Introduction

The Hong Kong Securities and Futures Commission (“SFC”) has issued a Supplemental Circular on Leveraged and Inverse Products (“L&I Products”) on 14 March 2019 (the “Supplemental Circular”), which is supplemental to SFC’s Circular on L&I Products first issued in February 2016 and last amended in December 2018 (the “L&I Products Circular”).

L&I Products are investment products for short-term market timing or hedging purposes and are only suitable for sophisticated trading-oriented investors.

The L&I Products Circular sets out the requirements under which SFC would consider when authorizing L&I Products structured as exchange trade funds (“ETFs”) for public offering in Hong Kong under sections 104 and 105 of the Securities and Futures Ordinance. SFC has then reviewed the product structure requirement and made corresponding changes to the L&I Products Circular by issuing the Supplemental Circular.

Public offering of L&I products

L&I Products seeking SFC authorization for public offering in Hong Kong must meet the applicable requirements in the Overarching Principles Section and the Code on Unit Trusts and Mutual Funds in SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products.

Amended product structure requirements

SFC has reviewed the leverage factor cap of Inverse Products and decided to relax the leverage factor cap to two-time (-2X) and accept applications for -2X Inverse Products. SFC also takes into account some new factors when assessing applications of L&I Products. SFC will only accept applications for L&I Products tracking commodities indices on a case by case basis where there is no potentially outsized impact from roll costs (i.e. costs incurred when replacing near-term futures contracts with long-dated ones (also known as “rolling”)) on the performance of the products. Meanwhile, SFC will take into account various new factors when assessing the applications, namely, (i) liquidity of underlying assets; (ii) costs internalized by the products; and (iii) fairness of product design.

As such, the Supplemental Circular has modified the product structure requirements in the L&I Products Circular as follows:

• Leveraged Products shall be subject to a maximum leverage factor of two times (2x); and Inverse Products shall be subject to a maximum leverage factor of two times (-2x) (instead of one time as before).
  
• SFC only accepts applications for L&I Products tracking (i) liquid and broadly based Hong Kong and non-Mainland foreign equity indices and (ii) on a case by case basis, non-equity indices, including commodities indices where there is no potentially outsized impact from roll costs on the performance of the products (newly added requirement). SFC will continue to keep in view the eligible indices of L&I Products but, at this time, SFC has no plan to accept applications for L&I Products tracking Mainland indices.
  
• In considering applications of L&I Products, SFC will generally assess, among others, (i) liquidity of underlying assets; (ii) costs internalized by the products; and (iii) fairness of product design (newly added requirement).

Other existing requirements for public offering

Product name

In view of the day trading nature of L&I Products as opposed to the investment nature of conventional ETFs, L&I Products that have been authorized by SFC would not be named as “ETFs”. Instead, these products must be named as “Leveraged Products” or “Inverse Products”, as the case may be.

Offering documents disclosure

The offering documents of L&I Products shall contain upfront disclosure in the product key facts statement so that investors will not mistakenly assume the L&I Products share the buy-to-hold characteristics of conventional ETFs.

Market making arrangements

To enable an L&I Product to meet its investment objectives as a short term trading tool, it is important that investors are able to enter into and exit their investments. As such, the presence of market makers as well as their performance is particularly important for L&I Products. In view of this, SFC requires that (i) an L&I Product must be terminated in the event of resignations of all market makers with a sufficiently long resignation notice period; and (ii) the performance of market makers will be monitored by the HKEX on an ongoing basis. Those who fail to meet the performance requirements set by the HKEX may have their market maker permits revoked and/or be banned from applying for market maker permits for other L&I Products for a period of time.

Performance simulator

The provider of an L&I Product is required to make available a “performance simulator”, which allows investors to select a historical time period and simulate the performance of the L&I Product during that period based on historical data.

Distribution

As L&I Products are derivatives products, intermediaries are subject to the applicable requirements under the Code of Conduct for Persons Licensed by or Registered with Securities and Futures Commission when they provide services to clients with respect to L&I Products.

Margin financing

Exchange participants are advised not to provide margin financing to investors for trading of L&I Products.

Conclusion

Following the recent review conducted by SFC, the leverage factor cap of Inverse Products is relaxed and changes are made to product structure requirements accordingly. Since L&I Products are investment products for short-term market timing or hedging purposes and are only suitable for sophisticated trading-oriented investors, SFC would review the aforesaid requirements on an ongoing basis and we should keep a close eye on any changes of the requirements.

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.