The Securities and Futures Commission (SFC) has issued a circular reminding management companies and market makers[1] of SFC-authorized exchange traded funds[2] (ETFs) of their regulatory obligations. The SFC has expressed concerns that management companies and market makers of ETFs may not be sufficiently prepared to respond to operational disruptions caused by COVID-19, following an incident where a sole market maker of an ETF had to temporarily suspend its market making functions after certain traders were placed under mandatory quarantine.
Key obligations from the circular are noted below.
Management companies of ETFs should:
- conduct due diligence and regular monitoring of market maker(s) engaged by the management company[3] and ensure that such market maker(s) remain(s) competent and properly resourced to duly discharge the market making functions (including ensuring that the appropriate business contingency plans are in place);
- closely monitor the secondary market trading and liquidity of the ETFs under its management;
- ensure arrangements are in place such that the relevant market maker will notify them immediately if the market maker anticipates any operational difficulties or disruptions that may affect the proper discharge of the market making functions;
- consider the risk presented by relying on a single market maker (if applicable) and manage this risk e.g. by procuring more than one market maker for an ETF or putting standby arrangements in place for an alternative market maker to step in where appropriate.
- report any cessation, disruption or suspension of market making activities[4] for units/shares in the ETF under its management to the SFC, assess whether the relevant event could adversely affect the interests of investors, and keep investors informed as required under 8.6(q) of the Code on Unit Trusts and Mutual Funds; and
- alert the SFC of any untoward circumstances relating to ETFs under its management, including matters which may adversely impact operations, secondary market trading or liquidity of the ETFs.
Market makers of ETFs should:
- establish and maintain appropriate internal controls and risk management measures to protect key business functions of market making. In particular, implementing effective business continuity and contingency plans that are appropriate to the size of the firm. [5] The plans should identify likely scenarios involving disruptions and include appropriate back-up facilities and alternative arrangements as well as maintaining personnel at a level sufficient to prevent disruption to market making activities;
- promptly initiate contingency measures in the face of potential operational disruptions in order to maintain key business functions; and
- alert the management company of the ETFs, the SFC and the HKEX immediately if the market maker experiences or anticipates experiencing any operational difficulties or disruptions that may prevent them from properly discharging their market making functions for the ETFs.
[1] This includes Securities Market Makers and Designated Specialists as defined in the Rules of the Exchange.
[2] This includes SFC-authorized passive ETFs, active ETFs and listed unit/share class(es) of unlisted SFC-authorized funds.
[3] The management company of an ETF is generally expected to use its best endeavours to put in place arrangements so that there is at least one market maker for the units/shares (traded in each counter) of the ETF.
[4] For further details, please refer to FAQ12 of the Frequently Asked Questions on Exchange Traded Funds and Listed Funds.
[5] For further details, please see paragraph 36 of the Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the Securities and Futures Commission.
