Before presenting our suggested IT solutions, we first outline some major ... each product with the latest securities regulations should also be checked.
Using Information Technologies to Restore Investor Trust By Antonio Wong, Ph.D., CFA and Pak-Lok Poon, Ph.D., CISA, CSQA, MACM, MIEEE The way a financial intermediary set itself apart from its competitors is how it services the clients, by virtue of its sound investment advice with the use of information technologies
Nowadays, many investors start to question the integrity of financial intermediaries (FIs) and hesitate to do further business with them.
To survive, these financial
intermediaries must restore investor trust at all cost.
With respect to the current
conditions of the financial markets in Hong Kong, this paper discusses how to restore investor trust by implementing appropriate technological solutions.
Investment Difficulties Faced by Retail Investors In today’s rapid changing financial market, we have seen a great flood of innovative and complex financial products.
Offering of these financial products provides an
investment opportunity to investors. In deciding on which financial products to invest, retail investors (people who invest for their own accounts), however, may find themselves in the midst of a tunnel because of two reasons. Firstly, they generally do not have sufficient knowledge of the financial products and the underlying investment risks. Secondly, these investors may not be well aware of the investment risk level that they can tolerate.
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Governance of Financial Products in Hong Kong In Hong Kong, all FIs who sell or recommend financial products to investors need to abide by the Code of Conduct (the “Code”) established by the Securities and Futures Commission (SFC) [1]. The Code requires that the “suitability” of the investors to invest a financial product must be thoroughly considered by the FI concerned with full disclosure of relevant information. To some extent, this requirement helps alleviate the investment difficulties confronted by the retail investors mentioned above. Following the recent collapse of Lehman Brothers, over 8,000 Lehman-related financial products investors have filed complaints with the SFC [2]. These investors complained that (a) FIs did not fully explain the features and the underlying risks of the Lehmanrelated financial products; and (b) FIs failed to consider the investors’ risk tolerance and personal circumstances when selling these products. In an attempt to get their money back, these investors joined in a protest to make some noise after losing money. A probe to investigate the cause of the saga is now underway by the SFC and a subcommittee of the Legislative Council of Hong Kong, and the outcome is yet to know. In fact, the financial loss of retail investors caused by the Lehman collapse is not the first scandal of this type. In 2004, SFC had instituted disciplinary proceedings against Towry Law (a financial advisor) as a result of its failure in relation to two hedge funds managed by third parties [3]. SFC alleged that “ Towry Law: (a) conducted insufficient due diligence into two funds before recommending them to clients; (b) sold the two funds to clients whose investment objectives and risk tolerance did not always match with the risk profiles of the two funds; (c) failed to conduct proper enquires into circumstances surrounding the two funds which indicated problems with the funds; and (d) failed to advise clients when it became clear the funds had problems [3].” In the end, disgruntled investors were compensated after the SFC reached a US$ 37.7 million settlement with Towry Law the biggest compensation in Hong Kong’s history [4]. Incidents like the above have unavoidably reduced the investor confidence in the integrity of FIs and in turn damaged Hong Kong’s reputation as an international financial center.
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SFC’s Code of Conduct To survive, particularly in the recent global financial crisis, it is of utmost important for FIs to restore investor trust, which can be achieved in two ways: (a) improving the internal business practices of FIs with a view to complying with the SFC’s Code of Conduct; and (b) making this compliance visible to the clients ( see Figure 1). Information technologies, if properly used, can help FIs to achieve (a) and (b). * * * Insert Figure 1 here * * * Before presenting our suggested IT solutions, we first outline some major requirements of the SFC’s Code of Conduct [1] as follows: (Requirement 1 ) Honest, fairness, and due diligence:
In conducting its business
activities, a FI should act honestly and fairly, with due skill, care, and diligence, and in the best interests of its clients and the integrity of the market. (Requirement 2 ) Competence of staff: Staff employed or appointed by a FI should be fit and proper in terms of their professional training and experience. (Requirement 3 ) Knowledge of clients and products: A FI should seek from its clients information about their financial situation, investment experience, and investment objectives relevant to the services to be provided.
Furthermore, the firm should fully
understand the financial products and their associated investment risks. (Requirement 4 ) Disclosure of information and explanations of investment advice: A FI should disclose relevant material information in its dealing with the clients. Furthermore, it should help each client make informed decision by giving proper and fair explanations of why the recommended financial products are suitable for the client and the nature and extent of risks the financial products bear. (Requirement 5 )
Documentation
standards:
To
demonstrate
compliance
with
regulatory requirements, a FI should document and record the information given to each client and the rationale for recommendations given to the client, including any material queries raised by the client and the responses given by the FI. In addition, a FI should
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keep sufficient documentation on all client transactions including the orders placed to the providers of financial products.
Using information technology (IT) to comply with SFC’s Code of Conduct Below we discuss our recommendations for using IT to help a FI comply with the SFC’s Code of Conduct and make this compliance visible to its clients ( see Table 1). (Recommendation 1 ) Evaluation of financial products: To act in the best interests of the clients, a FI should conduct a thorough evaluation of the structure, complexity, and the risk-return characteristic of every financial product concerned.
The compliance of
each product with the latest securities regulations should also be checked. The evaluation results should be stored in a financial product database and made publicly available via the FI’s corporate Web site [5, 6, 7, 8]. Because the financial markets are highly volatile, the evaluation exercise has to be repeated regularly from time to time as to each financial product. In this regard, the date of last evaluation should be provided in the corporate Web site to assure the clients that the FI stays current with the product knowledge. Furthermore, the FI’s corporate Web site should include navigation links to the Web sites of the providers of financial products, to facilitate information seeking by the clients. The above practices contribute to the fulfillment of Requirements 3 and 4 of the SFC’s Code of Conduct. (Recommendation 2 ) Credentials of frontline staff: To demonstrate to the clients that the credentials of the frontline staff are beyond dispute, information such as the educational background, professional training, and previous achievements of the staff members should be made available in the FI’s corporate Web site for browsing by clients [9]. This practice, coupled with our Recommendation 1 above, will make the clients feel that investment advice is given with a high standard of professionalism by the FI’s staff. As a result, Requirements 1 and 2 of the SFC’s Code of Conduct can be fulfilled. (Recommendation 3 ) Personal profiles of clients:
A database storing the personal
profiles of the clients should be established. Besides the client’s basic data such as age, educational background, and occupation, the database should keep other investment-
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related data including the client’s investment objectives and experience, risk tolerance level, as well as investment portfolio and constraints.
The client database should be
linked to the FI’s corporate Web site so that clients can browse their personal data online after completing an initial system sign-on process.
This recommendation helps fulfil
Requirement 3 of the SFC’s Code of Conduct. (Recommendation 4 ) Decision support system (DSS ) for investment advice: DSS has a long history of success in supporting the information needs of the financial sector [10, 11, 12, 13, 14]. A FI should consider acquiring or developing such a system, which takes the
financial
product
database
(Recommendation 1)
and
the
client
database
(Recommendation 3) as inputs, and generates investment advice (such as the financial products deemed fit for clients and the investment risks associated with these products) to be considered by the clients. A copy of the system output should be given to the clients, so that they can compare the investment advice generated by the DSS with the opinions from the FI’s staff. The clients may demand for an explanation if the staff’s opinions are not in line with the system-generated investment advice. This practice helps prevent a FI’s staff member from recommending financial products to the clients which are deemed unfit, with a view to earning a higher remuneration. In this way, Requirements 1 and 4 of the SFC’s Code of Conduct can be fulfilled. (Recommendation 5 ) Confirmation of investment orders:
The trading system
accepting and processing trade orders from clients should be linked to the investmentadvice DSS (Recommendation 4), the financial product database (Recommendation 1), and the client database (Recommendation 3). Through this linkage, whenever a trade order with detected “abnormalities” (for instance, the investment risk associated with the financial product to buy exceeds the risk tolerance level of the client, or the trade order is significantly different from the investment advice generated by the DSS) is entered into the trading system, an online warning message can be automatically generated to alert the FI’s staff and the client. If this happens, the FI’s staff should seek confirmation from the client (preferably after another round of detailed analyses and explanations) before committing to a trade.
This recommendation contributes to the fulfillment of
Requirements 1 and 4 of the SFC’s Code of Conduct.
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Note that a side benefit of the above recommendations involving the use of IT is a better support for document management (corresponds to Requirement 5 of the SFC’s Code of Conduct). Because data related to clients, financial products, and trade orders are now stored in electronic form, a FI can streamline its record-keeping process and tighten its data security and protection mechanism (by means of defining proper users’ access privileges and performing regular database backups). * * * Insert Table 1 here * * *
Conclusion Making it through tough times is a tricky business. A FI must react fast to formulate effective strategies for fighting through the global financial crisis. Otherwise, the firm’s doors will be shuttered and its assets put up for liquidation. A promising strategy is to restore investor trust of the firm.
Realizing this strategy requires improved business
practices (with respect to the fulfilment of the SFC’s Code of Conduct) which are visible to the investors. In this regard, the paper has provided some sound IT solutions to make it happen.
Figure 1: A Strategy for Restoring Investor Trust
SFC’s Code of Conduct
Financial intermediary Improve the internal business practices with a view to complying with the SFC’s Code of Conduct Make this compliance visible to the clients
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Investor Trust
Table 1: Solutions to Restore Investor Trust Recommended Solutions
SFC’s Code of Conduct
Regularly evaluate the structure, complexity, and risk-return characteristic of financial products
Check the compliance of financial products with the latest securities regulations
Store the evaluation results in a financial product database and make it publicly accessible
In the FI’s corporate Web site, provide navigation links to the Web sites of the providers of financial products
Credentials of frontline staff
Provide the credentials (e.g. educational background, professional training, and previous achievements) of frontline staff in the FI’s corporate Web site
Personal profiles of clients
Build a database for storing the client’s basic data and other investment-related data
Evaluation of financial products
Requirements 3 and 4
Requirements 1 and 2
Requirement 3
Link the client database to the FI’s corporate Web site Decision support system (DSS) for investment advice
Confirmation of investment orders
Better document management
†
Requirement Requirement Requirement Requirement Requirement
1: 2: 3: 4: 5:
Use a DSS (linked to the financial product database and the client database) to generate investment advice for the clients
Clients compare the investment advice generated by the DSS with the opinions from the FI’s staff, and demand for an explanation if necessary
Link the trading system to the financial product database, the client database, and the investment-advice DSS
The trading system automatically generates a warning message when a trade order with abnormalities is detected, and seeks confirmation from the client before committing to a trade
Streamline the record-keeping process
Tighten the data security and protection mechanism
Honest, fairness, and due diligence Competence of staff Knowledge of clients and products Disclosure of information and explanations of investment advice Documentation standards
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Requirements 1 and 4
Requirements 1 and 4
Requirement 5
†
References [1]
Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission. Securities and Futures Commission, Hong Kong, May 2006.
[2]
Issues Raised by the Lehmans Minibonds Crisis: Report to the Financial Secretary. Securities and Futures Commission, Hong Kong, December 2008.
[3]
“Towry Law (Asia) HK Limited Offers Ex-gratia Payments to Investors in GDT and GOT SFC Settles Disciplinary Proceedings with a Severe Reprimand.” Securities and Futures Commission, Hong Kong, Press Release, 17 August 2004.
[4]
D. Hilken, “ Towry Law Faces Fresh Pressure to Repay Investors,” The Standard (November 23, 2005).
[5]
A. Lymer, “ The Use of the Internet for Corporate Reporting: A Discussion of the Issues and Survey of Current Usage in the UK,” Journal of Financial Information Systems, 1997.
[6]
A.L. Meroño-Cerdan and P. Soto-Acosta, “External Web Content and Its Influence on Organizational Performance,” European Journal of Information Systems, vol. 16, no. 1, 2007, pp. 6680.
[7]
P.-L. Poon, D. Li, and Y.T. Yu, “Internet Financial Reporting”, Information Systems Control Journal, vol. 1, 2003, pp. 4245.
[8]
A. Wong and P.-L. Poon, “Control Issues of Using Corporate Web Sites for Public Disclosure,” Information Systems Control Journal, vol. 5, 2008, pp. 3840.
[9]
D. Noack, “Web Pages Help Build Investor Relations,” Investor’s Business Daily A1 (October 10, 1997).
[10] “CMoney:
Institutional
Investors
Investment
Decision
Support
System”
(http://
www.cmoney.com.tw/english/default.asp). [11] “Decision
Support
Systems
in
Portfolio
Management ”
(http://www.referencefor
business.com/management/De-Ele/Decision-Support-Systems.html). [12] J. Kingdon, Intelligent Systems and Financial Forecasting. Springer, New York, 1997. [13] S. Kotsiantis, D. Kanellopoulos, and V. Tampakas, “On Implementing a Financial Decision Support System,” International Journal of Computer Science and Network Security, vol. 6, no. 1a, 2006, pp. 103112.
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[14] B. Shane, M. Fry, and R. Toro, “ The Design of an Investment Portfolio Selection Decision Support System Using Two Expert Systems and a Consulting System,” Journal of Management Information Systems, vol. 3, no. 4, 1987, pp. 7992.
Antonio Wong, Ph.D., CFA, is a lecturer at the School of Accounting and Finance of The Hong Kong Polytechnic University. His research interests include corporate finance and investments, Web-based financial systems, and IT corporate governance. He holds a Ph.D. degree in finance from the Chinese University of Hong Kong and is a Chartered Financial Analyst (CFA ). Contact him at afcpwong @ inet.polyu.edu.hk.
Pak-Lok Poon, Ph.D., CISA, CSQA, MACM, MIEEE, is an associate professor at the School of Accounting and Finance of The Hong Kong Polytechnic University.
His research interests include software engineering, IT audit and control, electronic
commerce, business process reengineering, and computers in education. He has been a member of the editorial committee of the Information Systems Control Journal since 2002. He was a co-recipient of the Michael Cangemi Best Book /Article Award from the Information Systems Audit and Control Association in 2001. His articles have appeared in Information Systems Control Journal, Communications of the ACM, IEEE Transactions on Software Engineering, IEEE Transactions on Education, and other software engineering journals and conference proceedings. Pak-Lok holds a Ph.D. degree in software engineering from The University of Melbourne (Australia ) and a Master of Business (Information Technology ) degree from the Royal Melbourne Institute of Technology (Australia ). Before commencing his academic career, he was the Computer Audit Manager of an international airline company. Contact him at afplpoon @ inet.polyu.edu.hk.
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