SFC Guidelines for Online Platform Operators

3 May 2018

The SFC issued a consultation conclusion on the proposed Guidelines on Online Distribution and Advisory Platforms (proposed Guidelines) in March 2018 which aims to provide guidance to the industry on the design and operation of online platforms, and most importantly, to clarify how operators of these online platforms can discharge their obligations in ensuring the suitability of their recommendation or solicitation for clients.

As more and more industry players are getting into the robo-advice market, and the services that they offer are increasing and evolving rapidly, it is important that these robo-advisers, or online platform operators as defined broadly, now prepare to comply with the proposed Guidelines, where six core principles that are related to online platforms have been identified, including proper design of the platform, risk management, and review and monitoring.

The proposed Guidelines also distinguish between complex and non-complex investment products, and the SFC requires platform operators to ensure suitability in the sale of complex products online, including those sold on an unsolicited basis, which will be further elaborated below, together with other relevant areas that online platform operators need to take heed of.

Licensing Requirements for Online Platform Operators

Generally, companies that carry on a business in regulated activities in Hong Kong are required to be licensed with the SFC. Regarding online platforms, even if the operator is located offshore, it may still be required to obtain a license if it holds itself out as carrying on regulated business in Hong Kong, or that its services are actively marketed to the public in Hong Kong.

As some online platform operators provide advice on specific investment products, and others may also provide order execution and distribution services in respect of investment products, they will need to be appropriately licensed in Hong Kong as they are carrying on regulated activities as defined in the Securities and Futures Ordinance (SFO).

Application of the proposed Guidelines

The proposed Guidelines apply to all firms which provide order execution, distribution and advisory services in respect of investment products via online platforms in Hong Kong. In addition, these online platform operators will also need to comply with other applicable rules and regulations, such as the SFC Code of Conduct and the Guidelines for Reducing and Mitigating Hacking Risks Associated with Internet Trading.

Complex and Non-complex Products

The SFC stated that in order to determine whether a product is complex or not depends on whether a retail investor is able to understand the terms, features and risks objectively. Thus, each product should be holistically assessed by online platform operators on the basis of the totality of the facts depending on its specific terms and features.

The proposed Guidelines also include examples on complex and non-complex products respectively, and online platform operators should therefore ensure suitability of the sale of complex products online. Operators should also determine whether their obligations in respect of the suitability requirements are being fully discharged.

Examples of Complex Products include:
– Futures contracts
– Equity derivatives
– Synthetic Exchange-Traded Funds (ETFs) and Leveraged and Inverse Products (L&I Products)
– Complex bonds
– Derivatives fund (SFC-authorized and non-SFC authorized)
– Non-exchange traded structured investment products

Examples of Non-complex Products include:
– Listed securities
– Plain-vanilla bonds
– Non-derivative public funds and non-derivative ETFs
– Exchange-traded REITs

Having regard to the above examples, online platform operators will also need to refer to the proposed Guidelines to determine whether or not an investment product is complex in order to take further actions to fulfil their regulatory obligations. The key of the proposed Guidelines is the requirement for online platform operators to ensure suitability in the sale of complex products, even on an unsolicited basis.

A platform operator may treat an exchange-traded product as non-complex if it is of the same type as a non-complex product listed in the examples and is traded on an exchange in a specified jurisdiction, the list which will be updated by the SFC from time to time. Also, a non-SFC authorized fund may be considered as non-complex if it is a non-derivative overseas public fund which is authorized in a specific jurisdiction (e.g. US, UK and Mainland China).

However, for complex products which are also derivative products traded on an exchange in Hong Kong or in a specified jurisdiction similar to the ones above, where there has been no solicitation or recommendation, a platform operator is not required to comply with the requirement to ensure suitability for transactions in such products executed on an exchange, although it must still comply with the existing requirements in the SFC Code of Conduct on investor categorization and know-your-client (KYC) on derivatives products.

Suitability Requirement

Generally, the suitability requirement will be triggered by a solicitation or a recommendation, no matter whether it happened in an online or offline context, and the relevant obligations as stated in the SFC Code of Conduct must be discharged properly.

The consultation conclusions have included various instances where the suitability requirement will and will not be triggered. For example, the posting of factual, fair and balanced product-specific materials in research reports on online platforms would not itself amount to a solicitation or recommendation, whereas the posting of advertisements which include product-specific incentives such as cash rebates and fee discounts would trigger the suitability requirement.

In order to appropriately discharge their obligations on the suitability requirement, online platform operators should carry out adequate suitability assessments on their clients. They should consider the overall effect of their recommended products on their clients’ portfolios, as well as the risk return profile of the portfolio and their clients’ investment objectives. All of the aforementioned obligations already exist in the SFC Code of Conduct, which specifies that licensed firms should collect relevant information from clients, which include KYC information and other information such as the clients’ investment knowledge, investment horizon and risk tolerance.

Where a product is categorized as complex but with low risk, online platform operators should conduct proper suitability assessment which is similar to the one conducted in an offline context, and match the risk profile of the product and their clients’ risk tolerance level, thereby discharging their obligations.

Provision of Non-SFC authorized funds

As mentioned previously, the suitability requirement will usually be triggered by a solicitation or recommendation. For instance, the SFO generally restricts offers of investments of non-SFC authorized funds to the public of Hong Kong. As such, online platform operators should conduct proper KYC to establish whether a client can be categorized as a professional investor as defined in the SFO, thereby can be offered non-SFC authorized funds.

Further, these kind of non-SFC authorized funds may sometimes be included in a client’s model portfolio, and whether this would breach the SFO depends on whether there is an invitation to the public to acquire an interest in these funds. For instance, if an online platform operator only describes their scope of services to include the distribution of non-SFC authorized funds without specifying or disclosing the particulars of the products in the model portfolio which is generated, then this will not amount to an invitation to the public.

Similarly, if a tailor-made recommended portfolio which includes non-SFC authorized funds is offered to a particular client, after taking into account the client’s personal circumstances during the KYC process, then this again will not amount to an invitation to the public. This is on the assumption that proper client KYC was already done before the particular product or portfolio is offered and the online platform operator has a one-to-one advisory relationship with the client.

Other Technical, Operational and General Requirements

Online platform operators should appoint a “suitably-qualified person” to review the suitability assessments and the reasonableness of any recommendations or advice generated by the algorithm used and any rebalancing conducted on a regular basis, and the design and operation of the online platform should be tested ad reviewed at least annually.

Robust internal controls should also be in place to detect any failures in the algorithms used, and trading may need to be halted where necessary. This should be determined by the online platform operators after taking into account the circumstances, as well as the interests of clients and the integrity of the market in totality.

Regarding complex products, the minimum information to be provided has also been included in the consultation conclusions, such as worst case scenario analysis for structured products and whether potential gain may be capped or limited. Further, appropriate warning statements should be included in the online platforms, and should be presented in a prominent and clear manner.

Further Consultation on Offline Requirements Applicable to Complex Products
In order to avoid any loopholes and ensure a level playing field, the SFC has proposed to amend the SFC Code of Conduct to align the regulatory requirement for both online and offline sales of complex products, where a new paragraph regarding KYC on complex products is being added, which specifies suitability and disclosure requirements.

This proposal is similar to the requirements in the proposed Guidelines, such that when a licensed firm is offering complex products in an offline context, whether on a solicited basis or not, then the suitability requirements will be applicable. The licensed firm offering complex products should also provide sufficient information regarding the products and provide warning statements.

If a client has no knowledge of derivatives, but wishes to invest in a non-exchange traded derivative product on an unsolicited basis, then the licensed firm will need to comply with the existing requirements in the SFC Code of Conduct. This means warning the client about the transaction, providing advice on suitability and maintaining all relevant records of communications. Regarding complex exchange-traded derivative products in Hong Kong or a specified jurisdiction, licensed firms are not required to comply with the proposed KYC paragraph. This is in line with the regulatory requirements on the online sale of complex exchange-traded derivative products, whereas if they are not traded in a specified jurisdiction, then the proposed KYC paragraph will be applicable.

In line with the proposed Guidelines, the above proposed suitability and disclosure requirements are not exempted for Individual Professional Investors, but may be exempted for Corporate and Institutional Professional Investors.

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