October 2015 Hong Kong regulators publish proposed rules for mandatory clearing and expanded mandatory reporting On 30 September, the HKMA and SFC published their proposed next steps in the regulation of OTC derivative transactions, being: > phase 1 clearing: mandatory clearing of certain derivative trades, and Contents MANDATORY CLEARING 1 MANDATORY REPORTING... 7 > phase 2 reporting: a broader mandatory reporting requirement. The Consultation Paper on introducing mandatory clearing and expanding mandatory reporting sets out new rules relating to clearing, and revisions to the existing set of rules relating to reporting. In preparing the consultation paper, the regulators have evidently taken into account the clearing regimes implemented by other major jurisdictions and have tried to be consistent with those, while at the same time drafting the proposed rules in a clear and comprehensive fashion. The proposed road map for implementation is: 31 October Comments on the consultation paper due 30 November End of 2015 End of 2015 / early 2016 Mid-2016 Early 2017 Comments on the specific data requirements for reporting due Regulators finalise proposed rules Further consultation paper issued Mandatory clearing in effect Expanded reporting in effect We summarise below the scope and operation of the clearing rules and reporting rules, together with a few observations on their intended operation and on comparable rules in other jurisdictions. MANDATORY CLEARING Since these rules represent the first time clearing has been mandated for OTC products in Hong Kong, most market participants will be asking a few questions:
> What products are covered? > What entities are affected? > What does my trading exposure need to be before I am caught? > What do I have to do in practice to comply? > Will I fit in an exemption? What products are covered? Specified OTC derivative transactions must be cleared, and are initially proposed to cover interest rate swaps, specifically: > basis swaps and fixed-to-floating swaps which are: > denominated in HKD, USD, EUR, JPY or GBP, and > with a tenor between 28 days and 10 years, and > overnight index swaps which are: > denominated in USD, EUR, JPY or GBP, and > with a tenor between 7 years and 2 days. This includes all trades of those types, potentially including intra-group trades and trades performed entirely outside of Hong Kong (unless the prescribed person falls into one of the limitations or exemptions below). Too much, too soon? Some market participants may be questioning the practicality of mandatory clearing in relation to G4 interest rate swaps, as many regional CCPs do not presently offer one or more of these product types. Unless prescribed persons who are clearing members are confident that their clients would be prepared to clear with international CCPs (who do support those products), the market may attempt to resist inclusion of this requirement, as it would affect dealers ability to sell those products from Hong Kong. On the other hand, other market participants may be wondering why interest rate swaps denominated in RMB, being a systemically important currency in Hong Kong, have not been included. What entities will be affected? Prescribed persons must clear specified OTC derivative transaction with a designated CCP within 1 business day after that transaction is entered into, if: > they are a party to the transaction; > the other party is a prescribed person or a financial services provider; and > both parties to the transaction exceed their applicable clearing threshold.
This means that the obligation encompasses, at this stage, only dealer-todealer clearing: > Only trades by a prescribed person. Prescribed persons for the purposes of clearing are presently: > authorized financial institutions ( AIs ); > licensed corporations ( LCs ); and > approved money brokers ( AMBs ). Effectively, the only entities affected at this stage are major dealers that are regulated in Hong Kong. Even then, the clearing obligation only applies to AIs or AMBs incorporated outside Hong Kong if they book the relevant trade in Hong Kong. > Only trades with certain counterparties. Further, prescribed persons need only clear specified trades with certain counterparties, being (a) other prescribed persons, or (b) financial services providers. Financial services providers are effectively the overseas equivalent of AIs, AMBs or LCs that provide their services outside Hong Kong and are hence not required to be authorized or licenced in Hong Kong. > Only trades entered into above a certain aggregate notional. Finally, a trade need only be specified if both parties to the trade have exceeded their clearing threshold. The clearing threshold is a monetary cap which looks at an entity s average total position during a given period (which we discuss further below). Due to these restrictions, it is not expected that there will be much client clearing during this first stage of clearing, except between dealers who are clearing members of designated CCPs and dealers who are not. Cross-border comparison We expect that the jurisdiction-specific approach to the entities directly affected (prescribed persons) will be welcomed by the market. It is similar to the Phase 1 reporting obligation that was introduced earlier this year, and is also similar to the scope adopted in Singapore. It is clear that regulators intend to cover trades where at least one party is a prescribed person, and not those which are purely extra-territorial. This differs from the broader approach taken in the EU, United States and Australia. In those jurisdictions, anti-evasion provisions mean that, in certain circumstances, trades between two offshore dealers may need to be cleared; for instance, where the trade features a "direct substantial connection/effect" with the regulating jurisdiction.
What does my trading exposure need to be before I am caught? The clearing threshold limit looks to the average total notional across all of an entity s OTC derivatives (excluding deliverable FX). This net notional approach differs from other jurisdictions such as the EU, which look at exposure per asset class. Prescribed persons who are incorporated overseas will be caught if either their HK branch bookings exceed USD 20 billion, or their global bookings exceed USD 1 trillion, during the relevant calculation period. Who will be affected? We expect that the way the clearing threshold is presently drafted means that only the largest dealers will be caught. As the threshold is calculated on an entity, not group, basis, clever structuring might allow a large bank to avoid the requirement by pushing its trades into a local subsidiary. However, we expect this would be operationally cumbersome for the dealer, and that most dealers would look to comply instead. To make a few further observations: > Unlike the EU, and likely to the relief of the entire market, no frontloading requirement has been proposed. > The proposed rules do not include a clear methodology for FX conversion. Since cross-currency trades will be considered when calculating the clearing threshold, we would suggest that the final rules should include such a methodology. As an example, the approach taken under EMIR is to fix the FX rate for these purposes on the relevant Trade Date. Global application with no exit The present drafting of the threshold amount means that a large overseas-incorporated dealer which has just started operations in Hong Kong may be caught because their global bookings exceed the USD1 trillion threshold even though only a small number of trades are booked in Hong Kong. Further, as with most developed markets to have introduced clearing requirements, there are no exit thresholds. Once an entity crosses the clearing threshold, a subsequent reduction in its average total notional below that threshold will not disapply the clearing obligation. Accordingly, once the obligation applies, then (as presently drafted) it will apply indefinitely. This may mean that market participants will have to keep comprehensive records of both their global total notional and/or Hong Kong branch total notionals as well as those of their counterparties.
How will I comply in practice? A prescribed person can determine whether any given trade was in scope by asking four questions: > Is this a specified OTC derivative transaction? > Am I over the clearing threshold? > Is my counterparty a prescribed person or overseas financial service provider? > Is my counterparty over the clearing threshold? Since in many situations both parties will need information from the other in order to determine whether they must comply with the obligation, market participants would welcome a standard representation that could be requested from in-scope counterparties. It could even be possible that such questions could be addressed by a new or expanded ISDA protocol along the lines of the ISDA 2013 EMIR NFC Representation Protocol. If the trade is in scope, the prescribed person will need to take all reasonable steps to ensure that the transaction will be cleared, and terminate within T+1 if the transaction is not cleared due to factors beyond its control. Going out of control? If the proposed rules are enacted in their current form, market participants should keep careful records where (for whatever reason) their trades are not cleared. In most circumstances it will be fairly clear where a market participant has taken all reasonable steps to clear a trade, and where a trade is not cleared due to factors beyond its control, but these will be questions of fact, and it will always be preferable to have more evidence in such circumstances (for instance, of a power failure, or a breakdown in communication). Can I take advantage of an exemption? What about substituted compliance? Two exemptions are available from the clearing obligation: > Intra-group trades. A prescribed person can avoid the clearing obligation with respect to trades conducted with exempt affiliates. These are affiliates which the prescribed person has designated in a notice to SFC or Monetary Authority. Certain limitations apply here. For instance, the affiliate must actually be an affiliate (that is, it must be accounted for in the holdco s consolidated financial statements, subject to HKFRS, IFRS, or local equivalent standards in the place of incorporation), and it must be subject to risk evaluation, measurement and control procedures centrally overseen and managed within its corporate group. Also, collective investment schemes are excluded from the definition of affiliate so funds may not take advantage of the exemption. > Exempt jurisdictions. Prescribed persons that are not overseas incorporated authorised institutions are exempted from clearing
trades entered in their books in a jurisdiction outside Hong Kong, where: > the prescribed person has designated that jurisdiction in a notice (to the SFC or Monetary Authority, depending on the type of prescribed person); > the person s trades in that jurisdiction do not exceed 5% of their total position; and > the person s trades in all designated jurisdictions do not exceed 10% of their total position. Generally, this exemption is intended for jurisdictions which mandate clearing at a local CCP. These will include closed markets such as China and India, though the clearing rules do not expressly limit the scope of the exemption to these, and they can also apply to developed markets such as the UK and USA. It is hence possible for a prescribed person with small positions in open market jurisdictions to use this exemption for such positions, though it is worth noting that if a prescribed persons removes a particular jurisdiction from the list of jurisdictions with the applicable regulator, it can only reinstate that jurisdiction once. Substituted compliance. Finally, prescribed persons are exempted from clearing trades that have been cleared in accordance with the laws of a jurisdiction which the SFC has designated as a comparable jurisdiction. The trade must have been cleared with a central counterparty that is a designated CCP (being, in accordance with the existing statutory framework, a CCP that has been so designated by the SFC). The SFC may only designate a comparable jurisdiction if it is satisfied that its laws impose requirements similar to or serving a similar purpose as the proposed HK clearing obligation, and that these laws are appropriately supervised and enforced in that jurisdiction. The proposed list of comparable jurisdictions includes: > Australia; > Brazil; > Canada; > the member states of the European Union; > Japan; > Singapore; > Switzerland; and > the United States. Substituted compliance considerations Prescribed persons seeking to rely on substituted compliance will note that: > a trade can only be cleared in a comparable jurisdiction if it is cleared
with a CCP in that jurisdiction who is a designated CCP. A trade cannot be cleared with a CCP that has been approved by the regulator of a comparable jurisdiction that is not a designated CCP ; and > market participants cannot take advantage of exemptions that may be available in comparable jurisdictions. If a trade were exempt from clearing under the laws of such a jurisdiction, but would be not exempt from the Hong Kong clearing rules, then under Hong Kong law it would still need to be cleared. MANDATORY REPORTING Phase 1 mandatory reporting has been in force since July 2015 and, as anticipated, regulators are now consulting on expanding the scope of mandatory reporting as part of Phase 2 of mandatory reporting. Key points are: Reportable transactions. The OTC derivative transactions currently subject to mandatory reporting are certain types of non-deliverable forwards and interest rate swaps. Regulators propose to expand the scope of reportable transactions to all OTC derivative transactions. As a result, the product type and product class classifications used as part of Phase 1 reporting will no longer be needed. Reporting entities. The entities subject to reporting will stay the same as for Phase 1, with the addition of CCPs that are authorized ATS providers. Exempt person relief. Because the product type and product class classifications will no longer apply, the exempt person relief for AIs, AMBs and LCs that are small players and not active in the OTC derivative market will be calculated across all positions in OTC derivative transactions. An AI, AMB or LC will be able to enjoy this relief if the aggregate notional amount of all outstanding OTC derivative transactions to which the person is a counterparty does not exceed USD 30 million. Market participants that currently rely on this exemption will want to check this threshold carefully to see what impact this revision has on them. Reportable information. The scope of reportable information will be expanded. Regulators note that the transaction information to be reported may be technical and complex and have decided to take a different approach to specifying what information should be subject to reporting. Instead of having such information in legislation, they propose that the reporting rules should only set out the broad scope of such information, with details to be specified by notice in the Gazette. International harmony Some market participants have bemoaned the complexity of the Phase 1 reporting regime and the type and amount of information to be reported, which, on the face of it, seems detailed and tedious. Regulators are consulting on the types of transaction information to be reported and the proposed data fields. This is an area where regulators would very much value detailed comments from the market in seeking to streamline data
fields and to help ensure that reportable information is of a type that is harmonised with the global standards being set up by IOSCO and other regulators. Valuation information. As anticipated, regulators propose to require prescribed persons to report valuation information. This will be determined as follows: > for trades that are cleared through a CCP, entities should report the valuation determined by the CCP; > for non-centrally cleared trades where the parties have to exchange margin, entities should report the valuation mutually agreed between the parties for the purposes of exchange of margin; and > for other non-centrally cleared trades, the proposal is to allow the reporting of internal valuations that have been agreed between the parties. Valuation information should be reported daily and no later than 2 days after the day of valuation. Concession periods and grace periods: reporting entities will only have one concession period and grace period, which will apply across all OTC derivative transactions. Regulators propose that the concession period (which is a period of 6 months to allow reporting entities to build their systems) end on the same day for all entities, or, alternatively, to do away with the concept of a concession period and to simply defer the commencement of phase 2 of mandatory reporting for 6 months after the effective date of the rules. Apart from that, Phase 2 reporting and record keeping will work broadly the same way as for Phase 1 reporting.
Contacts For further information please contact: Chin-Chong Liew Partner +852 2901 4857 chin-chong.liew@linklaters.com Victor Wan Partner +852 2901 5338 victor.wan@linklaters.com I-Ping Soong Counsel +852 2901 5181 i-ping.soong@linklaters.com Karen Lam Counsel +852 2842 4871 karen.lam@linklaters.com Derek Chua Managing Associate +852 2842 4805 derek.chua@linklaters.com Author: Chin-Chong Liew, Victor Wan, I-Ping Soong, Joseph Cayzer 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 2015 Linklaters Hong Kong is a law firm affiliated with Linklaters LLP, a limited liability partnership registered in England and Wales with registered number OC326345. 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 www.linklaters.com. Please refer to www.linklaters.com/regulation 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 emailing us at marketing.database@linklaters.com. Stephen Song Managing Associate +852 2901 5440 stephen.song@linklaters.com Joseph Cayzer Associate +852 2901 5441 joseph.cayzer@linklaters.com or any of your usual contacts 10th Floor, Alexandra House Chater Road Hong Kong Telephone (+852) 2842 4888 Facsimile (+852) 2810 8133 / (+852) 2810 1695 Linklaters.com 9 09 Oct 2015