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SFC raises concerns about illiquid assets

Hong Kong's regulator emphasises the need for rigorous risk management by intermediaries in the wake of liquidity problems in high profile funds.

“Fund managers should conduct stress tests and closely monitor the liquidity profiles of their fund portfolios throughout the entire life cycle of their funds,” Julia Leung, the Securities and Futures Commission’s (SFC) deputy chief executive officer and executive director of intermediaries, said in a press statement.

The new warning follows an SFC circular last August that noted deficiencies and inadequacies in fund managers’ liquidity risk management practices, and was issued in the wake of difficulties encountered by high profile names in the global funds industry.

The SFC also now places responsibility with intermediaries to put in place sound risk governance structures. The roles and responsibilities of senior management should be clearly defined within the risk management and oversight functions of the firm.

In particular, licensed corporations should have appointed managers-in-charge (MICs) who are suitably qualified and experienced to be responsible for risk management functions.

The recommendations are contained within the latest “SFC Compliance Bulletin: Intermediaries”.

The bulletin highlights Neil Woodford‘s suspending the trading of a flagship fund exposed to illiquid and unquoted investments, the suspension of withdrawals by Lime Asset Management in South Korea when it could not sell convertible bonds, and the huge redemptions from funds run by London-based H2O Asset Management amid concerns about their corporate bond holdings.

“These incidents were warnings to the financial industry that funds which are overweight in less liquid investments face heightened risks in volatile markets. Managing liquidity risk is not only key for fund managers, but also for financial intermediaries with leveraged exposure to illiquid bonds,” said the bulletin.

Liquidity risk arises when there is a mismatch between a fund’s assets and its liabilities, and funds with an open-ended structure, especially those with daily dealing arrangements, run an even greater risk of liquidity problems when investors rush to redeem on any hint of trouble or poor performance.

“This was the case with Woodford Investment Management in the UK,” said the SFC.

The SFC also highlighted credit risk, exacerbated during a prolonged low interest rate environment that has led investors to move down the credit curve to earn incremental yields

In Hong Kong, sales of non-investment grade corporate bonds grew 65% between 2016 and 2018 and transactions in high-yield bond funds increased from $2 billion to $18 billion, according to the SFC.

“Many of these bonds [and funds] yield double digit returns, reflecting a high risk of default,” said the bulletin.

Responsibilities of intermediaries

“Intermediaries distributing or advising on these high risk products should be mindful of the requirements governing selling practices, including the suitability obligations under the SFC Code of Conduct,” said the bulletin.

They need to provide investors with sufficient and accurate information about these products, including their features and risks, and must present balanced views and not focus solely on the products’ advantages.

The SFC expressed particular concerns about “complex financing arrangements”

It pointed to cases where financial groups affiliated with securities brokers have had their capital substantially tied up in investments in defaulted corporate bonds or notes, overdue loans or mature but unsettled private funds. Some of these bonds, notes or loans were secured by illiquid shares or shares suspended from trading on the stock exchange.

It is paramount for intermediaries to exercise due care, skill and diligence and deploy necessary resources to manage and contain the risks facing their business activities. This is particularly important in times of market uncertainty and slower economic growth,” said the SFC.


Part of the Mark Allen Group.