The Third Wave
30 June 2017
Malaysia launches the framework for digital investment management services.
The Securities Commission Malaysia (“SC”) has in recent years taken various measures to increase the breadth and depth of the Malaysian capital market by introducing frameworks for new products which leverage on information technology and the digital space.
The first step was taken in 2015 when the SC introduced the framework for equity crowdfunding. This was followed by the launch of the peer-to-peer financing framework in 2016. On 9 May 2017, the SC took the third step by introducing the framework for digital investment management services.
WHAT IS IT?
Digital investment management services, also described as “robo-advisory”, is of fairly recent origin. It started in the United States about a decade ago and has since spread to the United Kingdom, Canada, Germany and Australia.
According to the SC’s media release on 9 May 2017, digital investment management is a fund management business which incorporates innovative technologies into discretionary portfolio management services.
Hence, unlike traditional investment management services, digital investment management services seeks to leverage on technology such as algorithms and automated processes to execute orders and manage and rebalance investment portfolios with minimal or no human intervention.
In other words, digital investment management services can be aptly encapsulated in the tag line adopted by Canadian robo-advisor, Wealthsimple – “Investing on Autopilot”.
To implement the framework for digital investment management services, amendments were made by the SC to its Licensing Handbook (“Handbook”) and Guidelines on Compliance Function for Fund Management Companies (“FMC Compliance Guidelines”) on 9 May 2017.
As fund management is a regulated activity under the Capital Markets and Services Act 2007, a person who proposes to offer digital investment management services is required to obtain a fund management licence in relation to portfolio management as a digital investment manager under paragraph 2.05(2) of the Handbook. The SC has announced that parties who are interested in providing these services may apply for such licence as from 9 May 2017.
The general requirements that have to be satisfied for a fund management licence (including a fund management licence for digital investment management) are set out in Chapter 4 of the Handbook. Among the requirements that are to be satisfied are that the applicant must –
(1) be a company incorporated in Malaysia;
(2) satisfy the fit and proper criteria set out in paragraph 4.01(1) of the Handbook;
(3) have (i) clear lines of responsibility and authority in its organisational structure; (ii) the necessary information technology systems and infrastructure for its business; (iii) adequate systems of internal control; (iv) risk management policies and processes; and (v) policies and procedures for managing conflicts and monitoring of unethical conduct and market abuse; and
(4) ensure that its directors, chief executive officers, managers and controllers are fit and proper and have the requisite qualifications and experience, as set out in the relevant provisions of Chapter 4 of the Handbook.
Chapter 4 of the Handbook also sets out specific requirements that are to be satisfied by an applicant for a fund management licence for digital investment management services. An applicant for such a licence must -
(1) have a sufficient understanding of the rationale, risks and rules behind the algorithm that underpins its digital investment management business;
(2) ensure at all times that the outcomes provided by its algorithm (i) are consistent with the company’s investment strategies; (ii) commensurate with the risk profile of the investor; and (iii) comply with securities laws;
(3) have the system to support the digital investment management business, including maintaining a secure environment pursuant to the SC’s Guidelines on Management of Cyber Risk and other relevant guidelines;
(4) comply with the digital value proposition, including demonstrating that (i) its digital business model can deliver positive outcomes to its target investors and other target beneficiaries; (ii) the delivery of its services is user-centric; and (iii) the core components of its portfolio management services, including risk profiling and asset allocation and rebalancing, are automated;
(5) have a director who has a minimum of five years relevant experience in fund management and holds a Capital Markets Services Representative’s Licence for portfolio management;
(6) have a dedicated compliance officer or a person responsible for compliance; and
(7) have a minimum paid up capital of RM2.0 million and at all times, a minimum shareholders’ fund of RM2.0 million.
A holder of a fund management licence for digital investment management services may be wholly-owned by non-Malaysians.
The SC may impose the conditions and restrictions set out in Chapter 7 of the Handbook that are applicable to a holder of a fund management licensee on a holder of a fund management licence for digital investment management services.
Variation of existing licence
A holder of a fund management licence for portfolio management or for boutique portfolio management may apply to the SC to vary its licence to include digital investment management if it satisfies the criteria that apply to digital investment management.
A holder of a fund management licence for digital investment management services is permitted to outsource its services to a technology provider subject to compliance with the relevant requirements in Chapter 10 of the Handbook.
As a general rule, every holder of a fund management licence is required to comply with the FMC Compliance Guidelines. These requirements would also apply to a holder of a fund management licence for digital investment management.
The requirements include complying with the 11 core principles set out in Chapter 1 of the FMC Compliance Guidelines, such as conducting its business with integrity, due care, skill and diligence, acting in the interest of its clients, avoiding conflicts of interest, protecting assets of its clients and taking reasonable care to ensure that its affairs are conducted in a responsible manner and with adequate risk management and in compliance with a sound compliance framework.
The board of directors and compliance officer of a holder of a fund management licence are required to comply with their respective responsibilities set out in Chapter 2 of the FMC Compliance Guidelines. The board is also required to establish a risk management framework that commensurate with the licensee’s business.
To safeguard the assets of its clients, a holder of a fund management licence is required to appoint a qualified custodian to hold the assets of its clients in trust for them.
In addition to the general requirements, a holder of a fund management licence for digital investment management is required to comply with the additional requirements set out in Chapter 13 of the FMC Compliance Guidelines. These include an obligation on the licensee’s board of directors to ensure that the licensee has the technological capabilities to undertake digital investment management business. The licensee must–
(1) continue to comply with the requirements set out in items (1) to (3) of the specific requirements applicable to an applicant for a fund management licence for digital investment management set out earlier in this article;
(2) conduct at least an annual review on the effectiveness of the governance and supervision of the technology and algorithm underpinning its digital investment management business;
(3) ensure that its risk management framework includes risks related to the digital investment management business;
(4) disclose and display prominently on its platform, all relevant information including the investment strategies used, the fact that an algorithm is used, the function of the algorithm used, the assumption and limitation of the algorithm, the risks inherent in the use of technology and the fees, charges and remuneration for the services provided; and
(5) establish, maintain and implement written policies and procedures including ensuring that (i) the algorithm is monitored and tested to ensure it is fit for purpose at all times; (ii) access to and the ability to make changes to the algorithm is limited only to authorised personnel; and (iii) ongoing due diligence is conducted on any third party that develops, owns or manages the technology and algorithm used by the licensee.
The compliance officer is responsible for establishing a compliance programme which takes into consideration the unique and specific aspects of the digital investment management business model.
A HAPPY COINCIDENCE?
Less than a fortnight after the launch of the framework for digital investment management, the SC announced that various measures will be introduced in 2017 to enhance the development of the domestic market for exchange traded funds (“ETF”). Among the measures being considered by the SC are reducing the issuers’ costs and capital requirements for issuers and the introduction of new products.
As some robo-advisors, such as Betterment, Wealthsimple and Stockspot, invest a large part of the funds under management in ETFs, these measures to boost the domestic ETF market are timely and may assist in the development of the digital investment management sub-sector as well. A happy coincidence or a master stroke in strategic planning?
According to the SC, the framework for digital investment management services aims to provide investors with a more convenient, affordable and accessible channel to manage and grow their wealth.
Sceptics have expressed doubts that the de-personalised “robo advisory” services will find favour with investors. Its proponents have, on the other hand, argued that the low minimum investment threshold and lower fees have made wealth management services accessible to a significantly wider segment of society.
In the final analysis, the success or failure of digital management services will depend primarily on whether the technology used will enable the investment objectives of the investors to be achieved in a reliable and secure manner.