July 2012 The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation. Contents On 11 July 2012, the Hong Kong Monetary Authority ("HKMA") and the Securities and Futures Commission ("SFC") jointly published the Joint consultation conclusions on the proposed regulatory regime for the over-thecounter derivatives market in Hong Kong (the "Consultation Conclusions"). This follows a public consultation 1 that ended in November 2011. The proposed regime requires mandatory clearing and reporting of OTC derivatives transactions and addresses the regulation of related market infrastructure and intermediaries. Mandatory trading is not proposed to be introduced in Hong Kong at the outset. The Consultation Conclusions noted that respondents were generally supportive of the proposed regulatory regime. Whilst the key proposals remain largely intact following consultation, a number of refinements have been made to address some of the respondents concerns. The main changes to the proposed reform package are outlined in the first part of this paper. The details of the proposed mandatory reporting and clearing obligations and the proposed regulations on market intermediaries along with our commentaries are summarized in the appendices to this paper. Regulatory Framework.. 1 Mandatory Reporting... 2 Mandatory Clearing... 3 Regulation of OTC derivatives market participants... 4 The way forward... 5 Appendix 1 Mandatory Obligations... 7 Appendix 2 - Regulation of OTC derivatives market participants... 18 Regulatory Framework Joint oversight by HKMA and SFC : The new regime is proposed to be subject to the joint oversight of HKMA and SFC, with HKMA regulating the OTC derivatives activities of locally and overseas incorporated authorized institutions ( AIs ) and inter-dealer brokers who are licensed and regulated by HKMA as approved money brokers ( AMBs ), and SFC regulating that of licensed corporations ( LCs ) and Hong Kong persons. HKMA is proposed to be given new investigatory and disciplinary powers in respect of breaches of mandatory obligations by AIs and AMBs and SFC s existing investigation powers will be extended to cover breaches of the mandatory obligations by other persons. AMBs would be subject to the mandatory reporting and clearing obligations as well as licensing requirements along similar lines as AIs. 1 The Consultation paper on the proposed regulatory regime for the over-the-counter derivatives market in Hong Kong (the Consultation Paper ) was jointly published by HKMA and SFC in October 2011. For further details, please refer to the Linklaters briefing on the Consultation Paper. The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 1
Refining the definition of OTC derivatives transaction : The definition of OTC derivatives transaction forms the bedrock of the new regulatory regime and is used to delineate its scope. The regulators will continue to define OTC derivatives transaction by reference to the existing definition of structured product. However, all exchange traded transactions (whether through an overseas or a local exchange subject to certain conditions), securitized products, embedded derivatives (including interest and currency linked instruments) and other similar products offered by a single issuer to a number of investors, spot contracts as well as authorized retail structured products are proposed to be excluded from the definition. Mandatory Reporting Reporting requirement for an originated or executed transaction requires a Hong Kong nexus : The mandatory reporting obligation is proposed to apply to a reportable transaction: to which a LC, an AMB, a locally incorporated AI (whether acting through a local or an overseas branch) ( Local AI ), a Hong Kong branch of an overseas incorporated AI ( Overseas AI ) or (subject to meeting the reporting threshold) a Hong Kong person is a counterparty; or which a LC, an AMB, a Local AI or a Hong Kong branch of an Overseas AI has originated or executed if the transaction has a Hong Kong nexus. The proposed definition Hong Kong nexus has been made clearer so as to require: in respect of equity and credit derivative trades, a Hong Kong listed entity or the Hong Kong Government (or its wholly-owned entity) to be the underlying entity (or in respect of trades specifying more than one underlying entity, a specified percentage of underlying entities must comprise such aforementioned entities); or in respect of other types of derivatives trades, a Hong Kong dollar or renminbi-denominated underlying asset, currency or rate. The proposed definition of originated and executed has been tightened up so as to require an AI, a LC or an AMB to have agreed the normal economic terms of the transaction and a related party to have been designated as the final contracting party. The proposed definition of Hong Kong persons has also been amended so that instead of covering (among other entities) funds managed in or from Hong Kong, it now refers to funds established under Hong Kong law. Exemptions from reporting obligation : In addition to the exemptions that were originally proposed in the Consultation Paper, the regulators are considering exemptions for central banks, monetary authorities and certain public bodies and global institutions (such as the International Monetary Fund ( IMF ) and the Bank of International Settlements ( BIS )). In addition, where the transaction is booked outside Hong Kong and compliance with the mandatory reporting obligation will breach foreign The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 2
law, it is proposed that the reporting obligation would not apply if the conflicting obligation cannot be overcome despite reasonable efforts. Extension of reporting timeframe : Timeframe for compliance with the reporting obligation is proposed to be extended to T+2 days (from T+1 day). HKMA TR is to be the only designated TR : HKMA TR is proposed to be the only designated TR although market participants may appoint a reporting agent (e.g. a global TR) through whom reporting to HKMA TR could be made. Reporting on cleared transactions: Where the transaction is anticipated to be cleared, that fact must also be reported to HKMA TR together with certain information about the clearing arrangement as well as subsequent changes arising from life-cycle events. Use of reported information : The regulators confirmed that information collected by HKMA TR will be used solely for regulatory and surveillance purposes and that public disclosure of such data will initially be on an aggregated basis only. The regulators also mention that sharing of information with other authorities, regulators and TRs will be subject to certain safeguards and conditions. Interim LEI regime : If a globally agreed legal entity identifier ( LEI ) regime is not available at the time the mandatory reporting obligation becomes effective, the regulators propose to use an interim LEI regime comprising of commonly used identifiers to be used for reporting the identity of counterparties involved in an OTC derivatives transaction. Mandatory Clearing No clearing requirement for originated or executed transactions : The mandatory clearing obligation is proposed to apply to a LC, a Hong Kong person, an AMB, a Local AI (whether acting through a local or an overseas branch) or (where the trade is booked through its Hong Kong branch) an Overseas AI if it is a counterparty to a clearing eligible transaction, both counterparties exceed the clearing threshold, and neither party is exempt from the clearing obligation. The clearing obligation no longer extends to transactions that are merely originated or executed by market participants. Reliance on counterparty confirmation as to clearing obligation : As the mandatory clearing obligation only applies where both counterparties have exceeded the clearing threshold and neither party is exempt from the clearing obligation, in ascertaining its own clearing obligation, a party acting in good faith can rely on a declaration by the other party as to whether that other party is subject to the clearing obligation. Exemptions from clearing obligation : Under consideration by the regulators are exemptions for: central banks, monetary authorities and certain public bodies and global institutions (such as IMF and BIS); intra-group transactions; The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 3
non-financial entities using derivatives to hedge commercial risks; and transactions involving participants from closed markets. It is notable that where either party is exempt from clearing, neither party would be required to clear. Amendments necessary to facilitate client clearing : The regulators recognise that a number of legislative changes would be required to facilitate client clearing (i.e., indirect clearing through a third party that is a member of a designated CCP), including measures to extend insolvency protection under the Securities and Futures Ordinance ( SFO ), and have indicated their intention to ensure that the necessary changes are made. De-clearing : In order to facilitate trade compression, the proposed regime will allow trades to be de-cleared although details of the specific provisions are not yet available. Acceptance of remote members by local CCPs: Local CCPs may accept a remote member (i.e., a member who is incorporated outside Hong Kong and does not have a place of business in Hong Kong) if such member s clearing activities are regulated under the laws of an acceptable overseas jurisdiction, and subject to certain other conditions. No location requirement : At this stage, there will be no requirement for products that are systemically important to Hong Kong to be cleared through a local CCP but the SFC will keep this under review. Recognition of overseas CCPs: Overseas CCPs may be designated as an acceptable CCP either under the recognized clearing house ( RCH ) or the automated trading services ( ATS ) regimes in the SFO. The latter would not appear to require the CCP to have any presence in Hong Kong (assuming the regime is applied in the same way as it is currently). Regulation of OTC derivatives market participants In relation to the proposed regulation of dealers, advisers and clearing agents in the OTC derivatives market, the regulators note that respondents were generally receptive of the proposals. In view of their comments, the regulators wish to seek market feedback on more detailed proposals on the scope of regulated activities ( RAs ) which form the subject of the Supplemental consultation on the OTC derivatives regime for Hong Kong - proposed scope of new/expanded regulated activities and regulatory oversight of systemically important players (the Supplemental Consultation ) also published by the SFC and HKMA on 11 July 2012. The proposals set out in the Supplemental Consultation include the following: Introduction of two new regulated activities: Type 11 RA will be introduced to cover the activities of dealers and advisers in relation to OTC derivatives transactions and Type 12 RA will be introduced to cover the activities of persons handling the clearing and settlement of OTC derivatives transactions. Carve-outs will be included so that persons whose existing licences already cover their OTC derivatives activities would not need to be licensed under the new RAs. AIs and AMBs will not have to be licensed or registered for the new RAs but to the extent their The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 4
OTC derivatives activities fall under other RAs (including the expanded Type 9 RA), they will still need to be licensed or registered for such RAs. A number of carve-outs from the existing RAs are carried over for Type 11 RA but the dealing as principal exemption will not be available. A new price-taker exemption from Type 11 licensing is proposed to be introduced primarily to cover non-financial institutions that may enter into OTC derivatives transactions for their own account. Type 12 RA would capture persons in Hong Kong who are CCP members, remote members of a Hong Kong CCP as well as agents of a CCP member to the extent the agent is involved in handling of client money or assets in connection with clearing and settlement of OTC derivatives transactions. There is proposed to be a carve-out for remote members of a local CCP who are regulated in an acceptable overseas jurisdiction in respect of clearing agency services and who either do not provide clearing services to Hong Kong persons or who conduct any marketing of their clearing services through an AI or LC. Expansion of Type 7 RA : Type 7 RA will be expanded to cover the provision of ATS in relation to OTC derivatives transactions. AIs and AMBs are proposed to be exempt from obtaining approval as an ATS provider where the ATS is intended to facilitate trading of OTC derivatives and the provision of the ATS is merely incidental to the AI or AMB s OTC dealing activities. Expansion of Type 9 RA : Type 9 RA will be expanded to cover the management of portfolios of OTC derivatives transactions. As is the case currently in respect of Type 1 and Type 2, a carve-out from Type 11 licensing/registration is proposed to be introduced for Type 9 LCs, AIs and AMBs that deal in or advise on OTC derivatives solely for the purpose of their Type 9 asset management activities. Regulation of systemically important players ( SIPs ) : SIPs are persons whose OTC derivative positions exceed a certain quantitative threshold so as potentially to pose systemic risk. The threshold is proposed to be specified by SFC and HKMA and is expected to be many times higher than both the reporting and clearing thresholds. Regulators will have the power to require SIPs to provide information and take certain action in respect of their OTC derivative positions and transactions. Breach by a SIP of these obligations would be subject to SFC disciplinary action. Comments are invited on the proposals contained in the Supplemental Consultation during a consultation period that closes on 31 August 2012. Upcoming developments OTC derivatives reforms continue to gather pace in Hong Kong as the regulatory landscape takes shape and the market infrastructure is being put in place. Regulatory developments The precise ambit of the mandatory obligations and other detailed changes to the regulations to implement the regime are expected to be the subject of a consultation on the subsidiary legislation to be conducted in Q4 2012. The The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 5
regulators are also working towards introduction of the bill on the proposed regulatory regime to the Legislative Council during Q4 2012. In terms of non-cleared OTC derivatives transactions, the regulators have indicated that they intend to impose higher capital and margin requirements for such transactions but specific proposals will be put forward for consultation only after the Basel Committee for Banking Supervision ( BCBS ) and the International Organization of Securities Commissions ( IOSCO ) have jointly issued their final proposal on margin requirements 2, and BCBS has finalized its guidance on the relevant capital requirements for banks. HKMA proposes separately to consult the industry bodies on any relevant guidance issued by BCBS. Market developments The Consultation Conclusions mention that the HKMA TR is expected to be ready in Q4 2012 to support any OTC clearing services offered by a local CCP. In addition, the CCP being established by The Hong Kong Exchanges and Clearing Limited ( HKEx ) plans to offer clearing services for interest rate swaps ( IRS ) and non-deliverable forwards ( NDFs ) in Q4 2012 (subject to obtaining authorization as a RCH under the SFO). The HKMA TR is expected to be ready in 2013 to support the implementation of the mandatory reporting obligation. Conclusion As Hong Kong looks set to implement the mandatory clearing and reporting obligations next year, market participants would be well advised to plan ahead for their implementation and consider the impact of these obligations on their operations worldwide. In terms of intermediary regulation, market players should ensure that care is taken in structuring their licensing requirements so that their OTC derivatives activities fall within one or more of the existing or new RAs. 2 IOSCO and BCBS issued a joint consultation paper on Margin Requirements for Non- Centrally-Cleared Derivatives on 6 July 2012 and the consultation period ends on 28 September 2012. The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 6
Appendix 1 Mandatory Obligations Regulatory Framework The new OTC derivatives regulatory regime is proposed to be set out in the SFO. The framework of the regime (such as the key terms of the mandatory reporting, clearing and trading obligations, the penalties for breach of such obligations, and the framework for designation of CCPs and trading platforms) is proposed to be set out in the primary legislation, leaving details of the regime (such as the types of products covered by the mandatory obligations and the conditions of CCP designation) to be set out in subsidiary legislation. Joint oversight by HKMA and SFC The new regime is proposed to be subject to the joint oversight of HKMA and SFC, with HKMA overseeing and regulating the OTC derivatives activities of AIs and AMBs, and SFC overseeing and regulating that of LCs and other persons. The Consultation Conclusions clarified the regulatory position of inter-dealer brokers (who are licensed as AMBs). Their OTC derivatives activities are primarily to come under the supervision of HKMA. The mandatory obligations apply to AMBs along similar lines as for AIs and LCs. The licensing obligations of AMBs in relation to their OTC derivatives activities are to be along similar lines as for AIs. As an AMB normally takes on a pure broking role for unrelated customers and does not typically take on a proprietary position, it is expected that the mandatory reporting and clearing obligations would have little practical impact on an AMB. HKMA is proposed to be given new powers under the SFO to investigate breaches of mandatory obligations by AIs and AMBs and to take disciplinary action against them for such breaches. An MOU is also proposed to be put in place to provide clarity over the division of regulatory oversight between HKMA and SFC and also to help achieve consistency in the application of regulatory requirements imposed on AIs, LCs and AMBs. With a history of uneven regulation of the securities business of banks and brokers by the HKMA and SFC (which has been the subject of recent criticisms by a Legislative Council Subcommittee 3 ), it remains to be seen whether the proposed measures will in practice bring about a level playing field among market participants in the OTC derivatives market. Scope of the new regime The scope of the SFO is proposed to be expanded via the new concept of OTC derivatives transaction. This definition is significant because it will delineate the widest possible scope of the mandatory obligations and it may be applied to determine who needs to be licensed with the SFC for the purposes of the proposed new Types 11 and 12 RAs and expanded Types 7 and 9 RAs in respect of OTC derivatives. 3 The Hong Kong Legislative Council Subcommittee to Study Issues Arising from Lehman Brothers-related Minibonds and Structured Financial Products published its report on 6 June 2012. For more details, please refer to the Linkaters bulletin on the report. The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 7
The proposed approach is to adopt a very wide definition of OTC derivatives transaction in the primary legislation, but provide that the mandatory obligations would only apply to those OTC derivatives transactions that are specified in subsidiary legislation, thus limiting the types of products that would actually be subject to such obligations. OTC derivatives transaction is defined by reference to the existing broad, all-encompassing structured product definition in the SFO, but with the following carve outs: transactions in securities and futures contracts that are traded on a market operated by a recognized exchange company (i.e. HKEx) and securities and futures contracts that are traded on overseas exchanges and markets meeting certain specified criteria; transactions in structured products that are offered to the public and the documentation for which is authorized under s.105 SFO (i.e. retail structured products); securitized products, embedded derivatives (which would include currency and interest rate linked instruments) and other similar products offered by a single issuer to a number of investors; and spot contracts. There will also be a power to include or exclude transactions from that definition through the subsidiary legislation. The current definition is an improvement over that proposed initially. However, it still seems that, as the stated intention of the regulators is to cover only bilateral derivative contracts, it would be preferable for the definition to state this directly rather than to try and achieve this result through carve outs from a much wider definition. Not only is this approach more complex, it creates potential for ambiguity and uncertainty, which is obviously undesirable given the central role played by the definition in the regulatory regime. Mandatory Reporting To facilitate monitoring of the OTC derivative market by Hong Kong regulators, they have concluded that the only designated TR would be the HKMA TR. However, it is anticipated that market participants would be able to appoint a reporting agent (e.g. a global TR) through whom reporting to the HKMA TR could be made. The regulators are considering how to address the issue of liability in the event of any breach of the reporting obligation by the reporting agent. What transactions are reportable The Consultation Conclusions confirm that a phased approach will be adopted to rolling out the reporting obligation to different product classes. Only the following types of products will be reportable transactions at the outset: single currency IRSs; The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 8
overnight index swaps; single currency basis swaps; and NDFs. HKMA and SFC are proposed to jointly determine the list of reportable transactions after market consultation. The Consultation Conclusions mention that reportable transactions should eventually be extended to cover other interest rate and foreign exchange derivatives as well as other asset classes such as credit and equity derivatives. Who needs to report The mandatory reporting obligation will apply in different ways to the following entities: LCs; Local AIs and Overseas AIs; AMBs; and Hong Kong persons. Hong Kong persons are individuals who are Hong Kong residents, the owners of sole proprietorships or partnerships based in, operated from or registered in Hong Kong, companies that are incorporated or registered in Hong Kong, funds established under Hong Kong law 4 or any other entity established or registered under Hong Kong law. A LC, an AMB or a Local AI is to be required to report all reportable transactions: to which it is a counterparty; or which it has originated and executed and that has a Hong Kong nexus. This obligation applies irrespective of whether the Local AI has conducted its activities through a Hong Kong branch or an overseas branch. Equity and credit derivatives trades will have a Hong Kong nexus if the underlying entity or the reference entity 5 is listed in Hong Kong (rather than incorporated or established in Hong Kong as originally proposed), or if the reference entity is or is wholly owned by the Hong Kong Government. Other types of derivative trades would have a Hong Kong nexus if an underlying asset, currency or rate is denominated in Hong Kong dollars or renminbi. Although there is initially no location requirement for clearing renminbidenominated OTC derivatives trades through a local CCP, following the 4 5 The definition of Hong Kong persons has been amended so that it includes funds established under Hong Kong law rather than funds managed in or from Hong Kong as originally proposed. However, since a fund manager managing a portfolio of OTC derivatives transactions in Hong Kong would be required to be licensed for Type 9 RA, the fund manager would in any event be subject to a reporting obligation in respect of an OTC derivatives transaction that it has originated or executed on behalf of a fund if the transaction has a Hong Kong nexus. In the case of a basket or index trade or a trade referencing more than one underlying entity, one would look at whether such Hong Kong entities comprise more than a specified percentage of the underlying entities. The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 9
consultation, the regulators felt that, given that Hong Kong is a major offshore renminbi business centre, there was a need to monitor financial institutions exposure to renminbi-denominated derivatives through imposing a mandatory reporting obligation. An AI, LC or AMB will be regarded as having originated or executed an OTC derivatives transaction if it has agreed the normal economic terms of the transaction with the counterparty and a related party has been designated as the final contracting party to the transaction. A related party would include any company in the same group as an AI or LC, the head office or overseas branch of an Overseas AI acting through its Hong Kong branch, or any entity on whose behalf the AI, LC or AMB has full authority to agree the terms of the transaction. The originated and executed requirement is designed to catch remote booking structures whereby transactions are arranged through an entity in Hong Kong but booked to another group entity or another branch. This limb would not catch an intermediary (e.g. an AMB) who conducts pure brokerage transactions between unrelated parties (where the intermediary has no authority to agree terms for the counterparty). It would, e.g., cover a fund manager who negotiates a reportable transaction on behalf of a fund that it manages. To facilitate HKMA s supervision and for anti-avoidance purposes, Local AIs may also be required by HKMA to procure that one or more of its subsidiaries (if and as specified by HKMA) report on their reportable transactions. This obligation is separate from any reporting obligation of the relevant subsidiaries and is therefore not subject to any reporting threshold. An Overseas AI is required to report all reportable transactions: to which its Hong Kong branch is a counterparty; or which its Hong Kong branch has originated or executed and that has a Hong Kong nexus. An Overseas AI is no longer subject to any reporting obligation where its Hong Kong branch is not involved at all in the OTC derivatives transaction. Exemption for AIs, LCs and AMBs An AI, LC or AMB that has originated or executed a reportable transaction that has a Hong Kong nexus would be taken to have discharged its reporting obligation in respect of that transaction if the counterparty on whose behalf it originated or executed the transaction confirms that it has reported the transaction to the HKMA TR. The Consultation Conclusions mention that no exemption would be available in the situation where there would be duplicative reporting by both sides to the transaction as it would allow for better data quality check and the system has been designed to avoid double-counting. Although requested by respondents, no exemption is proposed to be granted to Overseas AIs in respect of reporting of older/pre-dated trades. A Hong Kong person is to be required to report reportable transactions: to which it is a counterparty; and if the specified reporting threshold has been exceeded. The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 10
It is worth noting that the reporting threshold only applies to a Hong Kong person and not a LC, an AI or an AMB. Exemption for Hong Kong persons An exemption from the reporting obligation of a Hong Kong person is available if the relevant transaction involves an AI, a LC or an AMB that has an obligation to report such transaction. Therefore, assuming the reporting threshold has been met, a Hong Kong person would still be required to report on a reportable transaction with an AI, a LC or an AMB if the transaction is with an overseas branch of an Overseas AI or the transaction is originated or executed by the AI, LC or AMB and does not have a Hong Kong nexus. If an AI, a LC or an AMB is involved in a reportable transaction with a Hong Kong person but is not required to report the transaction to the HKMA TR, the regulators expect the AI, LC or AMB to give advance notice to the Hong Kong person of this fact. It is currently not proposed to subject overseas persons (i.e. persons that are not an AI, an AMB, a LC or a Hong Kong person) to mandatory reporting. Reporting threshold and exit threshold The reporting threshold will be set separately for each product class and is proposed to be in absolute dollar terms by reference to the average notional value (as opposed to market value) of the relevant transactions. To avoid any temporary fluctuations in positions, this will be assessed by referring to the average notional value of the relevant person s outstanding positions for the previous six months, based on month-end position. Gross positions (not the net positions after taking into account offsetting transactions) will be used to calculate the reporting threshold. This seems sensible given that if a person holding offsetting positions with different counterparties defaults, the counterparties exposure are to the gross position and therefore reporting of gross positions would be conducive to identifying concentrations of counterparty credit risks. In determining whether the reporting threshold has been exceeded, all transactions for that product class will be taken into account, even if this includes transactions that are not themselves reportable transactions and irrespective of whether an exemption applies. This will also include transactions that have been entered into prior to any mandatory reporting requirement becoming effective as long as they are still outstanding at the relevant time. It is proposed that a person will cease to be subject to the reporting obligation if the average notional value of outstanding transactions over the six month period falls below a specified exit threshold which will be set at a level lower than the reporting threshold. Other exemptions to the reporting obligation The following exemptions are under consideration by the regulators: Conflict with foreign law : Where the transaction is booked in a jurisdiction outside Hong Kong and the reporting of such transaction to the HKMA TR will infringe the foreign law in that jurisdiction, and the infringement cannot be avoided by reasonable efforts (e.g. by obtaining customer s The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 11
consent or masking the identity of the customer), the reporting obligation would not apply. Central banks, etc. : The regulators are prepared to consider exemptions in respect of central banks, monetary authorities or public bodies charged with the management of public debt and reserves and the maintenance of market stability, taking into account whether reciprocal exemptions are granted by relevant jurisdictions. A similar exemption is being considered in respect of mandatory clearing. Global institutions : Global institutions (such as IMF and BIS) are proposed to be granted full exemptions from the reporting obligation. A similar exemption is being considered in respect of mandatory clearing. Use of Legal Entity Identifiers If a globally agreed LEI regime is not available when mandatory reporting becomes effective in Hong Kong, the regulators propose to use an interim LEI regime for reporting the identity of counterparties involved in an OTC derivatives transaction. The proposed interim regime involves the use of a range of commonly used identifiers, to the intent that the highest ranking identifier (in terms of priority set by the regulators) available to the counterparty should be used. Reporting on cleared obligations The Consultation Conclusions clarify that where the transaction is anticipated to be cleared, that fact must also be reported to the HKMA TR together with certain information about the clearing arrangement as well as subsequent changes arising from life-cycle events. When the reporting should be made The timeframe for compliance with the reporting obligation is extended under the Consultation Conclusions to two business days immediately following the trading day (from T+1 day originally proposed). Grace period following effective date of reporting obligation Despite respondents calls for an extension to the grace periods, the Consultation Conclusions confirm the position under the Consultation Paper that a grace period of three months is to be given for setting up a reporting channel to HKMA TR and a grace period of six months (including the aforesaid three month period) is to be given for completing any backloading (i.e. reporting transactions already entered into and still outstanding). Use of reported information The regulators confirmed that information collected by the HKMA TR will be used solely for regulatory and surveillance purposes and that public disclosure of such data will initially be on an aggregated basis only. The Consultation Conclusions also mention that data collected by the HKMA-TR and any sharing of such data with local and overseas regulators and with overseas TR will be covered by the secrecy and disclosure provisions under the SFO. The regulators propose to put in place safeguards in relation to any sharing of data with overseas regulators. Any sharing of data with overseas TR would be conditional upon the overseas TR being adequately supervised The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 12
by its home regulator, and operated in accordance with internationally standards. Mandatory clearing A mandatory clearing obligation is proposed to be introduced whereby clearing eligible transactions must be cleared through a designated CCP. The mandatory clearing obligation is framed more narrowly than the mandatory reporting obligation. On the one hand, whilst a requirement that systemically important OTC derivatives be cleared through a Hong Kong CCP may, in the event of a clearing member failure, enable Hong Kong regulators to exercise effective supervisory powers to protect Hong Kong investors and ensure that Hong Kong insolvency law takes precedence, on the other hand, such a requirement may result in fragmentation of liquidity and breaking of netting sets for market participants which may be clearing OTC derivatives through foreign CCPs. The regulators have taken the policy stance, at least at the outset, not to impose such a location requirement in Hong Kong, although this issue would be kept under review. What transactions need to be cleared HKMA and SFC are proposed to jointly determine the list of clearing eligible transactions following market consultation. That list is expected to be set out in subsidiary legislation. A top-down and bottom-up approach is proposed to be used, which will take into consideration what regulators consider as products suitable for clearing as well as what the designated CCPs are able to clear. At the outset, clearing eligible transactions are proposed to cover the same classes of transactions as reportable transactions (i.e. NDFs and IRSs), although what types of transactions within those two classes should be cleared remain to be determined, and it would depend on what transactions the designated CCPs can clear. Who needs to clear The mandatory clearing obligation is proposed to apply to an AMB, a Local AI, (where the trade is booked through its Hong Kong branch) an Overseas AI, a LC, or a Hong Kong person if: it is a counterparty to a clearing eligible transaction; both counterparties have exceeded the specified clearing threshold; and neither party is exempt from the clearing obligation. As it would be difficult to ascertain whether or not a counterparty has exceeded the specified clearing threshold or is exempted from the clearing obligation, it is proposed that a person acting in good faith can rely on a declaration from its counterparty to that effect. The party receiving the declaration should maintain a proper record of the declaration. Going forward, parties to clearing eligible transactions should ensure that the transaction documentation provides for appropriate representations as to the clearing status of the parties and that the parties understand how the clearing threshold is to be calculated and are clear as to the applicability of any exemption being relied on. The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 13
In respect of a Local AI, mandatory clearing will apply irrespective of whether the clearing eligible transactions are carried out through its Hong Kong branch or from an overseas branch. An Overseas AI would only be subject to the clearing obligation if its Hong Kong branch is a counterparty. The requirement for transactions originated or executed by AIs or LCs to be cleared as originally proposed has been removed following consultation. It is proposed that HKMA may also require a Local AI to take into account positions held by one or more of its subsidiaries (if and as specified by HKMA) when determining whether the Local AI has exceeded its clearing threshold. If so, both the Local AI and its specified subsidiaries will have to submit their respective clearing eligible transactions to central clearing with a designated CCP. The obligation to procure that the specified subsidiaries comply with this clearing requirement rests with the Local AI. This is additional to any clearing obligation that may be imposed on the subsidiaries themselves if the requirements for general mandatory clearing obligation are satisfied in relation to these subsidiaries. Although extraterritorial reach of the proposed Hong Kong mandatory clearing obligation has been greatly reduced following the consultation, the potential for conflicting clearing obligations with other jurisdictions still exists as the mandatory clearing obligation will (assuming the clearing threshold is met and no exemption is applicable) extend to clearing eligible transactions entered into by overseas branches of Local AIs or by those overseas subsidiaries of a Local AI required by HKMA to clear through a designated CCP for the purpose of consolidated supervision. Whilst such extraterritorial impact may not be substantial in practice (given that overseas subsidiaries of Local AIs are only caught by the clearing obligation if designated by HKMA for consolidated supervision), we note that, unlike some other jurisdictions, the proposed Hong Kong regime does not currently recognise compliance with overseas clearing obligations as satisfying the Hong Kong clearing obligation (in other words, substituted compliance). Clearing threshold and exit threshold As for the reporting threshold, the clearing threshold is proposed to be determined on a per product class basis, in absolute dollar terms and by reference to the notional value. Again, this is proposed to be assessed by reference to the average notional value of a person s month-end gross positions for the preceding six months. As for the reporting threshold, in assessing whether the relevant threshold has been reached, all transactions in that product class will be taken into account, including non-clearing eligible transactions and transactions where there is an applicable exemption. Again, it is also proposed that a person will cease to be subject to the clearing obligation if the average notional value of outstanding transactions over the six month period falls below a specified exit threshold which will be set at a level lower than the clearing threshold. Exemptions to the clearing obligation The following exemptions are under consideration by the regulators: Central banks, etc. : As for mandatory reporting, the regulators are prepared to consider exemptions in respect of central banks, monetary authorities or public bodies charged with the management of public debt and reserves and the maintenance of market stability, taking into account whether reciprocal exemptions are granted by relevant jurisdictions. The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 14
Global institutions : As for mandatory reporting, global institutions (such as IMF and BIS) are proposed to be granted exemptions from the clearing obligation. Intra-group transactions : The regulators are prepared to consider the possibility of introducing clearing exemptions in respect of intra-group transactions, subject to certain (as yet unspecified) conditions. Non-financial end users : The regulators are considering an exemption for end-users who are non-financial entities using derivatives to hedge commercial risks. Transactions involving closed market counterparties : Due to currency controls and other regulatory restrictions in certain closed market jurisdictions (such as China), OTC derivatives transactions may be required, for legal or practical reasons, to be cleared through a local CCP in that jurisdiction, even if such CCP may not meet international standards. If Hong Kong imposes a conflicting mandatory clearing requirement in such circumstances, market participants may be forced to avoid such conflict by moving the transaction offshore. This, in turn, may have adverse consequence for Hong Kong as a financial hub in Asia. The regulators recognize this concern but indicate that they will make their own proposals to address this issue only after observing how other jurisdictions approach this issue. Grace period following effective date of clearing obligation Again, despite respondents calls for an extension to the grace periods, the Consultation Conclusions confirm the position under the Consultation Paper that a three-month grace period will be available. The three-month period counts from the date when the person first exceeds the clearing threshold and in any event the grace period will not expire within the first six months from the implementation of the mandatory clearing obligation. It is proposed that the same three-month and six-month grace periods will be available whenever the range of clearing eligible transactions is extended to cover a new product type. De-clearing As de-clearing is important for the purposes of trade compression, the regulators propose to provide for de-clearing although the specifics of such provisions are not yet available. Designation and regulation of CCPs It is proposed that clearing eligible transactions must be cleared through a designated CCP. Mutual recognition of CCPs between different jurisdictions will be important to resolve conflicts in mandatory clearing obligations. The Hong Kong regime allows both local and overseas CCPs to become designated CCPs. Overseas CCPs may be designated as an acceptable CCP either under the RCH or the ATS regimes in the SFO. The latter would not appear to require the CCP to have any presence in Hong Kong (assuming the regime is applied in the same way as it is currently). The RCH and ATS regimes give the SFC broad powers to determine what standards should be applied for the approval of an RCH or ATS. The SFC has indicated its intention to apply international standards (such as the The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 15
CPSS-IOSCO principles) in determining whether or not to grant approval. However, details of the approval requirements are not yet available. Although requested by respondents, no temporary CCP designation will be conferred on overseas CCP from acceptable overseas jurisdictions who are applying for CCP designation pending formal approval being granted. Acceptance of remote members It is proposed that local CCPs should be able to accept overseas clearing members if their clearing activities are regulated under the laws of an acceptable overseas jurisdiction and subject to certain other conditions. The Consultation Conclusions list the following as some of the factors to be taken into account in determining whether or not a jurisdiction is an acceptable overseas jurisdiction : whether the laws of the clearing member s jurisdiction regulate its OTC derivatives clearing activities to a level comparable to that in Hong Kong; the enforceability of the local CCP s rules (in particular those on default management and porting of margin and collateral upon the clearing member s default) against the clearing member and the collateral provided by the clearing member; and the adequacy of any regulatory cooperative arrangement with the relevant regulators in the clearing member s jurisdiction. These requirements apply only to local CCPs. It remains to be seen whether or not equivalent requirements will apply to overseas CCPs seeking recognition as an ATS in Hong Kong or whether Hong Kong regulators will defer to the home country regulators of the overseas CCPs to exercise supervision in relation to such matters. Client clearing Client clearing is important because the mandatory clearing obligation may potentially catch market participants who do not fulfill the membership criteria set by a CCP and will thus have to clear as clients of members of the CCP. Following consultation, the regulators agree that amendments to existing law will be necessary to facilitate client clearing and that they are now studying the specific changes required. Further information will be available when the subsidiary legislation comes under consultation later this year. Current Hong Kong insolvency protections in the SFO will protect only dealings between the CCP and its members and not those dealings between the members and its end clients. It would be important to ensure that insolvency protections are extended to cover client clearing. Specifically, the validity and enforceability of arrangements under the default management rules of the CCP that would come into effect upon default of a clearing member, such as porting (i.e., the transfer of contracts from a defaulting clearing member to a replacement clearing member) and margin segregation, would need to be supported by Hong Kong laws. The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 16
Breach of mandatory clearing or reporting obligations To support HKMA in its supervision of the OTC derivatives activities of AIs and AMBs, HKMA is proposed to be given new powers under the SFO to investigate breaches of mandatory obligations by AIs and AMBs and to take disciplinary action against them for such breaches. SFC s existing investigation powers will also be extended to cover breaches of the mandatory obligations by Hong Kong persons and LCs and the SFC will be responsible for taking disciplinary action against LCs. It is proposed that the Court of First Instance be given the power to impose civil fines of up to a specified amount (to be set in line with other major jurisdictions) on any person found to be in breach of the mandatory obligations. The regulators are considering how to address the respondents concerns that: market participants should not be penalized for breach of the mandatory clearing and reporting obligations where the failure was beyond its control or due to the failure of third parties; market participants should not have liability for damages arising from breach of the mandatory clearing obligation; and breach of the mandatory clearing obligation should not affect the validity and enforceability of the transaction. The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 17
Appendix 2 - Regulation of OTC derivatives market participants In relation to the proposed regulation of dealers, advisers and clearing agents in the OTC derivatives market, SFC noted that respondents were generally receptive of the proposals. In view of their comments, the regulators wish to seek market feedback on more detailed proposals on the scope of RAs which form the subject of the Supplemental Consultation. The Supplemental Consultation explores in further detail the amendments the regulators are proposing to make to the licensing requirements applicable to persons who trade, advise on and clear OTC derivatives. It also invites further comment on the criteria and requirements for persons who may be designated as SIPs under the new regime. Amendments to licensing requirements With the Supplemental Consultation, the regulators are now proposing to add two new RAs to the SFO: A Type 11 RA that would cover dealing in and advising on OTC derivatives transactions; and A Type 12 RA that would apply to the provision of clearing and settlement services in respect of OTC derivatives transactions through a CCP (located in Hong Kong or elsewhere) and on behalf of others (i.e., excluding clearing of proprietary trades). In the Consultation Conclusions, the regulators explained that separating OTC derivatives related activities into two RAs (as opposed to the single Type 11 originally proposed) would make it possible to impose more stringent regulatory requirements (such as capital and risk management requirements) on persons providing clearing services as opposed to those who are merely dealing in or advising on OTC derivatives. One point to note is that the new RAs cover the full scope of OTC derivatives transactions as discussed above, including transactions that are not subject to the mandatory reporting or clearing requirements. As such, it would capture OTC derivatives referencing a broad range of underliers including interest rates, commodities, currencies, equities and bonds. As in the initial consultation, the regulators are continuing to propose that AIs (as well as AMBs) be exempt from the new licensing requirements, in line with their view that OTC derivatives activities of AIs should be overseen by the HKMA. Given the licensing carve-outs discussed below, it appears that certain activities by banks currently subject to SFC regulation (such as dealings in equity derivatives) would become wholly subject to HKMA regulation, although how this oversight will be divided in practice remains to be seen. This approach also raises the question as to whether banks engaging in OTC derivative activities will be subject to similar conduct requirements compared with Type 11 licensees. Type 11 RA The Type 11 RA is largely similar in scope to the existing dealing and advising RAs for securities and futures. That is, it covers not only transactions (as agent or principal) in or intermediation of OTC derivatives transactions, but more broadly to offers or inducements to enter into trades. In response to feedback on the Consultation Paper, regulators have elected to include carve-outs for persons whose existing licences already cover the OTC derivatives activity. In other words, the Type 11 RA is designed to avoid altering the scope of the existing RAs under the SFO. For example, a person who brokers OTC equity derivatives under a Type 1 dealing in securities The Hong Kong OTC derivatives regime consultation conclusions and supplemental consultation 18