Consultation paper on the Securities and Futures (OTC Derivative Transactions Reporting and Record Keeping) Rules

31 July 2014 Consultation paper on the Securities and Futures (OTC Derivative Transactions Reporting and Record Keeping) Rules Contents On 18 July 2014, the Securities and Futures Commission ( SFC ) and the Hong Kong Monetary Authority ( HKMA ) jointly released the Consultation paper on the Securities and Futures (OTC Derivative Transactions Reporting and Record Keeping) Rules (the Draft Rules ) (the Consultation Paper ). This follows on from the enactment of the Securities and Futures (Amendment) Ordinance (the Amendment Ordinance ) on 26 March 2014, which brings into effect a new regime for OTC derivative transactions, including mandatory reporting, mandatory clearing and new licensing obligations. It is anticipated that the Amendment Ordinance will be brought into effect in phases, with the mandatory reporting and record keeping obligations to come into effect in the first phase. This follows from the earlier Consultation Paper and Consultation Conclusions in October 2011 and July 2012 respectively. Reporting obligation The Amendment Ordinance provides that certain types of OTC derivative transaction will be subject to mandatory reporting, that is, they will have to be reported by counterparties to the trade repository set up by the HKMA (the HKTR ). The Draft Rules provide more detail as to which types of OTC derivative transaction are reportable and as to other details of the reporting obligation. What types of transactions are reportable? The Draft Rules propose that reportable transactions be specified by their product class and product types. Reporting obligation... 1 What types of transactions are reportable?... 1 Who is subject to the mandatory reporting obligation?... 2 How will the mandatory obligation apply?... 2 What are the available exemptions?... 4 Threshold levels for Hong Kong persons... 5 What information needs to be reported to HKTR? 5 When does a transaction have to be reported?... 5 Backloading... 6 Masking... 6 Record Keeping... 7 Next steps... 7 Reportable transactions are initially proposed to be: Product class Interest rate swaps (IRS) Product type Plain vanilla IRS (floating vs. fixed) Plain vanilla basis swap (floating vs. floating) In each case, such IRS are to be in currencies and floating rate indices to be specified by the HKMA. The intention is to specify currencies and floating rate indices on the International Organisation for Reporting and Record Keeping) Rules 1

Standardization (ISO) 4217 currency list and FpML Coding Schemes respectively, and which are supported by HKTR Non-deliverable forwards (NDF) Other types of OTC derivative transaction NDFs in currencies (including some precious metals) to be specified by the HKMA. The intention is to specify currencies and precious metals on the ISO 4217 currency list, and which are supported by HKTR Other types of IRS and NDF, and other OTC derivative transactions will be added in stages The Consultation Paper consults the market as to whether it has comments or concerns about the proposed types of IRS or NDFs to be subject to the mandatory obligation and how they are proposed to be defined. Who is subject to the mandatory reporting obligation? The Amendment Ordinance already provides that the reporting obligation will apply to authorized institutions ( AIs ), authorized money brokers ( AMBs ) and licensed corporations ( LCs ) as well as any persons prescribed in draft regulations. The Draft Rules provide that the reporting obligation will also be extended to the following counterparties: recognised clearing houses in Hong Kong ( RCHs ) or foreign central clearing counterparties that are licensed to provide automated trading services under the SFO ( ATS-CCPs ). The reporting obligation will only apply when the RCH or ATS-CCP enters into a reportable transaction in its capacity as a central counterparty (CCP). Hong Kong persons. This is a new definition introduced by the Draft Rules and will be defined as: Individuals resident in Hong Kong A partner of a partnership established under Hong Kong law A trustee of a trust established under Hong Kong law A company incorporated in Hong Kong under the Companies Ordinance (Cap. 622) (the Companies Ordinance ) Overseas companies registered or requiring to be registered under Part 16 of the Companies Ordinance Any other entity established under Hong Kong law How will the mandatory obligation apply? Like under the European Market Infrastructure Regulation (EMIR), Hong Kong employs a two-sided reporting system, such that each of the entities below must report if a mandatory reporting obligation applies and if there is no available exception. Reporting and Record Keeping) Rules 2

LCs or AIs incorporated in Hong Kong An LC or AI incorporated in Hong Kong is proposed to be subject to the mandatory reporting obligation if it (i) is a counterparty to a reportable transaction or (ii) has conducted (see discussion below) the transaction in Hong Kong on behalf of a counterparty to the transaction that is an affiliate of the LC or AI. An LC or AI that is a fund manager licensed for Type 9 regulated activity is proposed to be subject to the mandatory reporting obligation if it manages a portfolio of assets for another person and in the course of managing the portfolio, enters into a reportable transaction on behalf of the other person (who is a counterparty to the transaction). AI incorporated outside Hong Kong AMBs RCHs and ATS-CCPs Hong Kong persons Funds As for AIs incorporated in Hong Kong. Also, if the AI is a counterparty to a reportable transaction and the transaction is booked in the head office or in a branch outside Hong Kong but one of the persons who made the decision to enter into the transaction (i) acted in his/her capacity as trader and (ii) was employed to perform a substantial part of his/her duties in Hong Kong. An AMB is proposed to be subject to the mandatory reporting obligation if (i) it is a counterparty to the transaction or (ii) has conducted the transaction in Hong Kong on behalf of an affiliate that is a counterparty to the transaction. An RCH will be required to report all reportable transactions that it enters into as part of the clearing process. In contrast, an ATS-CCP will only need to report all reportable transactions that it enters into as part of the clearing process where the counterparty is a Hong Kong company. A Hong Kong person is proposed to be subject to the mandatory reporting obligation only for transactions to which they are a counterparty and if its transactions in a particular product class exceed the specific reporting threshold and continue to be above the relevant specified exit threshold. Funds will potentially be subject to the mandatory reporting obligation in two ways: (i) a fund may be a Hong Kong person if it is incorporated or established under Hong Kong law; and (ii) if the fund has a manager or submanager which is a Type 9 licenced AI or LC, that manager will have to report reportable transactions it enters into in the course of managing the portfolio on behalf of the other fund (which is a counterparty to the transaction). Reporting and Record Keeping) Rules 3

Conducted in Hong Kong In the earlier Consultation Paper, regulators proposed that trades that had a nexus to Hong Kong be subject to mandatory reporting. The original requirement, namely that the trade had to be originated and executed in Hong Kong, has been refined after extensive consultation with the industry and to align with similar requirements in Singapore and Australia. The requirement is now that the transaction be entered into on the books of an affiliate and that it be entered into by a trader who was employed or engaged to perform a substantial part of his or her duties in Hong Kong. The word trader is not defined and carries its natural meaning, but the intention is to capture the person who makes the trading decision, as opposed to a salesperson. Such a trader must be employed or engaged to perform a substantial part of his/her duties in Hong Kong. The intention is to exclude traders who are predominantly based outside Hong Kong but who are in Hong Kong for a short period. Conversely, trades entered into by a Hong Kong trader who is outside Hong Kong temporarily will be reportable. The terms employed and engaged are not defined and carry their natural meaning. Market participants will want to assess whether the definition is sufficiently clear and whether they wish to ask regulators to refine the definitions further, possibly by way of guidance notes or FAQs. What are the available exemptions? Exceptions that apply to Hong Kong persons: A Hong Kong person will not have to report a transaction where an AI, AMB or LC is required to report such a transaction. In the case where a Hong Kong person is a partner of a partnership, such person is not required to report a transaction if another partner of the partnership has reported the transaction. Exceptions that apply to AIs, AMBs or LCs: an AI, AMB or LC will be taken to have complied with the reporting obligation if it entered into a transaction on behalf of an affiliate in Hong Kong and the affiliate has confirmed that it has reported the transaction. Further, an AI, AMB or LC will be exempted from reporting obligation if the outstanding OTC derivative transactions of such AI, AMB or LC in the relevant product class do not: (i) (ii) (iii) exceed five in total; have an aggregate gross notional value of greater than US$30 million; and have Hong Kong persons as a counterparty. Reporting and Record Keeping) Rules 4

It is important to note that AIs, AMBs or LCs that have already set up a connection with the HKTR for reporting transactions in a certain product class will not be able to enjoy the exceptions. Threshold levels for Hong Kong persons Further, and only for Hong Kong persons, regulators have set reporting thresholds with the intention of lessening the compliance burden. Such thresholds are to be assessed by reference to the average gross notional value of a person s outstanding positions for the previous six months, based on his month-end position. The proposed reporting and exit thresholds are US$3 billion and US$2.1 billion, respectively, for IRS and US$1 billion and US$0.7 billion, respectively, for NDF. The lower exit thresholds are to ensure that persons whose positions fluctuate around the level of the reporting threshold are not constantly alternating between falling within and outside of the reporting threshold. If the thresholds are set at these levels, the SFC and the HKMA estimate that over 95% of Hong Kong persons who hold positions in IRS and NDF will not be subject to mandatory reporting obligation. It is anticipated that the threshold levels will be lowered in the future, however, this is not expected to happen before 2017. What information needs to be reported to HKTR? If the reporting obligation applies, parties are to submit the information in Schedule 2 of the Draft Rules to HKTR. This includes details as to the counterparties to the transaction; whether the transaction will be cleared; and all subsequent transaction events. Subsequent transaction events include events that affect the product, the terms and conditions on which the transaction was entered into or the persons involved in entering into the transaction. There is also a new requirement to submit daily valuation of transactions to HKTR, which is in the process of building its capability to accept such information. It is worth noting that this requirement applies to all counterparties, unlike under EMIR, where the requirement to provide valuation and collateral data to trade repositories will only apply to financial counterparties and certain non-financial counterparties (NFC+s). It remains to be seen whether this requirement is practical for non-financial counterparties who may not be able to access valuation information for transactions. When does a transaction have to be reported? Under the Draft Rules, it is proposed that reporting obligations must be fulfilled on a T+2 basis. However, when a new product type becomes reportable, a period of up to 3 months (known as a concession period) will apply to allow reporting entities to set up their operational systems required to report such transaction while a period of up to 6 months (known as a grace period) will apply for the reporting entities to complete backloading described below. Reporting and Record Keeping) Rules 5

The exact lengths of the grace periods and concession periods will depend on whether the reporting entity is an AI, AMB, LC, RCH or ATS-CCP or a Hong Kong person. Reporting to HKTR and use of reporting agents Reporting can only be made to the HKTR. However, regulators anticipate that entities subject to mandatory reporting will be able to fulfil their reporting obligations by appointing a third party reporting agent to report on their behalf. The concern by market participants has been that they should only be responsible for breaches resulting from their own actions and not those of their agents. Regulators have declined to provide specific protection, saying that the existing regulatory regime provides sufficient flexibility for specific circumstances. In Europe, the initial expectation was that buy-side counterparties subject to the reporting obligation would seek to delegate the reporting function to their financial institution counterparties as their agent. The experience of some market participants in this respect has been that the financial institutions willing to accept this reporting function typically limit their liability for the accuracy of information provided and so in practice the information provided by the delegating counterparty needs to be very thoroughly checked. In reality, there may therefore be little gained from delegating reporting for some market participants, in which case they may consider establishing direct connectivity to the HKTR. Backloading The requirements for backloading apply to AIs, AMBs or LCs and Hong Kong persons. However, in the case of an AI, AMB or LC, backloading will only apply to transactions to which it is a counterparty and not those that are conducted in Hong Kong. For AIs incorporated outside Hong Kong, backloading will apply only if the transactions are also booked in the Hong Kong branch of the AI. In the case of a Hong Kong person who is a non-hong Kong company, only transactions entered into before such person has exceeded the reporting threshold but after the date on which such transactions became reportable will need to be backloaded. Backloading must be completed within six months for a Hong Kong person and within three to six months for other entities that are subject to the reporting obligation. Transactions which are terminated or have a maturity before the relevant backloading deadline will not need to be backloaded. Masking The Draft Rules provide that a reporting entity may mask information which will identify certain counterparties if (i) the disclosure of such information is prohibited by the laws of, or a regulatory authority in, an overseas jurisdiction (which is designated by the regulators) or (ii) in the case of historical information (i.e. transactions that have been entered into before the Draft Reporting and Record Keeping) Rules 6

Rules first take effect), the reporting entity cannot disclose such information without the consent of the counterparty and, despite using reasonable efforts, the reporting entity was unable to obtain the required consent. Record Keeping The Draft Rules propose a new mandatory record keeping obligation, aimed at ensuring that persons subject to the mandatory reporting obligation keep adequate records to demonstrate compliance with the reporting obligation. In the 9 months following the transaction, such records must be kept in any form or manner as long as they are readily searchable and transactions can be identified and thereafter, records may be maintained in electronic form or paper form. Records should be kept for no less than 7 years. Next steps Comments on the Consultation Paper are due before 18 August 2014. The aim is to finalise the Draft Rules and issue consultation conclusions in Q4 of 2014 and to introduce the final rules into the Legislative Council in that quarter. No commencement date has yet been announced. It is worth noting that HKTR has been in operation since July 2013 for voluntary reporting of interbank transactions. HKTR is in the process of extending its capability for other types of OTC derivative transaction and to include fields that would allow parties to report more types of information, for example as to valuation. Because voluntary reporting to HKTR is already underway, it is hoped that the start of mandatory reporting will come into effect smoothly and without the system hiccups that beset the start of mandatory trade reporting under EMIR in February 2014. Reporting and Record Keeping) Rules 7

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 Umesh Kumar Partner (+852) 2842 4894 umesh.kumar@linklaters.com I-Ping Soong Counsel (+852) 2901 5181 i-ping.soong@linklaters.com Karen Lam Counsel (+852) 2842 4871 karen.lam@linklaters.com Kevin Marr Counsel (+852) 2901 5286 kevin.marr@linklaters.com 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 2014 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. Derek Chua Managing Associate (+852) 2842 4805 derek.chua@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 Reporting and Record Keeping) Rules 8 /