SFC consults on refinements to the OTC derivatives regime and conduct requirements for licensed corporations

Transcription

1 January 2018 SFC consults on refinements to the OTC derivatives regime and conduct requirements for licensed corporations On 20 December 2017, the Securities and Futures Commission ( SFC ) launched a two-month consultation 1 on proposals to refine the over-the-counter (OTC) derivatives regime and to require licensed corporations ( LCs ) to properly manage financial exposure to connected persons. We set out in this Bulletin a summary of and our comments and observations on these proposals. Deadline for submitting comments to the SFC is 20 February Key Takeaways The proposals are part of the SFC s comprehensive reforms to strengthen Hong Kong s OTC derivatives regulatory regime and are very much to be welcomed as they enhance Hong Kong s status as an international financial centre. The proposals in the Consultation Paper are wide-ranging and cover issues from licensing to intra-group booking models, risk mitigation requirements for OTC derivatives, risk disclosures in client agreements and client clearing conduct requirements, just to name a few examples. The following three proposals seem to us to require close consideration: - The SFC proposes that group affiliates acting as booking vehicles for OTC derivative transactions be prudentially regulated entities. This may impact booking models commonly deployed by the industry. - The SFC proposes that new information and risk disclosures relating to OTC derivatives activities, for example the legal implications associated with different asset segregation and porting arrangements for client clearing, be made to clients. The industry may have to prepare for another exercise of updating their client terms. Contents Key Takeaways... 1 Background... 2 Proposed refinements to the scope of regulated activities under the OTC derivatives regulatory regime... 2 Proposed Risk Mitigation Requirements... 8 Proposed requirements on Client Clearing Proposed Record Keeping Requirements Conduct requirements to address risks posed by Group Affiliates and other Connected Persons Timing Next Steps The SFC has confirmed that it does not require corporate treasury desks of non-financial groups to be licensed as derivatives market intermediaries so long as they are not in the business of making markets in or offering price quotes for OTC derivative transactions. However, it is unclear how precisely one determines whether a group is financial or non-financial. Diversified conglomerates with both financial and non-financial businesses may find this challenging in the absence of further guidance. 1 Consultation Paper on (1) the OTC derivatives regime for Hong Kong Proposed refinements to the scope of regulated activities, requirements in relation to OTC derivative risk mitigation, client clearing, record-keeping and licensing matters; and (2) Proposed conduct requirements to address risks posed by group affiliates (the Consultation Paper ) corporations 1

2 Background The Securities and Futures (Amendment) Ordinance 2014 (the SFAO ) was enacted in March 2014 to provide for a regulatory framework for the OTC derivatives market in Hong Kong. The SFAO amended the Securities and Futures Ordinance (Cap. 571) (the SFO ) and provided for, amongst other things, - the regulation and oversight of key players in the OTC derivative market; - the introduction of mandatory clearing, reporting, trading and record keeping requirements; - the establishment of the necessary infrastructure through which the mandatory obligations will be fulfilled; - the introduction of two new regulated activities (Type 11 and Type 12) to cover activities of dealers, advisers and clearing agents and the expansion of the existing Type 7 and Type 9 regulated activities of asset management and provision of automated trading services ( ATS ) to include OTC derivative-related activities; and - the regulation of systemically important participants in the OTC derivative market. Implementation of the OTC derivatives regulatory regime is done in phases and not all provisions in the SFAO have come into effect generally speaking only those relating to the mandatory reporting and the mandatory clearing obligations (and those provisions providing for the general framework to support such mandatory obligations) have come into effect. The SFC is now proposing changes to the licensing regime in response to market comments by refining the scope of some of the regulated activities relating to OTC derivatives, and to introduce certain conduct requirements in the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the SFC Code of Conduct ) applicable to LCs when conducting OTC derivatives-related activities. Proposed refinements to the scope of regulated activities under the OTC derivatives regulatory regime As mentioned above, the SFAO introduced two new regulated activities under the new OTC derivatives regulatory regime: Type 11 (dealing in OTC derivative products or advising on OTC derivative products) and Type 12 (providing client clearing services for OTC derivative transactions). In addition, the existing Type 9 (asset management) and Type 7 (providing automated trading services) regulated activities have been expanded to cover OTC derivative transactions. These licensing-related provisions in the SFAO have not yet come into operation. The 12 types of regulated activities in Hong Kong: Type 1: dealing in securities Type 2: dealing in futures contracts Type 3: leveraged foreign exchange trading Type 4: advising on securities Type 5: advising on futures contracts Type 6: advising on corporate finance Type 7: providing automated trading services Type 8: securities margin financing Type 9: asset management Type 10: providing credit rating services Type 11: dealing in OTC derivative products and advising on OTC derivative products Type 12: providing client clearing services for OTC derivative transactions corporations 2

3 The SFC is proposing the following amendments to the regulated activities to address issues identified by the market. The SFC notes that the precise language of the amendments will be subject to the drafting practice and approach adopted by the Department of Justice. Corporate treasury activities of non-financial groups Corporate treasury personnel of non-financial groups have raised concerns that their activities may be caught by the current scope of the expanded Type 9 and the new Type 11 regulated activities. The SFC noted a couple of models with which groups can manage risks. Firstly, corporate treasury desks may manage risk exposures arising from the group s commercial activities centrally by having the treasury affiliate enter into OTC derivative transactions relating the group s overall exposure with market counterparties. The treasury affiliate may then enter into back-to-back transactions with the group affiliates where the exposure lies. Alternatively, some groups may choose not to manage risks centrally and instead have the relevant group affiliates hedge their exposure by entering into OTC derivative transactions with market counterparties. In this case, the corporate treasury desk may advise or arrange for the affiliates to enter into the hedging transactions. Some corporate treasury desks also manage their affiliates portfolio of OTC derivative transactions. The SFC confirmed that it is not their policy intention to regulate corporate treasury desks of non-financial groups as derivatives market intermediaries so long as they are not in the business of making markets in or offering price quotes for OTC derivative transactions (i.e. they are genuine price takers). To reflect this, the SFC is propose the following changes to these regulated activities: Type 11 (dealing limb): the SFC proposes to carve out (i) the entering into or offering to enter into an OTC derivative transaction with an affiliate, or (ii) the inducing or attempting to induce an affiliate to enter into or offer to enter into an OTC derivative transaction, in each case by a company within a group of companies which is not a financial group. As the SFC comments, this new carve-out will cover cases where both parties to the transaction are companies within a non-financial group, and thus make it unnecessary to rely on the price taker carve-out. To the extent that a corporate treasury desk within a non-financial group engages in OTC derivative transactions with external counterparties, it will still be able to benefit from the price taker carve-out (so long as it does not make markets in or offer price quotes for OTC derivative transactions as a business). As CIS will be excluded from the proposed definition of affiliate, the carve-out will not apply when a corporate treasury desk within a non-financial group engages in OTC derivative transactions for group companies which are funds. Type 11 (advising limb) the SFC proposes to expressly carve out advice given to an affiliate but only if the advice is given by a company within a group of companies that is not a financial group. Proposed definitions: Affiliate is proposed to mean any corporation within the same group of companies but excluding collective investment schemes ( CIS ). Group of companies is defined in Schedule 1 to the SFO and refers to the term subsidiary which is defined by reference to: (i) control of the composition of the board of directors; (ii) control of more than 50% of the voting power at general meetings; or (iii) ownership of more than 50% of the issued capital (excluding capital which carries no right to participate beyond a specified amount on a distribution of profits or capital). Financial group is proposed to mean a group of companies which is primarily engaged in the provisions of, or in supporting the provision of, financial services or the conduct of financial activities. Financial services is proposed to mean: services in a regulated activity; services in the banking business (as defined in the Banking Ordinance); or services in the insurance business as contemplated in the Insurance Companies Ordinance. When considering the primary nature of a group, the SFC would look at the activities of overseas affiliate within the group which if carried out in Hong Kong would constitute financial services proposed above. corporations 3

4 Type 9 the SFC proposes to amend the definition of OTC derivative products management to expressly carve out the management of a portfolio of OTC derivative products for an affiliate by a company within a group of companies which is not a financial group. The proposed definitions of affiliate, financial group and financial services are set out above. Further guidance on the meaning of primarily engaged in the context of diversified groups with both financial and non-financial businesses would be welcome. Activities of providers of post-trade portfolio compression services A. Multilateral portfolio compression services The SFC s view is that providers of multilateral portfolio compression services should not be subject to the licensing regime. It was noted that providers of multilateral portfolio compression services are not themselves contracting parties to the OTC derivative transactions which are subjected to the compression cycle or that result from the compression process. Also, they do not get involved in the execution or settlement of such transactions. However, given the role they play (in particular, providing compression proposals), their activities may constitute dealing in OTC derivative products or advising on OTC derivative products under the new Type 11 regulated activity. The SFC therefore proposes to carve out the provision of multilateral portfolio compression services from both dealing in OTC derivative products and advising on OTC derivative products. For this purpose, multilateral portfolio compression services is proposed to be defined as services that: a) are provided: (i) by a person (the service provider); (ii) in accordance with the rules of the service provider and within risk tolerance levels set by the persons referred to in (b) below (participants); (iii) for the purposes of reducing operational risk or counterparty credit risk for the participants; and b) whereby the portfolios of OTC derivative transactions of three or more persons (none of which is the service provider) are analysed; and c) proposals are put forward as to how some or all of the transactions may be: (i) modified to reduce their notional value; (ii) terminated; and/ or (iii) replaced with one or more new OTC derivative transactions with reduced exposures between or among the participants. Under the proposed definition, the carve-out only applies to compression cycles involving three or more participants. corporations 4

5 The SFC proposes that no amendment be made to the scope of ATS to carve out multilateral portfolio compression services. The SFC s rationale is that the providers of multilateral portfolio compression services essentially provide a service for calculating how the exposure of participants can be reduced, rather than a facility for terminating, modifying, or entering into replacement OTC derivative transactions. As such, the activities of the providers should not come within the scope of ATS. Conversely, to the extent that providers of multilateral portfolio compression services also facilitate the termination, modification or replacement of OTC derivative transactions, they should come within the scope of ATS. B. Post trade compression services by central counterparties and providers of client clearing services It was noted that a compression cycle provided by a central counterparty ( CCP ) may be conducted on a solo or bilateral basis. The carve-out discussed above will not suffice since it only applies to compression cycles involving three or more participants. A similar carve-out is therefore proposed to cover the provision of compression services by CCPs to their clearing members and the latter s clients. The following changes are proposed to be made to the Type 11 regulated activity: a) Advising limb: the SFC proposes to amend the definition of advising on OTC derivative products so as to carve out any advising act carried out by a CCP which is a clearing house recognized under section 37(1) of the SFO (a RCH ) or an ATS provider acting in its capacity as a CCP and authorized under section 95(2) of the SFO (an ATS-CCP ) but only if the act is an advising act that: (i) is carried out by an RCH or an ATS-CCP; and (ii) relates to any transaction to which the RCH or ATS-CCP is a counterparty in its capacity as a CCP. b) Dealing limb: the SFC notes that there is already a carve-out in respect of acts carried out by RCHs and authorized ATS providers for the purpose of performing their functions. In order to avoid any doubt as to whether the provision of portfolio compression services constitutes the performance of functions of an RCH or authorized ATS provider, the SFC proposes to also carve out any dealing act that: (i) is carried out by an RCH or an ATS-CCP; and (ii) relates to any transaction to which the RCH or ATS-CCP is a counterparty in its capacity as a CCP. As to the back-to-back transactions between the CCP s clearing member and the latter s direct and indirect clients which will have to be correspondingly compressed, the SFC proposes that a carve-out from the Type 11 advising limb be provided for persons licensed for the Type 12 regulated activity with respect to OTC derivative advising acts carried out by Type 12-licensed persons corporations 5

6 provided the act is wholly incidental to carrying on the Type 12 regulated activity 2. Activities of overseas clearing members and their agents Under the current scope of the Type 12 regulated activity, overseas clearing members of a Hong Kong CCP who (i) do not have a place of business in Hong Kong, (ii) market its services to persons in Hong Kong through an authorised financial institution or a LC and (iii) are governed by legal or regulatory requirements of a comparable overseas jurisdiction 3 are not required to be licensed for the Type 12 regulated activity. Further to market feedback, the SFC proposes to extend this carve-out to overseas clearing members of overseas CCPs. Considering that three of the four designated CCPs for the discharge of the Hong Kong clearing obligation are overseas CCPs, the proposed changes are to be welcomed. The SFC also proposes the following changes to the Type 11 regulated activity in order to carve out acts that are wholly incidental to the carrying on of the Type 12 regulated activity: (a) Advising limb: carve out from the scope of advising on OTC derivative products any OTC advising act that: (i) is carried out by an acceptable participant; and (ii) is wholly incidental to its provision of services akin to the client clearing services provided by persons licensed for the Type 12 regulated activity ; and (b) Dealing limb: carve out from the scope of dealing in OTC derivative products any OTC derivative dealing act that: (i) is carried out by an acceptable participant; and (ii) wholly incidental to its provision of services akin to the client clearing services provided by persons licensed for the Type 12 regulated activity. This proposal extends the current carve-out for persons licensed for the Type 12 regulated activity 4 to overseas clearing members of any CCP. Fund manager services and ancillary services The Type 12 regulated activity as currently drafted captures services for the clearing and settlement of OTC derivative transactions through a central counterparty..., whether or not as a member of the central counterparty. Certain market participants (e.g. custodians, settlement banks, authorized or licensed ATS providers providing straight-through-processing services relating to the clearing process, agents of providers of client clearing services marketing the latter s client clearing services) and licensed or registered fund 2 Note that a similar carve-out is not necessary in respect of dealing as section 2(i) of Part 2A of Schedule 5 to the SFO already carves out all dealing acts carried out by persons licensed for Type 12 regulated activity. 3 These overseas clearing members are defined in Schedule 5 to the SFO as acceptable participants. 4 Section 2(i) of Part 2A of Schedule 5 to the SFO. corporations 6

7 managers have raised concerns that their activities may be caught under Type 12 given the width of the legislative provision. The SFC has clarified that its policy intention is not to capture activities ancillary to the clearing and settlement process (e.g. those of custodians, settlement banks, agents marketing a provider s client clearing services) and fund managers to the extent that they provide client clearing services to funds which they themselves manage (which the SFC regards as being provided solely for the purpose of providing fund management services to their own funds). The scope of the Type 12 regulated activity is proposed to be narrowed as follows: (a) The provision of client clearing services by fund managers to funds they manage will be expressly carved out. Note that client clearing services provided by a fund manager to funds managed by other persons, including funds managed by their affiliates, will still be caught under Type 12. (b) The activity will refer to services for the clearing and settlement of OTC derivative transactions which are provided: (i) To another person through a CCP (whether in Hong Kong or elsewhere); and (ii) In the capacity of either: a. A CCP member; or b. A directly or indirect client of a CCP member. (c) The SFC will also be given a power to prescribe by subsidiary legislation further classes of persons whose activities may be carved out from the scope of the Type 12 regulated activity. Expanding carve-outs for fund managers The securities and futures contracts management limb of the existing Type 9 regulated activity contains carve-outs for (i) portfolio management services provided to wholly-owned group companies, (ii) Type 1 or Type 2 licensed or registered persons providing portfolio management services which are wholly incidental to the carrying on of the Type 1 or Type 2 regulated activity and (iii) certain professionals (e.g. solicitors, counsel, certified public accountants and trust companies registered under the Trustee Ordinance (Cap. 29)) providing portfolio management services which are wholly incidental to discharging their professional role. When the Type 9 regulated activity was expanded to include the OTC derivative products management limb, these carve-outs were preserved but only to the extent that the OTC derivative products in the portfolio also constitute securities or futures contracts. Further to market request, the SFC proposes to extend the existing carve-outs described in (i) and (iii) above to cover all OTC derivative products (not just OTC derivative products which also constitute securities or futures contracts). corporations 7

8 We note that it is unnecessary to extend the carve-out described in (ii) above to cover all OTC derivative products since the OTC derivative products management limb as currently drafted already contained a carve-out for portfolio management services which is wholly incidental to the carrying on of the dealing in OTC derivatives products activity for Type 11 licensed persons and authorized financial institutions or approved money brokers who are exempt from the Type 11 registration for OTC derivative dealing acts carried out in the ordinary course of business. The SFC also proposes that fund managers licensed for the Type 9 regulated activity be exempt from the requirement to be licensed for the Type 3 regulated activity if they deal in foreign exchange derivatives (here the SFC said only products which constitute both leveraged foreign exchange contracts and OTC derivative products may benefit from the carve-out) solely for the purpose of managing funds. The SFC proposes that it be given a power to prescribe by subsidiary legislation further classes of persons whose activities may be carved out from the scope of the expanded Type 9 regulated activity. The SFC has rejected a request by the market to extend the existing carveouts for Type 9 fund managers from the Type 1, Type 2, Type 4, Type 5 and Type 11 regulated activities for dealing and advising activities relating to the fund manager s management activities to cover dealing and advising services to funds managed by their affiliates. Amendments to the Securities and Futures (Fees) Rules, Securities and Futures (Insurance) Rules, Guidelines on Competence and Guidelines on Continuous Professional Training The SFC is proposing certain amendments to the Securities and Futures (Fees) Rules (Cap. 571AF), the Securities and Futures (Insurance) Rules (Cap. 571AI), the Guidelines on Competence and the Guidelines on Continuous Professional Training necessitated by the two new regulated activities (Type 11 and Type 12) and the expanded Type 3, Type 7 and Type 9 regulated activities. The details to these proposals can be found in Part VII of the Consultation Paper. Proposed Risk Mitigation Requirements The adoption of risk mitigation standards for non-centrally cleared OTC derivatives is one of the pillars of the global financial reforms to reduce counterparty credit risk and operational risk. The SFC is proposing risk mitigation requirements for non-centrally cleared OTC derivatives as conduct requirements on LCs to be included in a new Schedule 10 to the SFC Code of Conduct. The SFC said that given the global nature of OTC derivative transactions and market participants, it has taken a high-level, principles-based approach to the proposed risk mitigation standards rather than a prescriptive one to ensure compatibility with different cross-border requirements and firmspecific characteristics. The proposed requirements are to be applied in a proportionate manner commensurate with the LC s OTC derivatives exposure. corporations 8

9 It should be noted that margin requirements for non-centrally cleared OTC derivatives as applicable to LCs are not contained in the Consultation Paper and will be subject to a separate consultation in the future. The SFC did refer to such requirements in the proposed changes to the SFC Code of Conduct so these requirements will also be conduct requirements for LCs. With respect to authorised institutions ( AIs ) regulated by the Hong Kong Monetary Authority, risk mitigation standards for non-centrally cleared OTC derivatives have been introduced in the HKMA s Supervisory Policy Manual CR-G-14 (Non-centrally Cleared OTC Derivatives Transactions Margin and Other Risk Mitigation Standards) (the SPM Module ). The proposed risk mitigation requirements will only apply to LCs and not AIs. Scope of application: The SFC proposes that the following risk mitigation requirements be applicable to (i) all LCs in respect of non-centrally cleared OTC derivative transactions to which the LC is a contracting party (so not confining the requirements to Type 11 LCs only) and (ii) Type 9 LCs which carry out OTC derivative products management in respect of non-centrally cleared OTC derivative transactions executed by the LC on behalf of any CIS managed by it, except to the extent that the measures required are handled by the governing body of the CIS or its delegate. The risk mitigation requirements will not apply to centrally cleared (whether directly or indirectly) OTC derivative transactions. No quantitative threshold is proposed by the SFC so the proposed risk mitigation requirements will apply to all LCs regardless of the size of its non-centrally OTC derivatives. The risk mitigation requirements are generally consistent with those introduced by the HKMA and those of other overseas jurisdictions: - OTC derivatives trading relationship documentation LCs are required to execute written trading relationship documentation with each counterparty prior to or contemporaneously with executing a noncentrally cleared OTC derivative transaction. Long form confirmations may be used for one-off transactions and incorporation by reference to other documents (such as master agreements) is permitted. - Trade confirmation LCs are required to establish and implement policies and procedures to ensure that the material terms of all noncentrally cleared OTC derivative transactions are confirmed as soon as practicable after the execution of the transaction. One-way confirmations (i.e. negative affirmations) may be used if agreed by the parties so that the outcome is legally binding. - Valuation LCs are required to agree with its counterparties in writing on the process by which the value of a non-centrally cleared OTC derivative will be determined throughout the lifecycle of the transaction, from the time it is executed until its termination, maturity or expiration. The agreement on the valuation process should be documented in the trading relationship documentation or trade confirmation. Valuations should be based on mark-to-market basis or a mark-to-model. Use of valuation models: Proprietary models: Under the SFC proposals, LCs are required to ensure that the model: (a) employs a valuation methodology with an accepted economic or sound theoretical basis; (b) is appropriately calibrated and tested for validity; (c) is subject to independent model review, approval periodically and when material changes to the methodology or the model are made; and (d) outputs are subjected to regular independent review and verification. Third party models: LCs should exercise due skill, care and diligence to confirm that the model satisfied paragraphs (a) to (c) above, and the LC should conduct regular independent review and verification of the model outputs. corporations 9

10 - Portfolio reconciliation LCs are required to establish and implement policies and procedures to ensure that the material terms are exchanged and valuations are reconciled with counterparties in respect of all non-centrally cleared OTC derivative portfolios at regular intervals. The SFC did not propose any particular frequency for portfolio reconciliation and suggested that a risk-based approach should be adopted such that the frequency should be commensurate with the risk exposure profile of the counterparty. - Portfolio compression LCs with non-centrally cleared OTC derivative transactions are required to establish and implement policies and procedures to regularly assess and, to the extent appropriate, engage in portfolio compression (which may be performed on a bilateral or multilateral basis). - Dispute resolution LCs are required to agree in writing with its counterparties on the mechanism or process for determining when discrepancies in material terms, valuations or margin calls should be considered disputes, as well as how such disputes should be resolved as soon as practicable. Where the counterparty is not a financial counterparty, the LC may meet the requirement by establishing and implementing effective policies and procedures proportionate to the level of exposure to the counterparty. FX security conversion transactions (i.e. FX transactions entered into to facilitate the purchase or sale of foreign securities with a T+7 day cap on the settlement period) are proposed to be subject only to the proposed risk mitigation requirements for trading relationship documentation and trade confirmation. It should be noted that a discrepancy seems to exist for LCs (who will be subject to the SFC s proposed requirements in the SFC Code of Conduct) and AIs (who are subject to the HKMA s requirements in the SPM Module) with respect to the implementation timeline for risk mitigation requirements and how such requirements will be phased-in. Under the SPM Module, the adoption of risk mitigation standards will be phased-in on a similar schedule as initial margin. During the phase-in period (March 2017 to 31 August 2017), the HKMA risk mitigation standards apply in a one-year period (from 1 September of each year to 31 August of the following year) where both the in-scope AI and the covered entity have an average aggregate notional amount (AANA) of OTC derivatives positions exceeding certain thresholds 5. It may be worth highlighting this to the SFC. 5 HKMA risk mitigation standards will apply on a permanent basis from 1 September 2021 with zero threshold. corporations 10

11 Proposed requirements on Client Clearing Proposed amendments to the SFC Code of Conduct Additional SFC Code of Conduct requirements relating to (i) segregation and portability, (ii) indirect clearing and (iii) clearing confirmation to clients are proposed to be imposed on Type 12 LCs providing client clearing services for OTC derivative transactions, regardless of whether the LC itself is clearing member of a CCP. The proposed SFC Code of Conduct requirements do not apply to registered institutions. Segregation and Portability The minimum requirement imposed by the SFC is that a LC should segregate client collateral from the LC s own proprietary assets. The SFC proposes that a LC should not apply client assets for the benefit of its own position accounts, accounts of its directors or employees or accounts of any corporations with which the LC is in a controlling-entity relationship. As the mandatory clearing obligation for OTC derivatives under the Hong Kong regime is to be discharged by clearing the relevant transaction through a designated CCP, which may be a Hong Kong or overseas CCP, the SFC said that segregation requirements are proposed to be set at a high level in order to accommodate different legal forms of account and collateral arrangements in respect of CCPs in various jurisdictions. The SFC does not propose to prescribe which segregation model a LC must adopt, as long as the LC segregates those assets held for clients in separate accounts at the CCP which can be distinguished from its own proprietary assets. LCs are given the flexibility to agree with its clearing clients the optimal client clearing account structures and client asset segregation models. Where both individual client segregation and omnibus client segregation are offered by a CCP, the SFC is not requiring a LC which is a clearing member of the CCP to offer its clients both account structures. Requirements for explanation and risk disclosure to clients: Where different levels of client asset segregation at the CCP are offered to the clearing client, the SFC proposes that a LC be required to inform its client and provide a clear explanation of the costs, risks and portability arrangements of the different levels of segregation provided by the CCP, including the legal implications of the respective levels of segregation offered and the risk of loss mutualisation which the client may be subject to. This will necessitate a papering exercise with affected clients. Porting: the SFC proposes that client clearing agreement entered into by a LC providing client clearing services should provide for porting in the normal course of business where there is no default of the LC (so-called BAU porting ) and (where the LC is also the clearing member) following the LC s default, where permissible under the applicable legal framework and subject to any requirements of the relevant CCP. Different client asset segregation models: Omnibus client segregation model: Collateral belonging to clients of a particular clearing member is commingled and held in an account segregated from that of the clearing member. Clearing client may be subject to loss mutualisation pursuant to the rules and procedures of the relevant CCP. Individual client segregation model: Each client s collateral is held in a separate, segregated individual account at the CCP. Depending on the legal framework and the CCP s rules and procedures, a client s collateral may only be used to cover losses associated with the default of that client. Porting an individual client account to a replacement clearing member may be easier than porting an omnibus client account on the default of a clearing member, although this model is likely to be more expensive for the clearing client. Porting: Porting refers to the transfer of a clearing client s positions and collateral relating to its cleared OTC derivatives transactions to another clearing intermediary. corporations 11

12 Notification and information disclosure requirements in relation to indirect clearing The SFC proposes that a LC providing indirect client clearing services be required to notify the client of the names of (i) any clearing intermediaries (including the clearing member) through which the LC is submitting the client s OTC derivative transaction for clearing and (ii) the CCP. The LC is also required to explain to its clients the asset segregation arrangements between the LC and the clearing intermediaries in respect of the client s transactions and collateral, as well as the corresponding legal implications. Clearing confirmation to clients The SFC proposes that a LC which provides client clearing services be required to provide a clearing confirmation to its clients no later than the end of the following business day after the client s OTC derivative transaction is accepted for clearing by a CCP. Proposed Amendments to Securities and Futures (Client Money) Rules and Securities and Futures (Client Securities) Rules The SFC proposes that the Securities and Futures (Client Money) Rules (Cap. 571I) (the Client Money Rules ) be amended to cater for the Type 12 regulated activity and to allow a LC to deposit segregated client money with a CCP, or into a client account maintained by a clearing member of a CCP, to meet settlement or margin requirements arising from the client s OTC derivative transactions. Presumably, however, this should not apply to monies received by way of title transfer arrangements. To facilitate indirect clearing by a LC, the SFC proposes that the Securities and Futures (Client Securities) Rules (Cap. 571H) be amended to permit a Type 12 LC to deposit client securities and securities collateral with another intermediary licensed for providing client clearing services for OTC derivative transactions. This would allow the LC to deposit client margin with a clearing member of a CCP for clearing. Proposed Record Keeping Requirements The SFC proposes additional record keeping obligations to be set out in the Securities and Futures (Keeping of Records) Rules (the KRR ). LCs which are contracting parties to OTC derivative transactions or LCs managing portfolios of OTC derivative products which execute OTC derivative transactions on behalf of a CIS it manages are required to maintain records (including posttrade events, collateral and clearing-related details) of the OTC derivative transactions. Separately, the SFC proposes that trading relationship documentation, trade confirmations and valuation processes agreed with counterparties (which are all part of the risk mitigation requirements) be required to be retained for a corporations 12

13 minimum of five years after the termination, maturity, novation or assignment of OTC derivative transactions. Conduct requirements to address risks posed by Group Affiliates and other Connected Persons It is not uncommon for LCs belonging to large financial groups to conduct business with group affiliates (the example cited by the SFC was the placing of deposits with affiliated banks) or to enter into arrangements with group affiliates (e.g. providing guarantees for group affiliate s liabilities) giving rise to financial exposure on the LC to the group affiliates. The SFC is also concerned with the exposure which LCs may have to connected persons (e.g. shareholders, directors or employees) from lending. Separately, the SFC notes that the booking model of some LCs involves the LC acting as agency dealer of clients who would enter into OTC derivative transactions with a group affiliate of the LC (the SFC referred to the group affiliate as the client facing affiliate ( CFA )). Back-to-back transactions may also be entered into between the CFA and another group company (referred to by the SFC as the risk booking affiliate ( RBA )) who would retain the market risks of the OTC derivative transactions. CFAs and RBAs are usually unlicensed entities not subject to the SFC s regulatory oversight which may pose risks to clients and/or the LCs. To address these concerns, the SFC proposes to introduce new conduct requirements in the SFC Code of Conduct for LCs having financial exposures to group affiliates or other connected person or adopting the CFA/RBA models. Proposed conduct requirement for the management of financial exposures to group affiliates and other connected persons The SFC proposes to require LCs to properly manage financial exposures to group affiliates and other connected persons according to the same risk management standards they would deploy in respect of financial exposures to independent third parties undertaken by them on an arm s length basis to minimise interconnectedness risk. The SFC expects the same standards of approval, monitoring and control to be applied to group affiliates as to independent third parties. This proposed requirement can be overridden by an applicable requirement or exemption under any law, rule or regulation administered or issued by the SFC or the regulators of the group affiliates or other connected persons in respect of the exposure or transaction giving rise to the exposure. Proposed conduct requirements relating to the introduction of clients to enter into OTC derivative transactions with CFAs The SFC proposes that: (i) a LC be required to act in the best interest of its clients when it solicits or recommends clients to enter into OTC derivative transactions with a CFA or when it arranges for OTC derivative transactions to be entered into between a CFA and clients; corporations 13

14 (ii) (iii) (iv) the group affiliate with whom the client contracts in OTC derivative transactions (i.e. the CFA) must be a LC, an authorized financial institution or a corporation similarly regulated as an OTC derivative dealer or a bank in a comparable overseas jurisdiction; the introducing LC be required to include a specified risk disclosure statement in client agree ments reminding clients of the risks of entering into OTC derivative transactions with an unlicensed person; and LCs would be exempt from the proposed risk disclosure statement as described in (iii) above if the client is an institutional professional investor or a corporate professional investor whom the LC is exempt from the requirement to enter into a written client agreement with and to provide risk disclosure statements to under paragraph 15 of the SFC Code of Conduct. The proposed requirement in (ii) above may be relaxed if the client is a regulated institution (i.e. a LC, an authorized financial institution or a corporation similarly regulated as an OTC derivative dealer or a bank in a comparable overseas jurisdiction). The above proposed requirements would not apply to clients who are group affiliates of the LC. The need to include the risk disclosure statement may require a further exercise to revise client terms. Proposed conduct requirements for LCs booking OTC derivative transactions in RBAs The SFC proposes that a LC who arranges OTC derivative transactions for group affiliates (i.e. RBAs) who are not LCs, authorized financial institutions or corporations similarly regulated as an OTC derivative dealer or a bank in a comparable overseas jurisdiction be required to: (i) (ii) ensure the risks undertaken by the RBA in the OTC derivative transactions are properly managed in the case where the LC has responsibility for or oversight of the management of such risks; or in any other case, take reasonable steps to ensure that the risks undertaken by the RBA in the OTC derivative transactions are covered by a risk management program whose standards are not less stringent than the risk management standards set by the SFC for LCs, by the HKMA for authorized financial institutions or by a securities/futures/banking regulator in a comparable overseas jurisdiction for OTC derivative dealers or banks entering into similar transactions. Given that a large number of models in the market involve the booking of transactions to offshore entities which are not regulated in Hong Kong, the proposals relating to CFAs and RBAs may require some detailed consideration and necessitate changes to existing flows. At present, the interplay between the proposed requirement that CFAs be prudentially regulated entities (i.e. LCs, Proposed wordings for the risk disclosure statement: Risk of entering into overthe-counter derivative transactions with an unlicensed person If you enter into over-thecounter derivative transactions with [name of the group affiliate] ( The Unlicensed Affiliate Counterparty ) which is an affiliate of [name of the licensed corporation] ( Licensed Dealer ) and [state clearly the regulated status of the group affiliate and the name and country of its regulator], it is important for you to note that unlike the Licensed Dealer, the Unlicensed Affiliate Counterparty is not licensed by the Securities and Futures Commission ( SFC ) and as such, it is not subject to the regulation (including the financial and conduct requirements) of the SFC. Although the Unlicensed Affiliate Counterparty is regulated by another regulatory body, the regulation of such regulatory body may be different from the regulation of the SFC. It is possible that the protection that you may receive under the regulation of that regulatory body is not the same as the protection that you would receive if the Unlicensed Affiliate Counterparty were licensed by the SFC. You should cautiously consider whether it would be in your best interest to enter into overthe-counter derivative transactions with the Unlicensed Affiliate Counterparty instead of the Licensed Dealer and consult independent professional advice when in doubt. Comparable overseas jurisdictions: Proposed to be jurisdictions that have implemented a regulatory framework on OTC derivative dealing activities that is comparable to that of Hong Kong as set out in a list published on the SFC s website. corporations 14

15 authorized financial institutions or corporations similarly regulated as OTC derivative dealers or banks in a comparable overseas jurisdiction) and the core licensing provisions in the SFO remains somewhat unclear, as the proposed conduct requirements seem to prevent the use of the dealing through exemption in some scenarios where the unregulated person is an affiliate of the Hong Kong-regulated entity. Timing The SFC considers that the proposed SFC Code of Conduct requirements on risk mitigation and those addressing the risks posed by group affiliates and other connected persons should take effect six months after the gazettal of the relevant SFC Code of Conduct amendments, such amendments to be made as soon as possible. The requirements in other parts of the Consultation Paper (i.e. the proposed requirements on client clearing, record keeping, and the proposed changes to licensing fees and guidelines) will become effective when the new OTC derivatives licensing regime (including the SFC s present proposals on the licensing-related provisions) commences. Next Steps Given the wide-ranging nature of the proposals, the industry will need to consider the impact the proposed changes will have on their business, the actions they will need to take if the proposals were to be adopted and keep a watchful eye on the progress of the consultation. Linklaters has extensive experience in assisting clients with regulatory change projects and would be delighted to assist you with working through the new proposals or preparing for implementation. corporations 15

16 Contacts For further information please contact: Andrew Malcolm Partner (+852) Chin-Chong Liew Partner (+852) Victor Wan Partner (+852) Sumit Indwar Partner (+852) I-Ping Soong Counsel (+852) Author: Jenny Wong This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters. All Rights reserved 2017 Linklaters Hong Kong is a law firm affiliated with Linklaters LLP, a limited liability partnership registered in England and Wales with registered number OC It is a law firm authorised and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of the LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com. Karen Lam Counsel (+852) karen.lam@linklaters.com Jenny Wong Senior PSL (+852) jenny.wong@linklaters.com 10th Floor, Alexandra House Chater Road Hong Kong Telephone (+852) Facsimile (+852) / Linklaters.com corporations 16 A /1.0/04 Jan 2018