Hong Kong’s ETF deregulation examined

Author: Brian Yap | Published: 5 Apr 2016
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The Securities and Futures Commission's (SFC) move to deregulate Hong Kong’s budding exchange-traded funds (ETF) market is welcome, but limits on passporting have drawn criticism.  

The SFC announced its authorisation of the issuance of leveraged and inverse ETFs in February, while setting new requirements on the naming and trading of such products.

But counsel in Hong Kong have pointed to the continued rigidity of the territory’s approval process for cross-listing of ETFs, with the prospect of a new ETF regime being relatively slim.

Because ETFs are treated as specialised schemes, full compliance with the Hong Kong rules is required, according to Rolfe Hayden, partner at Simmons & Simmons in Hong Kong. "Anything that is slightly different or has already been launched may be a struggle," he added.

"It’s quite difficult to change things but Hong Kong regulation requires changes to be made", said Hayden.

Under Appendix I to the SFC’s Unit Trust Code (UT), an overseas ETF may be authorised through a streamlined recognition process… if it meets the core requirements under the UT Code.

"It was (once) hoped that ETFs could be passported and approved more quickly if they were already established in a recognised ETF regime, but in practice this has not happened," said Hayden.

Hayden added that investors in the territory once thought that the US would qualify as a recognised ETF regime, but it has never been approved by the SFC.

  • The SFC’s move to deregulate Hong Kong’s budding ETF market has received mixed reactions, with critics citing inflexibility over passporting;
  • The SFC announced its authorisation of the issuance of leveraged and inverse ETFs in February, while setting new requirements on the naming and trading of such products;
  • But counsel in Hong Kong have pointed to the continued rigidity of the territory’s approval process for cross-listing of ETFs, with the prospect of a new ETF regime being relatively slim.

Brokerage regulators and fund managers, such as BlackRock in the US, flagged the potential risks associated with inverse and leveraged ETFs, suggesting that they could "blow up" the entire industry. 

According to a December study by the Securities and Exchange Commission, nearly four percent of funds in the US have received exposure exceeding 150% of net assets.

While US regulators have raised concern about the suitability of these products for retail investors, they have gained traction in major Asian economies such as Japan and Korea.

Japan’s Next Funds Nikkei 225 Leveraged Index ETF, driven by a shift among domestic investors away from a volatile stock market, raked in 177.4 billion yen ($1.5 billion) in the first weeks of January.

"The SFC’s caution is understandable but there has been a growing feeling among ETF providers that Hong Kong was missing out on something which was doing very well in other markets," said Hayden.

The SFC’s cautious approach to the products was reflected in its plan announced last December to impose a 150% cap on the leverage an investor can derive from the trading of derivatives. The was in tandem of a similar proposal issued by the Securities and Exchange Commission following warnings from key industry players about the danger of exposing the EFT market to these leveraged products.

"The SFC has taken a cautious approach and not only is the ratio restricted but it has restricted the markets that these ETFs may be invested," said Taylor Hui, partner at Deacons in Hong Kong.


"The SFC has taken a cautious approach"


"They put them into the category of a hedging tool or a trading tool rather than a long-term investment," he added.

In addition to the statutory cap, the SFC has imposed a maximum leverage factor of two times on all leveraged products, while limiting all underlying tracking indices to those domiciled overseas.

"The major possible concern has been around naming in that you are not allowed to include "ETF" in the name of these products," said Hayden.

But some in the ETF industry have been surprised by the SFC’s move to introduce these leveraged products, while stressing the need for tight regulation of trading in the leveraged ETF market.

"To introduce something that is synthetic, or in some respect, more aggressive in the synthetic spectrum was a bit of a surprise," said Mark Shipman, partner at Clifford Chance in Hong Kong.

Shipman added that, while it is a positive development reflecting the SFC’s willingness to cater to market needs, a number of risk warnings that need to be added to these products; that they should be clearly categorised as products intended for hedging purposes and not for long term investment by sophisticated investors who are well-informed of market movements.

See also

ETFs: creator of risk or choice

HK ETF managers urged to comply promptly to new rules