Hong Kong’s regulatory requirements for over-the-counter (OTC) derivative transactions continue to take shape. The regulatory framework was set out in the Securities and Futures (Amendment) Ordinance 2014 (Amendment Ordinance), which was gazetted on 4 April 2014. That was followed in July with a consultation on proposed rules for mandatory reporting of OTC derivative transactions, the Securities and Futures (OTC Derivative Transactions – Reporting and Recordkeeping) Rules (the Draft Rules). You can view the consultation, including the Draft Rules,here. Current indications are for mandatory reporting to take effect in early 2015, to be followed by mandatory clearing and then implementation of the new licensing regime. Finally, the Amendment Ordinance allows for mandatory trading requirements to be introduced in the future.
So, what can an asset manager do now to prepare?
- Prepare for the new licensing regime. Plan your human resources now to ensure you will be able to meet eligibility criteria when the new licensing regime takes effect.
- Prepare for mandatory reporting. Identify any gaps in your systems, processes and data that you will need to address in order to meet mandatory reporting obligations, and ensure you have resources available to address those gaps.
- Keep track of announcements from the Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA).
Plan for the new licensing regime
The Amendment Ordinance expands type 9 regulated activity (type 9 RA, asset management) to include “OTC derivative products management”, defined as “providing the service of managing a portfolio of OTC derivative products for another person” (expanded type 9 RA). It also creates a new type 11 regulated activity (type 11 RA) for dealing in OTC derivative products or advising on OTC derivative products. For a more detailed description of expanded type 9 RA and type 11 RA, see our previous publications.
- Consider your licensing requirements under the new licensing regime If you are an existing type 9 RA asset manager and you already invest in or wish to invest in OTC derivatives, you will need to apply to the SFC for approval to engage in the expanded type 9 RA. If your licence is subject to a condition prohibiting you from managing futures contracts for investment purposes, you should probably also apply to lift the condition or you will still be prohibited from investing in listed futures even though you can invest in OTC derivatives. If you currently provide or wish to provide a discrete service of advising on OTC derivatives products, you will also need to apply to be licensed for type 11 RA.
- Consider whether you qualify for deemed licensing The Amendment Ordinance contains deeming provisions that permit an existing type 9 RA asset manager to be deemed licensed for the expanded type 9 RA and / or the type 11 RA, if the asset manager satisfies various criteria. A corporate applicant that applies to be deemed licensed for type 11 RA must have been carrying on the activity of dealing in or advising on OTC derivative products in Hong Kong for at least two years immediately before the commencement date of the new licensing regime. An existing type 9 RA asset manager does not need to show that it has been carrying on the activity of managing OTC derivative products previously, but it does need to have a responsible officer that has relevant experience, as set out below.
- Plan your human resources If you are currently licensed for type 9 RA and wish to apply to be deemed licensed for expanded type 9 RA, you must have (and confirm to the SFC that you have) at least one responsible officer who has at least two years of experience in managing OTC derivative products (in Hong Kong or elsewhere) over the six years immediately before the commencement date of the new licensing regime. If you apply to be deemed licensed for type 11 RA, you must have (and confirm to the SFC that you have) at least two persons who have applied to be approved as responsible officers in relation to type 11 RA, each of whom must have been carrying on the activity of dealing, trading or advising on OTC derivative products in Hong Kong for at least two years immediately before the commencement date of the new licensing regime, and at least one of whom must be an executive director.
- Update your business plan You will need to update your business plan previously filed with the SFC to reflect the addition of expanded type 9 RA and/or type 11 RA. The updated business plan should include:
- a description of the types of OTC derivative products you manage or advise on or propose to manage or advise on;
- an updated organization structure showing the human resources engaging in the asset management activity, including those who will manage or advise on OTC derivative products;
- an operational flowchart or procedures for managing or advising on the OTC derivative products;
- a brief summary of your history in managing or advising on OTC derivative products; and
- your internal controls and contingency plans relating to managing or advising on OTC derivative products.
Update your compliance policies and procedures
You will need to update your compliance policies and procedures to reflect the additional regulatory obligations that will apply to the conduct of expanded type 9 RA and/or type 11 RA.
The attached appendix sets out a timeline to help you plan for the new licensing regime.
Plan for mandatory reporting (and record keeping)
The Draft Rules impose mandatory reporting obligations on type 9 asset managers for certain OTC derivative transactions (reportable transactions) that they have entered into in their capacity as discretionary asset managers on behalf of a client (who becomes a counterparty to the transaction). So, you will have a reporting obligation if, as part of your type 9 activity, you enter into a reportable transaction for a managed account client or a fund (whether or not the managed account client or fund is onshore or offshore Hong Kong). We expect that a type 9 asset manager will be taken to have entered into a transaction on behalf of its client if it makes the decision but delegates execution to a third party outside Hong Kong.
Type 9 asset managers will also need to report reportable transactions that they are a counterparty to, or where they have conducted the transaction in Hong Kong on behalf of a counterparty to the transaction that is an affiliate.
Keep in mind:
- there is no substituted compliance – if a reportable transaction is reported to a trade repository outside Hong Kong, you will still need to report the transaction to the Hong Kong trade repository (HKTR);
- the Draft Rules require dual reporting – even if a counterparty to a reportable transaction (e.g. a bank) reports it to the HKTR, you will still need to report the transaction to the HKTR.
The initial reportable transactions are certain interest rate swaps - plain vanilla and basis swaps – in a specified currency and non-deliverable forward contracts relating to specified currencies and precious metals.
In order to prepare for mandatory reporting:
- Review and upgrade your internal infrastructure Reportable transactions must be reported to the HKTR electronically. You will need to:
- sign up with the HKTR and establish a reporting link to the HKTR’s systems – you have up to three months from the start of the mandatory reporting obligation (the start date) to do so;
- review and revise your internal systems to ensure you can:
- identify OTC derivative transactions that need to be reported;
- identify “subsequent events” relating to previously-reported transactions – where you have reported a reportable transaction, you will also have an obligation to report “subsequent events” in relation to that reportable transaction;
- collate the information that needs to be submitted to the HKTR for each reportable transaction and subsequent event; and
- report reportable transactions and subsequent events within the time permitted under the Draft Rules – generally, reporting is on a T+2 basis
- collate information about reportable transactions (i) that you entered into as a counterparty prior to the start date, and (ii) that remain outstanding at the start date – you have up to six months from the start date to report these transactions to the HKTR.
- Consider appointing an agent to report on your behalf
You can appoint an agent to report reportable transactions to the HKTR on your behalf. Note you will remain responsible for any failure by the agent to report. If you choose to appoint an agent, you will need to:
- identify a suitable agent and conduct due diligence on it;
- ensure the agent is given sufficient information to report reportable transactions to the HKTR on your behalf;
- put in place processes to monitor the agent’s performance.
- Revise your recordkeeping arrangements You will need to ensure that you can keep the required records, in the required form and manner. The Draft Rules (in Schedule 3, Part 1) set out a wide range of records that you will need to keep. These records must be readily searchable and identifiable by reference to the transaction and counterparty, and (with limited exceptions) must be kept in electronic form and stored in a computer or other electronic system. Note the form in which records must be kept is different from the general requirement under the Securities and Futures (Keeping of Records) Rules.
Update your compliance policies and procedures You will need to update your compliance policies and procedures to reflect the mandatory reporting (and related recordkeeping) obligations for OTC derivative transactions.
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