading Participant to show the
appropriate time stamp record.
3.8 If a Trading Participant does not become aware of an incorrect order specification until after
the order has been matched on the HKATS resulting in an options contract, the Trading
Participant must, on becoming so aware, make or arrange to make an appropriate adjustment
in DCASS.
3.9 If, prior to the start of the after business period (see Note to section 4.1) on the same trading
day or the trading day following that on which an order was matched and a client contract
arose, the client requests the Trading Participant to give-up the client contract to another
Trading Participant agreed with the client, the Trading Participant may request (if it is a
SEOCH participant) or instructed its designated General Clearing Participant to request (if it
is an non-clearing participant), by using the specific DCASS functions designated for this
purpose, the other Trading Participant to accept such give-up. This give-up request can only
be made by a SEOCH participant if a client so requests, and SEOCH may demand evidence
to substantiate the existence of such a request on any occasion when it is used.
3.10 If a give-up is accepted by the other Trading Participant, the client contract between the
Trading Participant which is a SEOCH participant and which requested SEOCH to effect the
give-up and its client must immediately be replaced by novation with a new client contract
between the Trading Participant which accepted the give-up and that client, as principals to
the new client contract.

Position limits and reporting requirements


3.11 Under the Securities and Futures (Contracts Limits and Reportable Positions) Rules, no person,
unless otherwise authorized by the SFC or the SEHK in certain specific contexts, may hold or
control futures contracts and stock options traded through a recognized exchange (HKFE and
the SEHK, respectively) in excess of the prescribed limits. The SFC has promulgated the
Guidance Note on Position Limits and Large Open Position Reporting Requirements.
3.12 In addition, the SEHK may prescribe the maximum number or value of long or short open
positions, or combinations of such positions, which an Options Exchange Participant is
permitted to hold at any particular time or to hold over any time period in any manner it may
determine.
3.13 The SEHK may at any time impose, increase, reduce or remove any position limits by giving
prompt notice to the SEOCH and each affected Options Exchange Participant. Position limits
are adopted mainly to assist in maintaining the integrity of a market. Notice may be given
orally (to be followed by a written notice) or in writing as the SEHK considers appropriate in
the circumstances and any imposition, increase, reduction or removal of position limits will
take effect as stipulated in that notice.
3.14 If the SEHK decides that any position limits imposed might be relaxed or lifted in the case
that the liquid capital of an Options Exchange Participant were to be increased, it will notify
that Options Exchange Participant in order to enable it to increase its liquid capital accordingly.
The SEHK may stipulate the position limits which apply pending such increase.
3.15 The SEHK may prescribe requirements for an Options Exchange Participant to notify the
SEHK of long or short open positions held by that participant that exceed certain limits.
3.16 The SEHK may require the Options Exchange Participant to disclose to the SEHK the identity
of clients ultimately beneficially interested in the client contracts comprised in the open
positions which are subject to the notification requirement of the Options Trading Rules.

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3.17 An Options Exchange Participant must immediately notify the SEHK if it exceeds any
position limits. The SEHK will require that participant to close or give-up such contracts
comprised in the relevant long or short open positions which will, in the opinion of the SEHK,
result in the participant complying with the required position limits.
3.18 The SEHK may also impose limitations on the number and type of contracts relating to one
or more option classes or option series which may be exercised at any one time or any period
of time, if the SEHK considers it to be in the interests of maintaining an orderly market.

Revision question:

Question 4: What is the main purpose of an exchange imposing position limits?


Answer 4: Position limits are adopted as part of maintaining the integrity of a market.

Paper 2 Version 2.4 6 - 13 Hong Kong Securities and Investment Institute


4 Clearing and margin
Client margin calculations
4.1 After the start of the after business period on each trading day, each Options Exchange
Participant is required to calculate margin in respect of all open positions and delivery
obligations of each of its clients. The margin so calculated in respect of each client must be
no less than the amount calculated in accordance with the methodologies prescribed by the
SEHK and described more particularly in the Options Trading Procedures. An Options
Exchange Participant may submit a claim to the SEOCH, either directly or through the Trading
Participant with whom it maintains an omnibus account, to have the open positions of a client
margined by the SEOCH on a portfolio basis according to the Operational Clearing Procedures
for Options Trading Exchange Participants of SEOCH, provided that the Options Exchange
Participant has obtained from the client prior written approval to that effect.
Note: After business period means the time period after trading but before batch processing
on each business day when input of clearing functions into DCASS by SEOCH
participants is no longer allowed.
4.2 The Options Exchange Participant may demand such additional SEOCH collateral as it sees
fit, having regard to the Traded Options business being or proposed to be transacted by his
client and the clients expected liabilities on that business.
4.3 Each Options Exchange Participant must ensure that each client is notified of his margin as
calculated and that sufficient SEOCH collateral is demanded to meet the margin requirement.
These activities must be carried out promptly.
4.4 The Options Exchange Participant must also ensure that each margin is settled by the delivery
of appropriate SEOCH collateral by each client to the Options Exchange Participant promptly.
If an Options Exchange Participant has not received appropriate SEOCH collateral due from
a client promptly, it may treat that client as being in default. For the avoidance of doubt, a
cheque received by an Options Exchange Participant from a client in good faith which he has
no reason to suspect will not be honoured on first presentation may be accepted in payment
of margin. The Options Exchange Participant may require a client to maintain SEOCH
collateral with the Options Exchange Participant in advance of accepting instructions from the
client, or may impose other requirements for the collection of SEOCH collateral as it thinks
fit.
4.5 Margin requirements of a SEOCH participant may be satisfied in the form of cash or non-cash
assets such as securities or Exchange Fund Bills/Notes. Normally, margin requirements will
first be satisfied by cash in the settlement currency, then cash in any other currency as
approved by the SEOCH and then by any non-cash collateral. The SEOCH has the sole and
absolute discretion to determine the maximum amount of a SEOCH participants margin
requirements that may be satisfied in the form of securities or Exchange Fund Bills/Notes.

Collection of premiums and collateral


4.6 Each Options Exchange Participant shall ensure that the premium payable by a client is
notified to that client on the day the options contract in respect of which the premium required
is made. The Options Exchange Participant shall also ensure that all such amounts are settled
in cash promptly. If an Options Exchange Participant has not received the premium from a
client promptly, it may treat that client as being in default. The Options Exchange Participant
may require a client to make arrangements for payment of the premium in advance of
accepting instructions from the client, or may impose such other requirements for the
collection of premium as it thinks fit.

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4.7 An Options Exchange Participant may set off all amounts due from a client in respect of
margin, settlement amount and premium against amounts due to the client in respect of
premium, settlement amount and surplus SEOCH collateral.

Default by clients
4.8 If a client defaults in respect of premium or SEOCH collateral, or defaults in the performance
of delivery obligations or on any other requirements under the Options Trading Rules, the
options client agreement or the options broking agreement, the steps which may be taken by
an Options Exchange Participant, without prior notice to that client, include the following:
(a) to decline to take further instructions from that client in respect of Traded Options
business;
(b) to close, give-up or exercise some or all of the client contracts to which that client is party;
(c) to enter into any contracts for the purpose of hedging risk to which it is exposed as a
result of that clients default;
(d) to make, on an exchange or otherwise, any contract for the purpose of meeting obligations,
or of hedging risks to which it is exposed, in relation to that clients default;
(e) to dispose of some or all of the SEOCH collateral (other than cash) held for or on behalf
of the client and apply those proceeds, plus any cash SEOCH collateral held for or on
behalf of the client, to all outstanding balances of that client owing to it, with any monies
left being refunded to that client; and
(f) to dispose of any or all securities held for or on behalf of the client in order to set off any
obligations of that client and to exercise any rights of set-off it may have in relation to
the client.
4.9 If any client defaults in respect of its Traded Options business, an Options Exchange
Participant must notify the SEHK of the default. The SEHK may require the Options
Exchange Participant to supply further information in relation to that default, as it thinks fit.

Intra-day margin
4.10 The SEOCH may perform intra-day mark-to-market calculations on open positions using such
method as it determines to be appropriate, including the possibility of taking into account
intra-day losses or potential losses arising from the purchase or sale of Traded Options. The
SEOCH may then demand intra-day margin from SEOCH participants.
4.11 The SEHKs mark-to-market system prevents losses to accumulate over time or allow a
market participant the opportunity to defer losses associated with market positions.
4.12 When a SEOCH participant receives a demand for intra-day margin and the demand cannot
be covered fully by the collateral provided by the SEOCH participant to the SEOCH, the
SEOCH participant should satisfy such demand by payment in cash no later than one hour
after the time of such demand. Intra-day margin calls may be satisfied by cash in the settlement
currency or any other currencies approved by the SEOCH.

Revision question:

Question 5: What actions may an Options Exchange Participant take in the event that one of its
clients defaults?
Answer 5: See the list at section 4.8.

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5 Settlement
Exercise of options
5.1 Each client contract comprised in a long open position of a Trading Participant may be
exercised by that Trading Participant by taking the following actions:
(a) if it is a non-clearing participant (see Note below), by requesting its designated General
Clearing Participant to exercise the contract with the SEOCH; or
(b) if it is a SEOCH participant, by exercising the contract with the SEOCH.
Note: A Trading Participant which is not a SEOCH participant is referred to as a non-
clearing participant.
5.2 The exercise function of the DCASS allows a SEOCH participant to exercise its or its clients
right as an option holder to buy or sell the underlying shares. A SEOCH participant must input
its exercise instruction through DCASS in respect of each and every contract it wishes to
exercise.
5.3 At the time the contract is exercised at the SEOCH, the contract is treated for all purposes as
having been exercised. Thus, at this same time, the fact of exercise becomes legally binding
that is, regardless of whether it has technically been reported back to the client.
5.4 On an expiry day, the DCASS will automatically generate exercise instructions in respect of
all open long positions in spot month contracts which are in-the-money by or above the
percentage prescribed by the SEOCH. Any automatically generated exercise instructions,
except those denied by the Trading Participant (if it is a SEOCH participant) or its designated
General Clearing Participant (if it is a non-clearing participant) before the start of the after
business period on the expiry day, are deemed to be valid exercise instructions.
5.5 Following the notification of an exercise of a short open position, the Trading Participant must
select for matching a client contract from among all its client contracts comprised in short
open positions of clients in the same options series. The client contract so selected will, by
operation of the options client agreement and the relevant Options Trading Rules, be treated
for all purposes as having been validly exercised at the same time as that selection.
5.6 Where relevant, the Trading Participant must promptly notify the Broker Participant of details
of the exercise of an options contract.
5.7 Upon exercise of an options contract under the Options Trading Rules, delivery obligations
arise, which must be carried out in accordance with the options client agreement and the
options broking agreement in a manner which enables the fulfilment of related delivery
obligations.
5.8 Stock transactions as a result of exercise and assignment of Traded Options are settled under
the Continuous Net Settlement System in CCASS.

Payment to clearing house


5.9 Under the memorandum of understanding signed between the SFC and the SEHK, the latter
is required to report to the SFC, among other things, any alleged misconduct by an Exchange
Participant which, if substantiated, would pose a material risk of default by the Exchange
Participant in respect of clearing and settlement obligations or other financial obligations due
to a third party. This includes any such potential default even on any failure to meet the SFCs
financial resource requirements.
5.10 Since the SEOCH options are premium paid up-front, intermediaries must pass cash premiums
to the SEOCH for onward payment transmission to sellers. Where cash collateral is used by
intermediaries, this must also be paid to the SEOCH within the approved time limits.

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5.11 While the risk management techniques of the SEOCH are specifically designed to prevent a
SEOCH participant from defaulting on its obligations, the SEHK, by rule and by operational
practice, has prepared measures to deal with such an event. If a SEOCH participant failed to
meet its financial obligations to the SEOCH, the SEOCH would take steps to recover the
situation. These could include closing or transferring positions and liquidating collateral
before there is a need to consider using its Reserve Funds and insurance cover.
5.12 The SEOCH-managed Reserve Fund provides instant liquidity to the market in the event of a
SEOCH participants default. If a SEOCH participant default, the Reserve Fund can be used
(in accordance with SEOCH Rules) to support the obligation of the SEOCH as the
counterparty of the defaulting SEOCH participant.

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B Over-the-counter (OTC) derivatives
6 Licensing
6.1 It should be noted at the outset that, as a result of decisions taken by the Group of Twenty and
Financial Stability Board (including Hong Kong), Hong Kong is in the process of
implementing a new regulatory framework for OTC derivatives transactions (the new OTCD
regime).
The Securities and Futures (Amendment) Ordinance 2014 (Amendment Ordinance) was
passed by the Legislative Council in March 2014. Among other things, it introduces two new
RAs and expands the scope of two existing RAs to cover OTC derivative transactions or
products.
The two new RAs are (i) Type 11 RA (dealing in OTC derivative products or advising on
OTC derivative products) and (ii) Type 12 RA (providing client clearing services for OTC
derivative transactions). The two existing RAs that their scope will be expanded are (i) Type
7 RA (providing automated trading services) and (ii) Type 9 RA (asset management). These
new RAs and expanded RAs will become effective after all the corresponding amendments to
various related rules, codes and guidelines have been finalised.
The following discussions are about the existing licensing framework.
6.2 Schedule 1 of the SFO (see Notes below) defines an OTC derivative product as a structured
product not including:
(a) a securities and a futures contract traded on a recognized market;
(b) a structured product authorized by the SFC under the SFO for sale to the public;
(c) a structured product that takes the form of a debt security deriving its returns from an
underlying pool of assets;
(d) an instrument that is in the form of debt or equity or fund or deposits that has an
embedded feature that makes it a structure product;
(e) a spot contract; and
(f) a structured product sold to multiple persons on the same terms (with identical price or
not) during an offer period not longer than 2 weeks.
Note 1: Securities and Futures (Amendment) Ordinance 2014 (Commencement) Notice 2015
was issued. It appoints that 10 July 2015 as the day on which some of the provisions
of the Amendment Ordinance, including the definition of OTC derivatives product,
come into operation.
Note 2: The following parts of the SFO are provided for candidates references: the definition
of securities in Schedule 1, SFO does not require that such instruments (i.e.
securities as defined) must be listed on an exchange. The definition of futures
contracts does require that transactions in such products are carried out under the
rules of a futures exchange. Section 392 of the SFO empowers the Financial Secretary
to prescribe any product as an OTC derivative product or as not being an OTC
derivative product.
6.3 Currently (before the new OTCD regulatory regime has been fully implemented),
intermediaries shall inform the SFC if they wish to engage in OTC derivatives business and
they will be required to comply with the relevant guidelines as mentioned in sections 6.4 to
6.35 below.

Paper 2 Version 2.4 6 - 18 Hong Kong Securities and Investment Institute


Fit and proper
6.4 In 1995, the SFC adopted the guidelines Operational and Financial Risk Management
Control Mechanisms For Over-the-Counter Derivatives Activities of Regulated Securities
Firms (IOSCO guidelines) which was issued by the International Organization of
Securities Commissions (IOSCO) in 1994 as a statement of minimum best practice for
intermediaries in respect of their management control systems for OTC derivatives activities.
In 2003, the SFC released Core Operational and Financial Risk Management Controls For
Over-the-Counter Derivatives Activities of Persons Licensed by or Registered with the
Securities and Futures Commission (SFC OTC Derivatives Guidelines). This document
confirms the SFCs adoption of the IOSCO guidelines.
6.5 The SFC OTC Derivatives Guidelines indicate the criteria which the SFC will apply in
assessing whether those engaged in OTC derivatives activities are fit and proper to be so
engaged while licensed by or registered with the SFC. Further, the SFC expects such persons
to adopt the IOSCO guidelines for internal control purposes in order to satisfy the fit and
proper criteria. At the same time, such criteria are in addition to other relevant SFC fit and
proper criteria.
6.6 When undertaking on-site inspections, the SFC also expects firms to demonstrate compliance
with the Introduction (summarised in section 6.10 below) and Parts I and II of the IOSCO
guidelines (summarised in sections 6.11 to 6.19 below), with the exception of paragraphs 11
and 12 of Part I (which deal with regulatory responsibility). Specifically, while allowing for
variation in approach, the SFC expects intermediaries to document their systems and
procedures fully and be able to demonstrate that their own specific internal controls are at
least as stringent as those of the IOSCO guidelines.
6.7 The SFC requires licensed or registered persons to have regard to the following matters:
(a) Framework of risk management
There must be clearly stated risk management policies and procedures overseen by the
board of directors or equivalent senior management body, well-defined chains of
responsibility and provision for accurate, informative and timely reports.
(b) Independent market risk management
The intermediary must have an independent market risk management function to monitor
the application of risk limit policies as well as to review and approve pricing models and
valuation systems (including mark-to-market mechanisms).
(c) Independent credit risk management
The intermediary must have an independent credit risk management function to set and
monitor credit limits, and to review leverage, concentration and risk reduction
arrangements.
(d) In-house expertise and resources
Intermediaries should dedicate adequate resources to all aspects of risk management
controls, including back office systems, accounting and supervision policies and ensure
adequate training.
(e) Risk reduction techniques
Intermediaries should as appropriate use risk reduction techniques such as master
agreements, netting arrangements, collateralisation of transactions and third party credit
enhancements, including letters of credit and guarantees. Firms should also consider risk
reduction techniques to address operations risk, including contingency planning.
(f) Valuations and exposures

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Intermediaries should make accurate risk valuations daily, using an acceptable pricing
methodology to mark to market and to identify concentrations. Potential exposures to
credit and market risk should also be calculated using appropriate methodologies.
Exposures may be aggregated provided that netting arrangements are acceptable and
enforceable.
(g) Systems
Intermediaries accounting, risk management and information systems should ensure
adequate and timely documenting, processing, confirming, approving as appropriate, and
reconciling of trades and valuation systems used by front and back offices; assessing of
risk on a global (firm-wide) basis; accurate and timely reporting to management; and
external reporting by management. Internal or external independent system reviews
should be used to verify that such systems are operating as designed.
(h) Liquidity, funding arrangements and financial performance
Intermediaries need to monitor on a continuing basis financial performance, including
profit and loss, funding requirements and sources and cash flows.

Risks of OTC derivatives trading


6.8 The IOSCO guidelines state that:
Derivatives are financial instruments whose values are derived from, and reflect changes in,
the prices of the underlying products. They are designed to facilitate the transfer and isolation
of risk and may be used for both risk transference and investment purposes. As such, they play
a valuable role for users of the marketplace. However, they may also increase risk and, in view
of the rapid growth of OTC derivatives business, regulatory agencies are paying increasing
attention to the risks arising from such trading. These risks include:
Credit risk: the risk that a counterparty will fail to perform an obligation owed to the
intermediary.
Market risk: the risk that movements in prices or values will result in loss for the
intermediary.
Liquidity risk: the risk that a lack of counterparties will leave an intermediary unable to
liquidate or offset a position (or unable to do so at or near the previous
market price).
Settlement risk: the risk that an intermediary will not receive funds or instruments from its
counterparty at the expected time.
Operations risk: the risk that an intermediary will suffer loss as a result of human error or
deficiencies in systems or controls.
Legal risk: the risk that an intermediary will suffer loss as a result of contracts being
unenforceable or inadequately documented.
6.9 While such risks are not unique to OTC derivatives, they are of special concern due to the
volume, scope and variety of OTC transactions, the degree of interrelatedness of participants,
the opaqueness and uncertain liquidity of OTC markets, and the complexity of and potential
leverage in such instruments. The financial risks of such complex instruments must be
carefully assessed, as a weakness in one market participant can affect other parts of the system.
6.10 The SFC accepts that the manner in which the statements (as stated in the IOSCO guidelines)
are applied will vary between intermediaries and that this reflects the dynamic and evolving
nature of the derivatives industry. It is very aware of the need to allow this flexibility to
intermediaries, and thus accepts such variants. However, such variants are permitted on the
basis that they do not render an intermediarys risk management system less stringent than

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those stated in the guidelines. It also expects each intermediary to fully document its systems
and procedures and be able to demonstrate that their own specific internal controls are as
effective as the worldwide approach in the IOSCO guidelines.

Risk management policies and procedures


6.11 The framework of risk management policies, procedures and management controls overseen
by the board of directors, or equivalent management body of the intermediary, should
specifically cover derivatives activity, clearly establish responsibility for its implementation,
and provide for accurate, informative and timely reporting to management. This framework
should be communicated to all concerned and should be reviewed as changes in business and
market circumstances.
6.12 Each intermediary must have risk management policies and procedures in written form, and
these procedures must be overseen by the board of directors or equivalent senior management.
The procedures must have a well-defined chain of responsibility and provision for accurate,
informative and timely reports.
6.13 Moreover, the policies and procedures should address the measurement of market and credit
risk, including aggregate exposures against risk-tolerant objectives (position limits or capital
at risk); acceptability criteria for counterparties, strategies and products (hedging, covered
writing, risk management, position taking and related legal risks); risk monitoring procedures
and exception reporting criteria; personnel policies (including expertise, training and
compensation policies); the separation of trading and risk management functions; and the
establishment of risk management controls and checks over accounts, traders, operational staff
and systems.
6.14 It is particularly important for intermediaries to be, and remain, fully aware of the risks
inherent in this type of business and to ensure that the procedural requirements are understood
by relevant staff via the chain of authority.
6.15 The intermediary must also have an independent market risk management function to develop
and monitor the application of risk limit policies, and to review and approve pricing models
and valuation systems (including mark-to-market mechanisms).
6.16 Regardless of how academically superior models used by an intermediary may be, no model
is perfect. Accordingly, all such activity needs to be back-tested to ensure that using models
forward can remain justified. Modelling techniques are theoretical assessments, and even
those which use artificial intelligence cannot always reflect actual outcomes under all
circumstances. It is also significant here that the requirement for market risk management is
that it should be operated independently. The consequence is particularly that traders, for
example, should not be permitted only to input their own volatility estimates. Thus, there must
be a separate function for assessing the inputs to models.
6.17 Controls should address stress scenarios, confidence levels, credit assumptions and market
risk measurement methodologies, the separation of back-office, accounting and compliance
functions from trading, risk policies and integration of accounting systems. Stress tests should
assess the consequences of severe price moves and changes in market behaviour, including
changes in correlations and other risk assumptions.
6.18 It is also important that controls should monitor conflicts of interest which may arise between
an intermediarys operating divisions, where individual capital allocation and profitability
(and bonus direction) estimates may not be known below board level. Accordingly, the effects
of such conflicts should form part of the intermediarys risk management profile.
6.19 It will be prudent for the risk management process to ensure, within the account opening
procedures, that counterparties have appropriate approval for such transactions. It is too late,
following a counterparty failure or dispute, to discover that, for example, a transaction is ultra
vires (i.e. outside the legal powers of the counterparty to effect such a transaction).

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Oversight by senior management
6.20 It is important that, even though policies will have been designed and/or approved by the
board, their implementation is supervised and enforced by senior management personnel. In
particular, this should mean that at least two of the senior management, and preferably also at
board level, fully understand the practical activities being undertaken by the intermediary and
appreciate the impact of any errors, risks and practical obstacles which can arise in this type
of trading activity.
6.21 This also means that such senior management should receive regular reports (preferably daily,
but even better if these are on-line) of all transactions undertaken and positions that result
from such trades. They should be aware of any potential human errors in electronic reporting
and, from time to time, assess manual sample check systems to ensure that the electronic
system is not being abused. Of special interest to senior managers should be an additional
internal audit system of monitoring any manual input data to the modelling systems and
regular assessments of the effects on capital adequacy resulting from positions, and even more
importantly, exposures and potential exposures, particularly where these may be affected by
failures (even short-term ones) by counterparties.
6.22 As traders will normally seek to maximise profits, it is important to assess risk/reward ratios
and thus to supervise the efficient use and application of the intermediarys capital, time and
rate of return.
6.23 One additional action often taken by senior management is the use of limits on credit risk
exposures for particular traders below the credit risk analysis ceiling in order to allow for an
element of flexibility and timing in managing problem accounts.
6.24 Executive officers should also remind themselves that it is an offence under s. 107, SFO
fraudulently or recklessly to induce others to invest money. While this is particularly set out
by the SFC in order to protect individual investors, it should not be forgotten that at the
institutional trading level a good reputation for managing risk will be an advantage to the
intermediary and its significant clients.
6.25 While senior management is required under the IOSCO guidelines to effect back-testing of its
models generally, it is prudent to make regular use of model stress testing (back-testing),
particularly on positions and exposures with the intermediarys largest accounts. As
international regulators move towards a risk assessment basis for regulation, intermediaries
should appreciate that large intermediaries with large clients present a much higher profile in
terms of potential systemic risk than many others.
6.26 Finally, it should be noted that actions must be taken swiftly against any breaches of policies,
practices and guidelines. A delay in taking action could spell disaster.

Independent credit risk management


6.27 The intermediary must have an independent credit risk management function to set and
monitor credit limits, and to review leverage, concentration and risk reduction arrangements.
6.28 The function of credit risk management should be to assess each new client application, with
no trader allowed to transact business with a client until the credit department has approved
the financial assessment and awarded the client a credit limit. Traders should not be a party to
any such risk assessment and must be kept informed of any changes to the approved credit
limit. It should be considered a breach of in-house procedures for a trader to exceed a client
credit limit without first having gained approval from senior management.
6.29 Appetite for risk, quality of credit, level of concentration, reliance on credit enhancements,
measurement methodologies and separation of sales supervision from exposure supervision
should be subject to controls. Controls should also address the risk of failure to deliver or of
termination provisions, as appropriate.

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6.30 The credit risk management function for any business contact should have similar importance
to that of other account opening procedures, in that a due diligence approach to deciding on
credit facilities (and exposures) for counterparties should be adopted. However, the task is not
complete even after the initial assessment and limit is established. The function must ensure
that continuous monitoring of counterparty financial status assesses any known changes, and
requires, at least, an annual review following receipt of audited financial figures from the
counterparties.
6.31 It is further pertinent at this point to ensure that, in establishing an account, the intermediary
makes full use of master agreements. While there are a number of clauses that will need to be
particularised for each different client, the adoption in principle of these agreements gives an
intermediary reasonable certainty in regard to jurisdiction and understanding of definitions of
terms. These agreements in themselves are thus the most useful risk management tool.

Adequate resources
6.32 Intermediaries should ensure that all aspects of risk management controls are supported by
adequate resources, including back-office systems, accounting and supervision policies, and
ensure adequate training.
6.33 In view of the speed of evolution and complexity of derivatives products, intermediaries
should devote adequate resources to all aspects of risk management controls, including back-
office systems, accounting and supervision policies. Intermediaries should also make every
effort to ensure that knowledge at all levels of the intermediary, and of traders and risk
managers, is adequate in terms of market developments for the appropriate assessment and
management of risks.
Note: Resources here refers to in-house expertise in both personnel and automated and
manual systems. Where an intermediary does not have either available resources or
sufficient applicable resources, the SFC would consider that activities should be
restricted in line with the resources that are available.
6.34 However, even strong management controls are only one element of the management of
financial exposures. In particular, they are not a substitute for adequate capital. In this regard,
funding risk calculations should be made on a daily basis.
6.35 It has been seen that, under the fit and proper requirements, the SFCs additional requirements
are centred around the intermediary meeting the IOSCO guidelines. However, what is most
important for the soundness of the intermediarys business in the OTC area is the quality of
these policies, systems, processes and procedures. Hence, for the intermediary, the more
significant elements are those which can insulate the intermediary against surprise losses, just
as much as those which provide it with appropriate mechanisms for dealing with any such
situations as they occur in the most effective and efficient manner.

Progress of the developing new OTCD regime


6.36 The new OTCD regime is being implemented in phases. Besides those mentioned in the
beginning of this section, Phase 1 mandatory reporting obligation started to be effective on 10
July 2015. On 1 September 2016, Phase 1 mandatory clearing obligations and the expanded
definition of automated trading services under the SFO have started to be effective in so far
as it relates to the implementation of the clearing of OTC derivative transactions.
6.37 Candidates should refer to Topic 2 for the requirements to fulfil mandatory reporting
obligation and mandatory clearing obligation regarding OTC derivatives transactions.
6.38 In relation to capital and other prudential requirements to be imposed on licensed corporations
engaging in OTC derivatives activity, the SFC released a consultation paper in July 2015 on
proposed changes to the Securities and Futures (Financial Resources) Rules. The
consultation conclusion has not yet been published. Other aspects to be developed and

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implemented include platform trading requirements, regulation of systemically important
participants and conduct requirements.

Revision questions:

Question 6: What is the difference between credit risk and settlement risk?
Answer 6: Credit risk is defined as the risk that a counterparty will fail to perform an obligation
owed to the intermediary, whereas settlement risk is defined as the risk that an
intermediary will not receive funds or instruments from its counterparty at the
expected time.
Question 7: What are the additional SFC fit and proper conditions for an intermediary carrying
out OTC derivatives business?
Answer 7: The SFC expects those engaged in OTC derivatives activity to adopt the IOSCO
guidelines contained in the SFC OTC Derivatives Guidelines for internal control
purposes in order to satisfy the fit and proper criteria. While allowing for variation
in approaches, the SFC expects intermediaries to document their systems and
procedures fully and be able to demonstrate that their own specific internal controls
are at least as stringent as those of the IOSCO guidelines.

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7 Ongoing requirements
7.1 Most of the first section of Part B of this Topic (i.e. Section 6 of this Topic) has been devoted
to elements of risk management which need to be adopted at the outset of structuring OTC
derivatives business and opening accounts with counterparties. The prime focus of this second
section of Part B (i.e. this section) is on additional on-going requirements to meet acceptable
standards.

Systems
7.2 Intermediaries accounting, risk management and information systems should ensure adequate
and timely documenting, processing, confirming, approving as appropriate, and reconciling
of trades and valuation systems used by front and back offices; assessing of risk on a global
(intermediary-wide) basis; accurate and timely reporting to management; and external
reporting by management. Internal or external independent systems reviews should be used
to verify that such systems are operating as designed.
7.3 The complexity and dynamic nature of derivatives trading activity and portfolios require that
accurate and timely information is always available. Systems must be kept constantly under
review to be certain that they permit tracking and reporting financial performance and carrying
out management policies. Significant deficiencies in the design or operation of the systems
that could adversely affect the entitys ability to record, process, summarise and report
financial data should be reported on. This is not intended to define the scope of external
financial audits.

Risk reduction techniques


7.4 Intermediaries should use appropriate risk reduction techniques such as master agreements,
netting arrangements, collateralisation of transactions and third party credit enhancements,
including letters of credit and guarantees. Intermediaries should also consider risk reduction
techniques to address operations risk, including contingency planning.
7.5 While market forces can provide significant incentives for intermediaries to develop effective
operational and financial risk control mechanisms, intermediaries can often best safeguard
their own positions by terminating or restricting activities with other market participants the
adequacy of whose management controls may be in doubt. Moreover, an intermediarys own
commercial interests are likely to ensure that it checks that a counterparty:
(a) has the power to enter into a proposed transaction;
(b) is represented by an officer with actual or ostensible authority;
(c) is creditworthy; and
(d) has access to appropriate payment systems.
7.6 Controls should address credit enhancements in terms of exposure and explore the use of
master agreements to reduce documentation risk and increase the potential to assign and/or
otherwise unwind transactions. The legal capacity of counterparties to transact and the legality
of netting arrangements should be evaluated.
7.7 Intermediaries may also find it prudent to deal through special purpose vehicles (SPVs).
These vehicles can be separately capitalised, credit-rated and domiciled in a suitable taxation
location, which isolates some of the inherent risks from a parent company.

Valuations and exposures


7.8 Intermediaries should make accurate risk valuations daily, using an acceptable pricing
methodology to mark-to-market and to identify concentrations. Potential exposures to credit

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and market risk should also be calculated using appropriate methodologies. Exposures may
be aggregated provided that netting arrangements are acceptable and enforceable.
7.9 Arrangements should be made to value dynamic portfolios frequently enough to address
exposures, taking into account legal netting arrangements. Outputs of simulations should be
tested against actual results and adjusted accordingly.
7.10 Value at risk (VAR) models and notional value assessments may be used subject to
regulatory approval and evidence of effective and adequate back-testing. Nevertheless,
management should ensure that, at all times, such models input is regularly validated for
current market consequences in particular, as to directional, volatility and interest/dividend
data.

Monitoring of financial performance


7.11 Monitoring of financial performance on a continuing basis, including profit and loss, funding
requirements and sources and cash flows, is necessary for intermediaries.
7.12 Risk management personnel need to take account of revenues and the adequacy of funding
arrangements in designing and implementing risk management strategies. Liquidity planning
should attempt to anticipate changes in cash flow or funding requirements and should
accommodate the possible need to rebalance portfolios, augment collateral and permit the
management of defaults.

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Topic summary
In this Topic we reviewed regulatory considerations in regard to the trading and settlement of options
in the Hong Kong financial market and the regulatory aspects of trading in OTC derivatives.
In Part A, we gave a brief introduction to options in general, the applicable exchange and clearing
house rules and the trading and clearing systems for Traded Options.
Next, we reviewed the participant types, access rights and relevant requirements of the SEHK and
the SEOCH for Traded Options business.
There followed consideration of trades monitoring, position limits and reporting requirements.
We also looked at clearing and margin requirements, including the requirements that intermediaries
must calculate client margin amounts and that SEOCH collateral is collected, the circumstances where
clients may receive intra-day margin calls and be called in default.
In the final section we considered the processes of option exercising and, last but not least, the
payments due to and from the clearing house.
In Part B, we reviewed the current regulatory considerations for OTC derivatives business, noting
that a new regulatory framework is being introduced in phases. We looked at the current licensing
and on-going requirements, risk management, senior managements role and the requirement of
adequacy of resources in this respect. A brief summary for the progress of the developing new
regulatory regime was also provided.

Checklist
Below is a checklist of the main points covered by this Topic. Candidates should use this list to test
their knowledge.
Part A: Exchange traded options
Options on stocks are traded on the SEHK and generally referred to as Traded Options.
Traded Options are studied under the operations of the SEHK as part of Type 1 RA.
Only Options Exchange Participants may transact options business for clients.
Requirements that must be met by a Trading Participant.
Requirements that must be met by a Broker Participant.
Requirements that must be met by a SEOCH participant.
In order to promote liquidity, the SEHK operates a market-maker mechanism in Traded Options
market.
All Exchange Participants are eligible to trade through HKATS, subject to obtaining the prior
approval of the SEHK in the form of registration.
Each market maker is entitled to enter quotes into the HKATS.
Subject to conditions of percentage responses, each market maker is obliged, on receipt of a
quote request for an option series in an option class for which he holds a current market maker
permit, to enter a quote into HKATS for at least a minimum number of option contracts (lots)
and to hold the quote for a minimum period of time.
Each market maker must be available to respond to quote requests on all trading days.
A Broker Participant is not permitted to have system access rights.

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A Broker Participant is entitled to conduct Traded Options business for the account of his clients
by entering into options broking agreement with a Trading Participant and corresponding client
contracts with his clients, in each case acting as principal.
A Broker Participant can only be a party to one options broking agreement.
Every Trading Participant must monitor the ability of each Broker Participant with whom he has
entered into an options broking agreement.
An Options Exchange Participant must be able to comply with the requirements regarding the
identity of a client in accordance with the Code of Conduct and the Client Identity Rule Policy
to disclose all information regarding the identity of a client to the SEHK or its designated staff
on the request of the SEHK.
A Broker Participant can effect any Traded Options business for its own account or for the
account of an affiliate. The Broker Participant should identify whether the instruction is for a
client of the omnibus account or for the Broker Participants own account when it gives
instructions to a Trading Participant.
Each Options Exchange Participant must ensure that each client is notified of his calculated
margin and the SEOCH collateral demanded, and that this is carried out promptly.
If an Options Exchange Participant has not received appropriate SEOCH collateral due from a
client promptly, it may treat that client as being in default.
The Options Exchange Participant may require a client to maintain SEOCH collateral with the
Options Exchange Participant in advance of accepting instructions from the client.
Each Options Exchange Participant shall ensure that the premium payable by a client is notified
to that client on the day the options contract in respect of which the premium required is made.
If an Options Exchange Participant has not received the premium from a client promptly, it may
treat that client as being in default.
An Options Exchange Participant may set off all amounts due from a client in respect of margin,
settlement amount and surplus SEOCH collateral.
If any client defaults in respect of its Traded Options business, an Options Exchange Participant
must notify the SEHK of the default. The SEHK may require the Options Exchange Participant
to supply further information in relation to that default, as it thinks fit.
Stock transactions as a result of exercise and assignment of Traded Options are settled under the
Continuous Net Settlement System in CCASS.
Since the SEOCH options are premium paid up-front, intermediaries must pass cash premiums
to the SEOCH for onward payment transmission to sellers.
While the risk management techniques at the SEOCH are specifically designed to prevent a
SEOCH participant from defaulting on its obligations, the SEHK, by rule and by operational
practice, has prepared measures to deal with such an event.
Should the defaulting SEOCH participants obligation not be fully satisfied by the margining
system, the SEOCH would utilise the Reserve Fund to help meet the unsatisfied obligation.
Part B: OTC derivatives
A new regulatory framework for OTC derivative is developing and implementation are in phases.
The Amendment Ordinance was passed by the Legislative Council in March 2014. Amongst
others, it introduces two new RAs and expands the scope of two existing RAs to cover OTC
derivative transactions or products and defines OTC derivative product.
These new RAs and expanded RAs will become effective after all the corresponding
amendments to various related rules, codes and guidelines have been finalised.

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Securities and Futures (Amendment) Ordinance 2014 (Commencement) Notice 2015 was issued
to appoint that 10 July 2015 as the day on which some of the provisions of the Amendment
Ordinance, including the definition of OTC derivatives product, come into operation.
Under current regulatory regime, the SFC expects intermediaries adopt the IOSCO guidelines
contained in the SFC OTC Derivatives Guidelines for internal control purposes in order to satisfy
the fit and proper criteria.
The intermediary must have an independent market risk management function to monitor the
application of risk limit policies as well as review and approve pricing models and valuation
systems (including the mark-to-market mechanism).
The intermediary must have an independent credit risk management function to set and monitor
credit limits, and to review leverage, concentration and risk reduction arrangements.
Intermediaries should make accurate risk valuations daily, using an acceptable pricing
methodology to mark to market and to identify concentrations.
Each intermediary must have risk management policies and procedures in written form, and these
procedures must be overseen by the board of directors or equivalent senior management.
Controls should address stress scenarios, confidence levels, credit assumptions and market risk
measurement methodologies, the separation of back-office, accounting and compliance
functions from trading, risk policies and integration of accounting systems.
Stress tests should assess the consequences of severe price moves and changes in market
behaviour, including changes in correlations and other risk assumptions.
Controls should also address the risk of failure to deliver or of termination provisions, as
appropriate.
Intermediaries should make full use of master agreements.
Intermediaries should ensure that all aspects of risk management controls are supported by
adequate resources, including back-office systems, accounting and supervision policies, and
ensure adequate training.
Significant deficiencies in the design or operation of the systems that could adversely affect the
intermediarys ability to record, process, summarise and report financial data should be reported
on.
Intermediaries should use appropriate risk reduction techniques such as master agreements,
netting arrangements, collateralisation of transactions and third party credit enhancements,
including letters of credit and guarantees.
Intermediaries should also consider risk reduction techniques to address operations risk,
including contingency planning.
The legal capacity of counterparties to transact and the legality of netting arrangements should
be evaluated.
Arrangements should be made to value dynamic portfolios frequently enough to address
exposures, taking into account legal netting arrangements.
VAR models and notional value assessments may be used subject to regulatory approval and
evidence of effective and adequate back-testing.
Certain parts of the new OTCD regime, including Phase 1 mandatory reporting obligation and
Phase 1 mandatory clearing obligation, have started to be effective on 10 July 2015 and 1
September 2016 respectively.
A consultation paper for proposed changes to the Securities and Futures (Financial Resources)
Rules has been issued in relation to capital and other prudential requirements for carrying out
OTC derivatives activity, pending the consultation conclusion to be published.

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Other aspects of the new OTCD regime to be developed and implemented include platform
trading requirements, regulation of systemically important participants and conduct requirements.

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Topic 7: Market misconduct and improper trading practices
Table of contents
Topic overview 1
Learning outcomes 1
1 How market misconduct is regulated in Hong Kong 3
The dual approach 3
Criminal or civil 3
2 Market misconduct 5
Definition of market misconduct in the Securities and Futures Ordinance 5
Insider dealing 5
False trading 6
Price rigging 7
Stock market manipulation 7
Disclosure of information about prohibited transactions 8
Disclosure of false or misleading information inducing transactions 8
International aspects 8
Conduct not constituting market misconduct (safe harbour rules) 8
Fraud and deception 8
Disclosure of inside information 9
3 Consequences of market misconduct 11
Market Misconduct Tribunal (MMT) 11
Orders made by the MMT 11
Criminal sanctions imposed by the courts 12
Private civil actions 12
Transactions not void 12
4 Unsolicited calls 13
5 Improper practices 15
Boiler room activities 15
Churning 15
Corporate mis-governance 15
Front running 15
Rat trading 16
Unsuitability 16
Unauthorized trades 16
6 SFC Disciplinary Fining Guidelines 17
General considerations 17
Some specific considerations 17
Public register 18
The role of senior management 18
7 Enforcement actions 19
Case 1: Reprimand and fine for breach of Securities and Futures (Financial Resources)
Rules 19
Case 2: Reprimand and fine for failure in internal controls 19
Case 3: Reprimand and fine for negligence and non-compliance with order recording
requirements 20
Case 4: Imprisonment for price rigging 20
Case 5: Community services and fine for false trading 21
Topic summary 22
Checklist 22
Topic overview
In this final Topic, three important areas of misconduct are reviewed: market misconduct proceedings
and criminal offences under the Securities and Futures Ordinance (SFO) relating to dealing in
securities; the offence created under the SFO concerning unsolicited calls; and practices which the
Securities and Futures Commission (SFC) regards as improper and involve a breach of one or more
of the SFCs codes.
Part XIII, SFO establishes the Market Misconduct Tribunal (MMT) and defines the forms of market
misconduct which may be dealt with through proceedings before the MMT, under a civil (i.e. not
criminal) standard of proof. Market misconduct includes: insider dealing, false trading, price rigging,
stock market manipulation, disclosure of information about prohibited transactions, disclosure of
false or misleading information inducing transactions.
Part XIV, SFO defines the market misconduct offences which may be tried before a criminal court.
The offences are largely parallel provisions to those set out in Part XIII. Part XIV also provides for
certain additional offences which do not fall under Part XIII.
The SFC is empowered to make rules excluding any act defined as market misconduct from the
definition. These are commonly referred to as safe harbour rules.
The dual approach (i.e. civil and criminal alternatives for similar underlying conduct) adopted in the
SFO allows the SFC to deal with a particular case of market misconduct through proceedings before
the MMT, or through criminal proceedings before a criminal court.
The SFO also provides for a private right of civil action for investors who have suffered loss as a
result of market misconduct.
Section 174, SFO sets out the circumstances in which an intermediary may or may not call on a client
without being solicited or invited to do so, i.e. cold calling. The consequences of entering into
investment agreements in pursuance of a cold call are also reviewed.
In contrast to the above forms of market misconduct, which derive from the SFO, some improper
trading practices which have in the past caused the SFC concern are further reviewed. Such activities
include boiler-room operations, churning, corporate mis-governance, front running, rat trading,
providing unsuitable advice and unauthorized trades.
It follows a review of the SFC Disciplinary Fining Guidelines which the SFC refers to when it
imposes disciplinary actions against a licensed or registered person.
The final section of this Topic examines some enforcement actions of the SFC in order to highlight
some of the misconduct issues discussed in this Topic and regulatory breaches discussed in previous
topics, together with the disciplinary approach adopted by the SFC.

Learning outcomes
At the end of this Topic, candidates should be able to:
(a) explain the rationale for the structuring of the misconduct provisions in the SFO into two sections,
separately covering the treatments of MMT proceedings and criminal prosecutions for market
misconduct, as well as explain how the SFC uses the two routes in following up the results of its
investigations into particular cases;
(b) describe the role of the MMT and the procedures used by the MMT;
(c) describe the areas of market misconduct involving insider dealing, false trading and price rigging
as defined in Part XIII, SFO;
(d) describe the other acts of market misconduct, including stock market manipulation, disclosure
of information about prohibited transactions and disclosure of false or misleading information

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inducing transactions defined in Part XIII, SFO, as well as explain possible defences against
some charges of market misconduct;
(e) distinguish offences under Part XIV, SFO;
(f) discuss the possible consequence of market misconduct under MMT proceedings and criminal
law;
(g) explain the private actions available under the SFO for persons affected by market misconduct;
(h) understand the prohibition against unsolicited calls;
(i) identify and explain various common forms of improper trading practices;
(j) understand the principles applied by the SFC in imposing its fining powers under the SFO; and
(k) identify the reasons behind enforcement actions taken by the SFC.

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1 How market misconduct is regulated in Hong Kong
The dual approach
1.1 Market misconduct provisions are set out in Parts XIII and XIV, SFO and can be considered
in three main areas:
(a) Part XIII, which defines market misconduct, establishes the MMT and empowers the
MMT to conduct proceedings involving market misconduct;
(b) Part XIV, which establishes criminal offences to be tried before a criminal court; and
(c) the private rights of civil action which may be brought by persons suffering pecuniary
loss (i.e. loss relating to money) as a result of any market misconduct as defined in Parts
XIII or XIV.
The provisions of Parts XIII and XIV largely replicate each other (with the omission of
negligence from Part XIV). This establishes a dual legal regime for the same acts, an approach
reflecting the international trend that has already been adopted in the United States, the United
Kingdom and Australia.
1.2 This dual approach is intended to give further flexibility to the regulatory system in pursuing
acts of market misconduct. However, the SFO makes it clear that proceedings before the MMT
and criminal prosecution cannot both be instituted against the same person for the same act of
market misconduct.

Criminal or civil
1.3 The important distinction between the two routes of pursuing market misconduct is the issue
of evidence and the standard of proof required in each case. A criminal conviction requires
the case to be proved beyond reasonable doubt, a high standard of proof. In contrast, the
MMT determines its proceedings based on the civil standard, on the balance of probabilities,
a lower standard of proof. The dual system therefore allows a choice of avenues, the civil
route or criminal prosecution, according to the nature of the acts allegedly committed and the
strength of the available evidence.
1.4 In deciding which route to pursue, the SFC will make a decision on the basis of its
investigation into any particular case. If it decides that the civil route is appropriate, it may,
with the consent of the Secretary for Justice, institute proceedings in the MMT. The MMT
will hear and determine any question or issue arising out of the proceedings instituted before
it in respect of the alleged market misconduct. However, if the SFC is of the view that the
criminal route is appropriate, it will refer the facts to the Secretary for Justice, who will decide
whether or not a criminal prosecution should be brought before the court. In deciding whether
to prosecute, the Secretary for Justice will follow the Departments prosecution policy, which
is based on the criteria of sufficiency of evidence and the public interest. The SFC also has
the power under s. 388, SFO to prosecute minor cases summarily in a magistrates court,
subject to the overriding power of the Secretary for Justice to prosecute.
1.5 How market misconduct is defined in the SFO will now be reviewed, followed in the next
section by a consideration of the consequences of engaging in market misconduct.

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Revision questions:

Question 1: How does Hong Kong regulate market misconduct?


Answer 1: In Hong Kong, the SFO provides two approaches for regulating market misconduct:
The civil route: To institute proceedings in the MMT the MMT is established
to review market misconduct cases using civil procedures and to impose civil
sanctions on offenders; and
The criminal route: Part XIV, SFO provides a criminal route for dealing with
market misconduct where there is sufficient evidence to meet the criminal
standard and where it is in the public interest to bring prosecution before the
courts.
Question 2: What are the actions that the SFC can take when it suspects market misconduct?
Answer 2: The SFC may, with the consent of the Secretary for Justice, institute proceedings in
the MMT or may refer the facts to the Secretary for Justice for possible criminal
prosecution, or it may prosecute (for minor offences) summarily in a magistrates
court.

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2 Market misconduct
Definition of market misconduct in the Securities and Futures
Ordinance
(s. 245, SFO)
2.1 Market misconduct is defined as:
(a) insider dealing;
(b) false trading;
(c) price rigging;
(d) stock market manipulation;
(e) disclosure of information about prohibited transactions; or
(f) disclosure of false or misleading information inducing transactions.
As already mentioned, each of these offences is largely replicated in both Parts XIII and XIV,
SFO.
2.2 In addition to the above, Part XIV specifies other types of market misconduct, including the
following which are relevant to this manual:
(a) fraudulent or deceptive acts or the use of fraudulent or deceptive devices in Type 1, Type
2 or Type 3 regulated activity (RA) (s. 300, SFO); and
(b) disclosure of false or misleading information inducing others to enter into leveraged
foreign exchange contracts (s. 301, SFO).

Insider dealing
(Division 4, Part XIII and Division 2, Part XIV, SFO)
2.3 The definition of insider dealing is set out in ss. 270 and 291 of the SFO. Insider dealing can
be thought of as comprising two different ways of engaging in market misconduct, sometimes
referred to as dealing and tipping-off:
(a) a person dealing or counselling or procuring another person to deal, in the Hong Kong
listed securities of a corporation or its related corporation or their derivatives where the
first-mentioned person:
(i) is connected with the listed corporation and knowingly has inside information in
relation to the listed corporation; or
(ii) is contemplating (or has contemplated) making a take-over offer for the listed
corporation, which is known to the person as inside information in relation to the
listed corporation (and the dealing or counselling or procuring to deal is done
otherwise than for the purposes of the take-over); or
(iii) has received such information which he knows is inside information directly or
indirectly from a person known to be connected with the listed corporation; or
(b) a person connected with a listed corporation disclosing inside information or knowledge
of a take-over offer to another person knowing or having reasonable cause to believe that
the other person will make use of that information for dealing or counselling or procuring.
2.4 Two important terms that need to be understood are:
(a) inside information is specific information in relation to a corporation, its shareholders
or officers, or its listed securities or their derivatives:

Paper 2 Version 2.4 7-5 Hong Kong Securities and Investment Institute
(i) which is not generally known to the persons who are accustomed to dealing, or
would be likely to deal, in its listed securities; but
(ii) where, if such information were generally known to them, it would be likely to affect
the price of the listed securities materially;
(b) persons connected with a corporation include:
(i) directors, employees or substantial shareholders (for this purpose, those holding at
least 5% of the total number of shares comprised in the relevant share capital of the
corporation) of a corporation and its related corporation;
(ii) persons who may reasonably be expected to have access to inside information by
reason of having a professional or business relationship with the corporation or
related corporation or an officer or substantial shareholder in that corporation or
related corporation; and
(iii) connected persons of another corporation where the inside information relates to
transactions between the two corporations.
2.5 Listed securities include unlisted and/or unissued securities which are reasonably foreseeable
to be, and in fact are subsequently issued and listed.

Defences against a charge of insider dealing (ss. 271-273 and 292-294, SFO)
2.6 There are a number of possible defences provided for in the SFO, including the following:
(a) Chinese wall where one or more of the directors or employees of a corporation possess
inside information and the corporation deals (or counsels, etc.), the corporation will not
be regarded as having engaged in insider dealing if the persons actually engaged in the
dealing (or counselling, etc.) are not in possession of the inside information at the relevant
time (i.e. they were on the other side of an effective Chinese wall);
(b) excluded purpose the purpose of the insider dealing taking place through dealing,
counselling, etc. was not for the purpose of making a profit or avoiding a loss by using
inside information;
(c) market contract the dealing in question was a market contract;
(d) dealing of a connected person dealing where the other party to the dealing knows or
should know the person dealing is a connected person; and
Note: This defence is available only where the connected person played no role in
counselling or procuring the other party to the transaction to deal.
(e) exercise of an existing right dealing as a result of the exercise of a right to subscribe for
or acquire securities would not be regarded as insider dealing where the right was
acquired prior to becoming aware of the inside information.

False trading
(ss. 274 and 295, SFO)
2.7 False trading occurs in r