SFC and HKMA publish OTC derivatives market consultation conclusions in Hong Kong

On 11 July 2012 the Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA) published their joint conclusions (Conclusions Paper) arising from responses to the consultation paper on the proposed regulatory regime for OTC derivatives in Hong Kong (Original Proposals) released in October last year (see related briefing SFC and HKMA publishes OTC derivates markets consultation in Hong Kong). The Conclusions Paper outlines the SFC and HKMA’s proposals for taking the OTC derivatives initiative forward in line with relevant G20 objectives. In doing so, the Conclusions Paper responds to concerns expressed by the industry and results in more focused and tightened proposals which help address a number of practical and compliance implications potentially caused by the Original Proposals.

At the same time, a supplemental consultation paper on the proposed scope of the new/expanded regulated activities and regulatory oversight of systemically important players (SIPs) has been published (Supplemental Proposals). Public responses on the Supplemental Proposals are requested by 31 August 2012.

This client briefing highlights the key conclusions in the Conclusions Paper (and areas of change to the Original Proposals), as well as areas to be addressed and next steps. It also briefly looks at the Supplemental Proposals.

The Conclusions Paper confirms the original proposal to extend the scope of the Securities and Futures Ordinance (SFO) to cover the main obligations of a new derivatives regime, together with the introduction of new subsidiary legislation containing the details of the regime. To address the G20’s proposed reforms, the new regime will involve mandatory reporting and clearing and will apply to authorised institutions (AIs), licensed corporations (LCs) and approved money brokers (AMBs), as well as “Hong Kong persons” in certain circumstances.

The Conclusions Paper has narrowed certain definitions proposed in the Original Proposals which helps to reduce the scope of those who will be required to comply with the new regime, whilst also addressing some of the extra territorial impact arising from the Original Proposals. However, it is worth noting that ultimately the scope of the definitions, and the regime, will depend on the final legislative wording which has yet to be consulted on.

“OTC derivatives transactions”

The Conclusions Paper makes clear that one of the main concerns raised by respondents was the scope of the definition of “OTC derivatives transactions”. In light of these concerns, the SFC and the HKMA (together, the Regulators) have agreed to narrow the scope of the proposed definition. Whilst “OTC derivatives transactions” will continue to be defined by reference to the term “structured product” (as defined in the SFO), the Regulators have agreed to incorporate into the definition appropriate exclusions in respect of:

1. transactions in securities and futures contracts that are traded on a market operated by a recognised exchange company, or on such other regulated markets as may be specified;
2. transactions in structured products that are offered to the public and the documentation for which is authorised under section 105 of the SFO;
3. transactions in securitised products, embedded derivatives and similar products (i.e. products offered by a single issuer to a number of investors); and
4. spot contracts.

In addition, the Regulators have confirmed that they will incorporate a power to enable specific transactions to be included within, or excluded from, the definition. They also emphasise that the mandatory obligations will apply only in respect of specific types of OTC derivatives transactions. Initially, mandatory reporting and clearing will only apply to certain interest rate swaps and non-deliverable forwards. Subsequently this will be extended, in phases, to cover other interest rate and foreign exchange derivatives, as well as other asset classes such as credit and equity derivatives.

“Hong Kong nexus”

This definition is particularly relevant in the context of defining the reporting obligation of an overseas AI. It was originally proposed that a transaction would be regarded as having a Hong Kong nexus if its underlying asset, currency or rate is (or includes one that is) denominated in or related to Hong Kong dollars, or in the case of credit or equity derivatives (if and when included), the underlying reference entity is established, incorporated or listed in Hong Kong or under Hong Kong law. In response to concerns from the industry as to the breadth of the definition, a narrower definition is proposed, which would provide as follows:

1. in the case of equity derivatives and credit derivatives,
   
   (a) that the underlying entity or the reference entity is listed in Hong Kong, and where there is more than one underlying entity or reference entity, a specified percentage of the entities (and this may be by value or otherwise) are listed in Hong Kong, or
   
   (b) that the underlying is an index and a specified percentage of the underlying companies (and again, this may be by value or otherwise) are listed in Hong Kong, or
   
   (c) that the reference entity is, or is wholly owned by, the Government of the Hong Kong Special Administrative Region, and
2. in the case of other derivatives, that the underlying asset, currency or rate is denominated in or related to (or includes an asset, currency or rate that is denominated in or related to) Hong Kong dollars or Renminbi.

Notably, limb (2) of the definition now includes a reference to Renminbi denominated or related derivatives. The Regulators have explained this addition as a result of Hong Kong being a major offshore Renminbi business centre with many financial institutions active in conducting Renminbi deliverable and non-deliverable derivatives transactions. Accordingly, the Regulators believe there is a need to monitor financial institutions’ exposure to these transactions, as well as any systemic risk that such transactions in aggregate might pose.

“Hong Kong persons”

The Regulators have also reconsidered the definition of “Hong Kong persons” which is relevant in determining who the mandatory obligations are applicable to. Whereas the original definition captured all funds managed in or from Hong Kong, the revised definition captures only those funds that are domiciled in Hong Kong. Furthermore, AMBs will not be Hong Kong persons.

“Originated or executed”

Finally, the meaning of “originated or executed” has come under some scrutiny. Originally it had been proposed that a transaction should be regarded as “originated or executed” by a person if he has negotiated, arranged, confirmed or committed to the transaction on behalf of himself or any of the counterparties. The Regulators have clarified that this concept is not intended to include an act of pure broking of OTC derivatives transactions for unrelated customers (being the typical business model of AMBs) and have stated that an AI, LC or AMB will only be regarded as having originated an OTC derivatives transaction if:

1. it has agreed with the counterparty the normal economic terms of the transaction, either directly or through an intermediary, and
2. a “related party”, rather than the AI or LC itself, has been designated to be the final contracting party to the transaction.

For these purposes, a “related party” will include (i) companies within the same group as the AI or LC, (ii) the head office and any overseas branch of an overseas-incorporated AI (where the OTC derivatives transaction is originated or executed by that overseas-incorporated AI acting through its Hong Kong branch), and (iii) any entity on whose behalf the AI, LC or AMB has full discretion and authority to agree the terms of the transaction.

Scope

The original proposal, to impose mandatory reporting on all reportable transactions to which locally incorporated AIs and LCs are a counterparty, is largely unchanged. However, in relation to reportable transactions “originated or executed” by locally incorporated AIs and LCs, the Regulators have confirmed that such transactions must now also have a Hong Kong nexus in order to fall within the mandatory reporting requirement. They have also clarified that AMBs will be subject to the same mandatory reporting requirements as AIs and LCs.

As regards overseas incorporated AIs, the Original Proposals were that they should also be required to report reportable transactions in certain circumstances, including where the transaction involved their Hong Kong branch, or where they were a counterparty and the transaction has a Hong Kong nexus. In response to concerns expressed about the compliance difficulties such an approach could cause for overseas incorporated AIs, the Regulators have decided to narrow the reporting obligation. Accordingly, overseas incorporated AIs will only be caught by the mandatory reporting obligation where (i) the AI has become a counterparty to a reportable transaction through its Hong Kong branch, or (ii) the AI has originated or executed a reportable transaction through its Hong Kong branch and the transaction has a Hong Kong nexus.

Exemptions

The Regulators have confirmed that they intend to build a degree of flexibility into the mandatory reporting obligations to both reduce the compliance burden and allow for situations where a transaction cannot be reported due to conflicting legal obligations under overseas laws which cannot be overcome despite reasonable efforts. For example, a Hong Kong person who has exceeded the reporting threshold will be exempt if the transaction involves an AI, LC or AMB who has an obligation to report. Similarly, in the case of an obligation arising in respect of (ii) above, this may be discharged if the counterparty on whose behalf the AI, LC or AMB was acting has reported to the HKMA trade repository.

The Regulators have also indicated that they are prepared to consider extending exemptions from mandatory reporting to: (a) central banks, (b) monetary authorities or public bodies charged with responsibility for the management of public debt and reserves and the maintenance of market stability, and (c) certain global institutions such as the International Monetary Fund and the Bank for International Settlements. They have confirmed that reciprocity will be taken into account when determining whether to grant an exemption for central banks, monetary authorities and public bodies.

The Conclusions Paper also confirms that a fiduciary (e.g. an investment manager) is not subject to separate reporting obligations itself and would not have to report a reportable transaction executed on behalf of its clients. However, in the case of funds, the Regulators’ thinking is that the reporting obligation in respect of a fund could rest with the legal owner of the assets of the fund (e.g. the trustee, if the fund is structured in the form of a trust) but the reporting threshold should be triggered at a fund level. For an umbrella fund, where each sub-fund operates as a separate unit and its respective portfolio is segregated from other sub-funds, it is stated that the reporting obligation could apply at a sub-fund level.

Trade Repository

Reporting to a global trade repository (TR) will not be permitted. Reporting will be solely to the TR established by the HKMA (which is currently being set up). The Regulators believe this will enable them to obtain relevant information more effectively.

To the extent a reportable transaction is reported to the HKMA TR and is centrally cleared, additional information will be required together with updates of certain changes.

More details on the specifics of the mandatory reporting obligation will be provided when a further public consultation is undertaken on the detailed requirements in Q4 this year.

Confidentiality of data collected

In response to concerns voiced by respondents, the Regulators have confirmed that data collected by the HKMA TR will be used solely for regulatory and market surveillance purposes. They have further confirmed that the secrecy and disclosure provisions under the SFO will be expanded, as necessary, to cover the data collected, and provide for any sharing of such data with authorities and regulators in Hong Kong and overseas, as well as with overseas TRs.

Reporting time frame and obligation

The Conclusions Paper notes concerns raised by respondents on the initial proposal to report within a “T+1” timeframe. Given these concerns and potential technical issues arising from reporting by overseas entities in a later time zone, the Regulators are now proposing to extend the reporting timeframe to “T+2”.

Scope

Mandatory clearing has been reduced in scope to address the issues arising out of the Original Proposals. Mandatory clearing was originally proposed for certain OTC derivative transactions where locally incorporated AIs or LCs were a counterparty or where an AI or LC had originated or executed the transaction. In response to opposition from respondents, the clearing requirement in relation to trades that are only originated or executed by AIs or LCs has since been removed. Accordingly, the Regulators are now proposing to impose mandatory clearing only on certain OTC derivative transactions where locally incorporated AIs or LCs are a counterparty and in the case of an overseas AI, booked in Hong Kong.

Mandatory clearing will only be triggered where both parties have met or exceeded the clearing threshold and neither is otherwise exempt from compliance. Where one of the counterparties has not exceeded the clearing threshold or is otherwise exempted from the clearing obligation, the Conclusions Paper confirms that the transaction will not be subject to mandatory clearing, and that it will suffice for the other counterparty to rely on a declaration from the first party that it has not reached the clearing threshold or is exempted from the clearing obligation.

Exemptions

The Conclusions Paper also addresses possible exemptions from mandatory clearing in respect of transactions with counterparties noted above in the context of possible exemptions from mandatory reporting. In addition, the Regulators have stated that they are prepared to consider extending exemptions in respect of non-financial entities using OTC derivatives for commercial hedging purposes, intra-group transactions and transactions involving “closed markets” (i.e., where there are local restrictions, such as foreign exchange controls, that make it impractical to clear other than in the local jurisdiction).

More details on the specifics of the mandatory clearing obligation will be provided when a further public consultation is undertaken on the detailed requirements in Q4 this year.

Central counterparties (CCPs)

The Regulators have confirmed that there will be no location requirement for CCPs - although they have said they will keep this area under review. CCPs may therefore be located in an acceptable jurisdiction where they are subject to compatible regulation and oversight. However, a CCP is required to be either a recognised clearing house or an authorised automated trading services provider (holding an appropriate licence under Part V of the SFO or authorised under Part III of the SFO - or otherwise exempt). As noted in the Original Proposals, the definition of automated trading services will need to be expanded as appropriate to cover OTC derivatives transactions as well.

The Regulators have confirmed that their intention is to allow local CCPs to be able to accept overseas clearing members (i.e. remote members), but only if such members’ clearing activities are regulated under the laws of an “acceptable overseas jurisdiction” (which is discussed in further detail in the Conclusions Paper).

Insolvency override and overseas clearing members

The Regulators have reiterated their intention to facilitate indirect clearing (i.e. client clearing) which they acknowledge will necessitate amendments to ensure that the insolvency override provisions under the SFO are appropriately extended. In the meantime, the Securities and Futures (Futures Contracts) Notice 2012, which came into effect on 27 June 2012, extends the insolvency override provisions under Part III of the SFO so that they also cover OTC derivatives transactions that are cleared and novated through a recognised clearing house and subject to the rules of a recognised exchange company. Further information is to be provided as part of the consultation on the subsidiary legislation later this year (in relation to which, please see further below).

The Regulators have clarified their intention with regard to consolidated supervision which is intended to prevent locally incorporated AIs circumventing mandatory reporting and clearing requirements. The HKMA will specify relevant subsidiaries of an AI on a case by case basis.

The Regulators have revised their original proposals in relation to the regulation of intermediaries. Rather than introducing one new regulated activity (Type 11) for non-AIs (other than end users) that carry on business in Hong Kong as dealers or advisers or clearing agents in the OTC derivatives market, it is now proposed to introduce two new regulated activities:

1. a Type 11 regulated activity which would capture the activities of dealers and advisers only; and
2. a Type 12 regulated activity to capture the activities of clearing agents including CCP members and intermediaries between the CCP member and the counterparty.

The aim of Type 12 regulated activity is to cover persons who handle client assets in the course of clearing and settlement of OTC derivatives.

The Conclusions Paper acknowledges that the new regulated activities will need to include a number of carve-outs, particularly to address overlap with, and in some cases to replicate some of the carve-outs to, existing regulated activities. These proposals are set out in the Supplemental Proposals. It is worth noting in particular that:

1. AIs and AMBs will not have to be licensed (or registered) for the new Type 11 or Type 12 regulated activity; instead their activities as OTC derivatives dealers, advisers and clearing agents will be overseen by the HKMA. However, they will need to be licensed (or registered) to the extent that their OTC derivatives activities overlap with an existing regulated activity including the expanded Type 9 regulated activity (see below);
2. the existing Type 9 regulated activity (asset management) will be expanded to cover the management of portfolios of OTC derivatives and therefore a person holding the expanded Type 9 licence will not be required to have a Type 11 licence; and
3. there will be no exemption from a Type 11 licence where the transactions are on a principal-to-principal basis.

With regard to overseas clearing agents, they will not be required to be licensed in Hong Kong as long as they are regulated in an acceptable overseas jurisdiction and do not service persons in Hong Kong, nor actively market to the Hong Kong public.

The Regulators have proposed putting in place transitional arrangements for the implementation of the new Type 11 and 12 regulated activities and the expanded Type 9 regulated activity. In particular, persons wishing to be licensed/registered for any of the new regulated activities who submit their applications within a specified period will be deemed to be so licensed or registered until their application is determined, provided they confirm that they have been engaging in relevant OTC derivatives activities in Hong Kong for an appropriate period of time before the new regulatory regime comes into force.

In the Conclusions Paper the Regulators confirm their intention to exert a degree of regulatory oversight in respect of SIPs (being persons in Hong Kong who are not otherwise regulated by the HKMA or the SFC and whose positions or activities in the OTC derivatives market may nevertheless raise concerns of potential systemic risk). This will include certain reporting requirements and actions to be taken by a SIP where OTC derivative transactions exceed a certain threshold. The SFC will be given powers to take disciplinary action against a SIP for breach. In terms of clarifying the SIP, the SFC will use quantitative criteria which are still being considered.

The Proposals Paper recognises the need to have clarity on the division of regulatory responsibility and the Regulators have confirmed that the HKMA will need to be given specific powers under the SFO to investigate any breach of the mandatory obligations by AIs and AMBs, and to take disciplinary action against them in the event of such breach.

The Regulators also reference the need to put in place a memorandum of understanding that covers the HKMA and SFC’s regulatory oversight of the OTC derivatives market to help achieve a unified approach so that the regulatory requirements imposed on AIs, LCs and AMBs are aligned and consistently applied.

In addition to those fines originally set out in the Original Proposals, the Regulators have indicated that they will seek to introduce new provisions in the SFO to allow a court of first instance to impose civil fines on persons who breach the mandatory obligations. Furthermore, it is suggested that Regulators should also be able to take disciplinary action against AIs, AMBs or LCs who breach the mandatory obligations.

The Regulators have stated that they are targeting publication of a consultation paper on the subsidiary legislation in Q4 2012, which will provide market participants with further information on the proposed detailed requirements of the new regime. Among other things, we understand that the Q4 consultation will elaborate on the precise ambit of the mandatory obligations, including:

1. definitions of some of the key concepts delineating the mandatory obligations (e.g. originated or executed, Hong Kong nexus, and Hong Kong person);
2. which specific types of transactions will be subject to the mandatory obligations;
3. who will be subject to the mandatory obligations, and in what circumstances;
4. what the reporting and clearing thresholds will be, and the circumstances in which they will apply;
5. which types of persons and transactions may be exempted from the mandatory obligations;
6. what information will have to be included when reporting a transaction to the HKMA- TR;
7. details relating to grace periods, backloading, etc;
8. the impact of a breach of the mandatory requirements, if any, on the validity and enforceability of a transaction.

Whilst the detail of the proposals in the Conclusions Paper differ from regulatory proposals in other jurisdictions, in broad terms they are aligned with the main provisions common to the regulation of OTC derivatives in the G20 countries.

The narrowing of the “Hong Kong nexus” and “Hong Kong persons” definitions and the scope of the mandatory reporting and clearing obligations on overseas AIs, is a welcome development for the international market, especially as the debate over the extra-territorial reach of both Dodd-Frank and European and Markets Infrastructure Reform intensifies, and the practicalities of meeting the various regulatory standards is becoming an increasingly important focus.

View Joint consultation conclusions on the proposed regulatory regime for the over-the-counter derivatives market in Hong Kong

View Consultation paper on the proposed regulatory regime for the over-the-counter derivatives market in Hong Kong

View Consultation begins on proposed regulatory regime for OTC derivatives market

View OTC Oracle - the Norton Rose Group guide to OTC derivatives regulatory reform