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The recent joint thematic review shared by the SFC and HKMA sheds some light on key areas where intermediaries need to sharpen their focus regarding non-exchange traded products to meet regulatory expectations. Problematic fields identified included PDD, ongoing monitoring and suitability, leaving firms with work to be done to improve their processes around client due diligence to avoid regulatory action.
The regulators identified some issues on intermediaries’ practices in performing product due diligence (PDD) and suitability assessment, ensuring investment products are in the best interests of the clients and that they’re provided with all the necessary information.
PDD and ongoing monitoring
PDD is a critical aspect of ensuring the suitability and appropriateness of investment products for clients.
The SFC found that senior management teams approved substandard PDD documentation which had obvious omissions or contained inaccurate analyses on investment products without verification. There were also instances identified where these managers sometimes overlooked qualitative factors such as market and industry risks, leading to inadequate analysis and unsuitable recommendations.
In other cases, some firms’ investment products were not sufficiently reviewed to identify key terms, features and risks. This oversight could impact a firm’s ability to accurately assess the risks required to effectively advise their clients.
Inconsistent assessment of product risks was another issue observed by the SFC in the review. Many firms assigned risk ratings to investment products inconsistently, impacting clients’ risk tolerance levels. For instance, adequate guidance on adjusting risk scores wasn’t provided, resulting in inconsistent assessments. Firms also classified funds into different level of risks without setting out clear criteria, leading to further inconsistencies.
Many firms in scope didn’t conduct ongoing PDD to ensure that investment products remained suitable for clients over time. Previous PDD assessments were not reviewed, even when circumstances changed such as bond issuer defaults or changes in investment managers Product risk ratings were also not reassessed when returns deteriorated or volatility increased, leading to outdated risk assessments.
Suitability
Suitability assessment is a risk-based process that involves matching investment products with the personal circumstances and risk tolerance of clients. While many firms primarily rely on matching the product risk rating with the client’s risk profile, the SFC emphasised considering all relevant client-specific circumstances, including financial situation, investment experience, objectives, horizon, and concentration risk.
Some firms have been found to use risk profiling questionnaires (RPQs) that may produce skewed results towards high-risk tolerance. For example, an RPQ may assign significant weighting to a client’s investment experience, leading to disproportionate correlations with risk tolerance. This lack of focus on understanding a client’s tolerance of capital loss can result in inaccurate risk assessments and unsuitable product recommendations.
Many firms set concentration thresholds on clients regarding the maximum proportion of their net worth or investment portfolio that may be invested in high-risk products. However, some firms could not justify these thresholds or any exceptions. For instance, allowing clients with moderate risk tolerance to invest up to 80% of their portfolios in high-risk products lacked justification and may not align with clients’ overall risk profiles or circumstances.
How to stay on track
The review identifies common errors made by firms around keeping clients informed regarding transactions:
- Failing to disclose the maximum percentage of monetary benefits received from fund managers through their execution brokers. This impacts clients’ understanding of potential conflicts of interest and the true cost of investments.
- Inaccurately representing themselves as independent while receiving fees and commissions for distributing investment products. This can lead to clients misinterpreting the firm’s position.
- Not disapplying provisions related to professional investors (PIs), creating confusion around whether Code of Conduct requirements are effectively disapplied when dealing with PIs.
It’s therefore crucial to firms to
- fully understand the nature of structured products and provide clients with detailed product information that clearly explains the characteristics of the products
- when conducting suitability assessments, consider all relevant client circumstances such as client’s financial situation, investment experience, objectives, horizon and concentration risk
- adequately assess the risk return profiles of products
- disclose all relevant information to clients and ensure that the information provided is accurate without any misleading representations.
How we can help
We specialise in navigating regulatory complexities and can offer tailored solutions to address the challenges highlighted by the SFC’s thematic review.
Our team can support by conducting mock inspections that mirror the SFC routine inspection process, leveraging our experience and dealings with the regulator to prepare you for a real assessment.
We can also review your compliance framework, policies and procedures to ensure that you stay compliant with the latest regulatory requirements. Our consultants regularly conduct thematic reviews on existing systems and controls, recommending enhancements and assisting clients with closing any gaps.
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