Derivatives are back—but be careful

The Securities and Futures Commission (SFC) has authorized the issuance of “Exchange-Traded Funds” a year-and-a-half after these products were banned.

It authorized Deutsche Bank AG to issue six “synthetic ETFs” on Dec. 30. This was the first time since mid-2009 SFC has given permission for these products that mimic the behavior of exchange-traded funds through the use of derivatives

The Hong Kong Monetary Authority (HKMA), however, is requiring banks to explain to clients the riskier nature of these products. It urged banks to ensure that customers understand the risks of buying complex products such as subordinated bonds in an effort to strengthen disclosure.

Hong Kong’s de facto central bank said in a letter to financial institutions that they should explain to clients that so-called junior securities “bear higher risks” than senior debt. Subordinated debt doesn’t pay out in the case of a default until after senior debt holders are paid in full.

“Disclosure and representation relating to credit information should be clear and not misleading,” the authority said. The circular said banks should refer customers to documents detailing risks of other investments, particularly ETFs.

HKMA is responsible for the stability of the city’s banking system. SFC, however, has the statutory responsibility to protect investors.