The Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) continue to develop the Hong Kong regulatory framework for over-the-counter (OTC) derivative transactions.
Where we are now
The Securities and Futures (Amendment) Ordinance (Amendment Ordinance) was gazetted on 4 April 2014. Various provisions of the Amendment Ordinance, in particular in relation to the reporting obligations for OTC derivative transactions, came into effect on 10 July 2015. The remaining provisions of the Amendment Ordinance will come into effect on a future date, to be specified. For a more detailed description of the changes made by the Amendment Ordinance, please refer to our earlier client alert and newsletter article:
The Securities and Futures (OTC Derivative Transactions - Reporting and Record Keeping Obligations) Rules (Reporting Rules) also came into effect on 10 July 2015. The Reporting Rules set out Hong Kong reporting obligations for non-deliverable currency forwards and certain interest rate swaps. For asset managers, the reporting obligations apply where either they are a counterparty to relevant OTC derivative transactions or they conduct relevant OTC derivative transactions in Hong Kong on behalf of an affiliate, where the affiliate is a counterparty. For further information on the Reporting Rules, please refer to our earlier client alert:
Recent SFC consultations on capital requirements, clearing and reporting
The SFC has recently published two consultations relating to OTC derivatives:
- the Consultation Paper on Proposed Changes to the Securities and Futures (Financial Resources) Rules (the FRR Consultation) and
- together with the HKMA, the Consultation paper on introducing mandatory clearing and expanded mandatory reporting (the Clearing and Reporting Consultation).
The FRR Consultation was published on 17 July 2015 and the comment period closed on 16 October 2015. It sets out the SFC’s proposed financial resources requirements for SFC-regulated intermediaries that engage in OTC derivative transactions, either for themselves or on behalf of clients. These requirements will apply at the time the expanded licensing regime under the Amendment Ordinance comes into effect.
For asset managers that only have a licence for type 9 regulated activity (asset management), the FRR Consultation proposes to keep the same minimum capital requirements as at present. For asset managers that are also licensed for other activities - such as type 1 regulated activity (dealing in securities) - or that intend to apply for the new type 11 regulated activity (dealing in OTC derivative products or advising on OTC derivative products), the FRR Consultation proposes potentially significant increases in minimum capital requirements, as well as added complexity in monitoring compliance with minimum capital requirements.
The Clearing and Reporting Consultation was published on 20 September 2015 and the comment period closes on 31 October 2015. It sets out the SFC and HKMA proposals for the parties and the OTC derivative transactions that will be subject to mandatory clearing, and proposals to expand the scope of mandatory reporting under the Reporting Rules.
For mandatory clearing, the Clearing and Reporting Consultation states that the requirements have been designed to capture only “dealer-to-dealer” OTC derivative transactions initially. The mandatory clearing requirements will apply where the following three elements are present:
- the OTC derivative transaction is a “plain vanilla” interest rate swap,
- one of the counterparties is an authorised institution, approved money broker or licensed corporation, and
- both counterparties exceed a specified clearing threshold.
The specified clearing thresholds have been set at a high level so, even if an asset manager is a counterparty to a “plain vanilla” interest rate swap, it is unlikely the asset manager’s proprietary OTC derivative positions will exceed the clearing threshold.
The Clearing and Reporting Consultation contemplates substituted compliance, the ability to clear a relevant OTC derivative transaction in accordance with the requirements of another jurisdiction, in certain circumstances. A key part of the mandatory clearing regime (and substituted compliance) will be which entities are authorised as designated central counterparties, and so eligible to clear OTC derivative transactions for Hong Kong purposes.
For mandatory reporting, the Clearing and Reporting Consultation proposes to extend the mandatory reporting obligation to all types of OTC derivative transactions and to introduce a requirement for daily valuation of all OTC derivative transactions that have previously been reported and that remain outstanding. These proposals will likely mean reporting entities need to significantly enhance their information and reporting systems.
As at present, for asset managers, the enhanced reporting obligations will only apply where either they are a counterparty to an OTC derivative transaction or they conduct an OTC derivative transaction in Hong Kong on behalf of an affiliate, where the affiliate is a counterparty.
What to expect in future
On 22 October 2015, the SFC issued its “Circular to intermediaries and other persons engaging in activities concerning over-the-counter (OTC) derivative products or transactions” (the Circular). The Circular gives a brief overview of the current regulatory regime and the recent consultations. It also set out a useful summary of the new licensing regime and transitional provisions that will apply to participants in Hong Kong’s OTC derivative market, once the licensing provisions of the Amendment Ordinance come into effect.
Future developments of the OTC derivatives regulatory regime noted in the Circular include:
- further expansion of mandatory reporting and clearing;
- implementation of platform trading requirements;
- implementation of a “systemically important participant” regime for entities that are not regulated by the HKMA or the SFC, but that are active in Hong Kong’s OTC derivative market; and
- implementation of the new licensing regime.
The Circular indicates the HKMA and the SFC aim to conclude the Clearing and Reporting Consultation by end 2015 or early 2016 and introduce subsidiary legislation to the Legislative Council - amended Reporting Rules and new rules for mandatory clearing - for negative vetting in the first quarter of 2016. The new licensing regime will be implemented at a later date, and not before mid-2016.