G-20 regulatory authorities (in particular the US and EU) have launched many initiatives aimed at over-the-counter (“OTC”) derivatives, some of which have extraterritorial impact in APAC. Regional regulatory initiatives have been launched by Hong Kong and Singapore in particular, which aim to ensure integration with the rapidly evolving global regulatory system. InsightLegal Asia (www.insightlegalasia.com) specializes in ‘clarifying complexity’ and below we provide an update to our previous Dodd-Frank/EMIR guidance. Specifically, we analyze how global regulatory initiatives affect Asia-Pacific financial institutions and focus on how key regional regulatory frameworks are being re-shaped as a result?
Many market participants across Asia remain confused about how the new US and EU regulations affect them and what additional registration, reporting and documentation are required in order to be compliant therewith. The most significant outcome in terms of documentation following years of regulatory activity in the US and EU manifests itself in the form of protocols to which certain counterparties are bound to adhere to when entering into certain OTC derivative transactions.
In the US, we have seen the August 2012 (“Dodd-Frank I”) and March 2013 Dodd-Frank (“Dodd-Frank II”) Protocols (collectively, the “DF Protocols”), while in the EU the European Securities and Market Authority (“ESMA”) pursuant to its July 2012 European Market Infrastructure Regulation (“EMIR”) launched the NFC Representation Protocol (“EMIR NFC Protocol”) and Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol (“EMIR Disclosure Protocol”) (collectively, the “EMIR Protocols”).
Beyond the DF-Protocols and EMIR Protocols, there are also a number of additional documents that market participants should be aware of, such as the Dodd-Frank Disclosure Documents, Cross-Border Swaps Representation Letter and the EMIR Timely Confirmation Amendment Agreement (“Ancillary Documentation”).
Let us consider the extraterritorial impact of US and EU regulations in turn, followed by a look at the efforts by the International Swaps and Derivatives Association (“ISDA”) to ensure new regulatory requirements are captured in standardized market documentation.
II. US Regulatory Framework
Regulation of OTC derivatives in the US is bifurcated, with the Commodity Futures Trading Commission (“CFTC”) overseeing "swaps" and the Securities and Exchange Commission (“SEC”) overseeing "security-based swaps". Since Asian OTC markets consist mainly of foreign exchange and interest rate swaps, CFTC regulations are the most relevant and the most material requirements are:
- Anyone who is deemed to be a swap dealer (“SD”) or major swap participant (“MSP”) is required to register as such with the CFTC.
- SDs and MSPs must have policies and documentation that comply with the CFTC's swap-related requirements in order to offer or enter into new swaps or modify or unwind existing swaps. The application of these requirements differs depending on:
- whether the entity is a US or non-US person;
- in the case of a US SD or MSP, whether the swap is with its foreign branch; and
- whether the counterparty is a US or non-US person, the foreign branch of a US person, or is guaranteed by or an affiliate conduit of a US person (“GCA”).
- The CFTC's requirements are categorized into (a) entity-level and (b) transaction-level requirements:
- Entity-level requirements. Generally apply to US SDs and MSPs, including their foreign branches. It also generally applies to non-US SDs and MSPs, except that ‘substituted compliance’–which allows for compliance with local rules in certain jurisdictions (i.e., those with sufficiently similar regulatory standards)–is potentially available for the first category of entity-level requirements. Substituted compliance is also potentially available to the same firms for entity-level requirements (except for large trader reporting (“LT Reporting”)), but only where the counterparty is a non-US person. For swap data reporting purposes, a non-US person cannot be a GCA and the CFTC must have direct access to the data housed at the foreign trade repository.
- Transaction-level requirements. A US SD or MSP must comply with all transaction-level requirements. Where the swap is with its foreign branch, it must also comply with all transaction-level requirements where its counterparty is a US person. If its foreign branch's counterparty is the foreign branch of a US bank that is a SD or MSP or a non-US person (including a GCA), it need only comply with Category A transaction-level requirements, and substituted compliance may be available. Non-US SDs or MSPs (not acting through their US branches) must comply with all transaction-level requirements only where the counterparty is a US person (other than a foreign branch of such US person). Where its counterparty is the foreign branch of a US person or a GCA, only Category A transaction-level requirements apply with the possibility of substituted compliance. No transaction-level requirements apply where its counterparty is a non-US person that is not a GCA.
- Where the swap is with the foreign branch of a US SD located outside of the six acceptable jurisdictions for purposes of ‘substituted compliance’ (namely Australia, Canada, EU, Hong Kong, Japan or Switzerland), the "5% exemption" is also potentially available where its counterparty is a non-US person that is not a GCA. Compliance with local law requirements in place of Category A transaction-level requirements is allowed if:
- the aggregate notional value of the swaps of all its foreign branches in all jurisdictions other than the six jurisdictions does not exceed 5% of the aggregate notional value (measured on a quarterly basis) of all the swaps of the US SD; and
- it maintains records with supporting information to verify point (i) and to identify, define and address any significant risk that may arise from the non-application of these requirements.
III. EU Regulatory Framework
EMIR applies to financial counterparties and non-financial counterparties (“NFCs”) established in the EU and therefore by extension to firms dealing with them. A EU-established entity includes its foreign branches. There is some extraterritorial application where transactions between third country entities that have a “…direct, substantial and foreseeable effect within the EU…”, or where “…necessary or appropriate to prevent evasion…” of any provision of EMIR. ESMA has made some progress in identifying what entities are covered by EMIR’s obligations:
- At least one counterparty is a third country entity guaranteed by an FC;
- Both counterparties are EU branches of third country entities; or
- Where the primary purpose of the transaction is to defeat the object, spirit or purpose of any provision of EMIR that would otherwise apply.
All OTC and exchange-traded derivative transactions where one party is a NFC and the other a FC are subject to trade reporting requirements. Further, OTC derivative contracts subject to mandatory clearing must be cleared if the parties to such contracts are financial counterparties or non financial counterparties that exceed any of the prescribed asset class clearing thresholds (“NFC+s”).
Further, if the other party is an entity established in a third country that would have been subject to mandatory clearing had it been established in the EU, the transaction must be cleared. Risk mitigation requirements for un-cleared trades apply to both financial counterparties and NFC+s. Only the risk mitigation requirements relating to timely confirmations, portfolio reconciliation and compression and dispute resolution apply to non-financial counterparties that do not exceed any of the clearing thresholds (“NFC–s”).
IV. ISDA Protocols
ISDA protocols and other documents address the plethora of regulatory requirements arising from Dodd-Frank and EMIR where such requirements either (a) necessitate changes to documentation or (b) can be fulfilled through further documentation. As the Dodd-Frank and EMIR requirements become effective at different dates, the publication of ISDA protocols and Ancillary Documents have to be synchronized to account for such effective dates.
A detailed summary of the ISDA protocols and Ancillary Documents that may be of relevance to an Asian counterparty (i.e., a non-US person that is not a GCA and not established in the EU) that is not registered as a SD or MSP (assuming that neither substituted compliance nor the 5% exemption is available) is available in the appendices to this briefing upon request.
V. OTC Regulatory Developments in Hong Kong
Hong Kong’s response to the new global OTC regulatory landscape is summarized below.
OTC Clearing Hong Kong Limited (“OTC Clear”) launched its OTC derivatives clearing services in November 2013, making OTC Clear the first CCP to clear OTC derivatives in Greater China.
OTC Clear provides market participants the necessary financial market infrastructure to comply with mandatory clearing requirements. Market participants may now clear certain interest rate swaps (“IRSs”) and non-deliverable forwards (“NDFs”) on a voluntary basis in anticipation of mandatory clearing, which is expected to come into effect later this year.
OTC Clear has been established in accordance with the requirements set out in the report on Principles for Financial Market Infrastructures published by CPSS-IOSCO (the “FMI Principles”).
Hong Kong Exchanges and Clearing Limited (“HKEx”) holds 75% of OTC Clear with the remaining 25% (non-voting) held by a consortium of 12 shareholders, which means that HKEx retains 100% of the voting power.
Key Points to Note:
- OTC Clear has launched clearing services for IRSs denominated in, and NDFs referencing, a wide range of currencies--including RMB;
- OTC derivatives contracts cleared by OTC Clear benefit from insolvency protection under the SFO;
- Authorized institutions and licensed corporations carrying on business in Hong Kong can be admitted as clearing members, while remote clearing members will be considered for future membership; and
- Client clearing and acceptance of non-cash collateral are expected in the near future.
An overview of the key features of OTC Clear include:
- Scope of Clearing Services: OTC Clear intends to offer clearing services for a wide range of OTC derivatives products. Initially, clearing services are offered for IRSs denominated in RMB, HKD, USD and EUR; in addition, clearing services for NDFs referencing RMB, TWD, KRW and INR are available. Although clearing services (including RMB) currently only cover inter-dealer trades, OTC Clear plans to launch client clearing in the future alongside the implementation of mandatory clearing obligations in Hong Kong.
- Novation: Contracts between two clearing members are ‘instantly’ novated to OTC Clear, meaning that OTC Clear acts as the buyer to every seller and as the seller to every buyer in the original bilateral trade (i.e., OTC Clear is a CCP). Post-novation, OTC Clear is the counterparty to each party to the original bilateral trade, thereby guaranteeing the performance of the trade to one party in case a party to the original trade defaults.
- Membership: OTC Clear only admits clearing members who are either an authorized institution or a licensed corporation carrying on business in Hong Kong; however, OTC Clear is considering admitting clearing members that are neither authorized institutions nor licensed corporations and do not have a place of business in Hong Kong (“remote clearing members”). The SFC and foreign regulators will need to ensure that there is proper and sufficient regulatory oversight of remote clearing members.
- Insolvency Protection: The Securities and Futures Ordinance (Amendment) Bill includes provisions to support the clearing of OTC derivatives in addition to transactions in securities and futures contracts in Hong Kong. Pending the passing and the implementation of such changes, interim measures to support the clearing of IRSs and NDFs are provided by way of the Securities and Futures (Futures Contracts) Notice (the “s392 Notice”) issued by the Financial Secretary, pursuant to which certain OTC derivatives currently cleared by OTC Clear are designated as “futures contracts” under the Securities and Futures Ordinance (“SFO”). Furthermore, margin provided by clearing members to OTC Clear and provisions in the clearing rules of OTC Clear (the “Clearing Rules”) dealing with the default of a clearing member also enjoy insolvency protection under the SFO as “market collateral” and “default rules”.
- Margin and Guarantee Fund: Consistent with developing international market practices with regards to OTC derivatives clearing (e.g., the FMI Principles), OTC Clear requires the provision of margins by clearing members and the maintenance of a guarantee fund.
§ Margin: Initial margin and variation margin must be provided in the amounts, forms and times prescribed by OTC Clear. OTC Clear only accepts margin in the form of and outright transfer of cash to OTC Clear.
§ Guarantee Fund: The Clearing Rules set forth the payment waterfall that becomes applicable in the event that a defaulting clearing member’s margin is insufficient to cover losses. Both clearing members and OTC Clear contribute to the guarantee fund.
§ Non-cash collateral: Eventually, OTC Clear will accept non-cash collateral in the form of margin by way of security, and in the form of guarantee fund will be accepted by way of outright transfer.
- Default Protection: In the event of a default or the insolvency of OTC Clear, OTC Clear may terminate outstanding cleared contracts and determine the net termination amount in respect of the affected clearing member(s). Further, the liability of non-defaulting clearing members’ is capped and replenishments to the guarantee fund are limited in such an event, even if multiple clearing members default in close succession during a severe financial crisis. Upon the default of a clearing member, OTC Clear will close out such defaulting party’s contracts and the cleared contracts of the defaulting clearing member will be auctioned to non-defaulting clearing member(s) to replace the closed out contracts.
VI. OTC Regulatory Developments in Singapore
Singapore has made some great strides in terms of compatibility with global regulatory initiatives. On 31 December 2013, the Singapore Exchange (“SGX”) adopted several changes to its rules, including the introduction of remote clearing members (“RCMs”) and closer alignment of SGX Derivatives Clearing Limited’s (“SGX-DC’s”) rules with the CFTC’s regulations. In so doing, SGX-DC has taking active steps to fulfill its obligations to qualify as a derivatives clearing organisation (“DCO”) (under the CFTC’s rules).
SGX’s primary purpose for introducing the RCM category was to create a class of membership that would be appropriate for FCMs, but there is scope within the RCM category to allow for RCMs from jurisdictions other than the U.S. in the future. More stringent eligibility criteria and on-going obligations apply to RCMs.
SGX-DC Clearing Fund and OTCF Default Management Procedures: SGX proposed refinements to its Clearing Fund structure and improvements to the auction process for managing defaults of a member that clears OTC financial derivatives contracts (“OTCF”), such as:
- Apportioning SGX-DC’s 25% contribution to the Clearing Fund across two layers to cater for multiple defaults in different contract classes. SGX-DC will contribute at least 15% of the Clearing Fund to the first layer and make a further contribution of at least 10% of the Clearing Fund to an intermediate layer. The first layer will be used before members’ contributions and in the event of subsequent member default in a different contract class, the intermediate layer will be used before members’ contributions.
- If the auction of a defaulting member’s OTCF portfolio is unsuccessful, each member’s Clearing Fund contribution will be used to offset losses according to the distance of the member’s bid from the successful bid. Currently, the aggregate Clearing Fund contributions of each non-defaulting clearing member who clears OTCF contracts are used on a pro-rata basis in proportion to their Clearing Fund contributions, regardless of whether the non-defaulting clearing member was required to participate in the auction.
While the new global regulatory landscape impacts certain financial institutions in APAC, the extent of such impact depends entirely on the type of entity involved, in addition to the scale and type of OTC activity undertaken by such entity.
Hong Kong and Singapore have both brought their regulations up to par with the major global jurisdictions (and ‘substituted compliance’ applies for the most part) and the level of OTC derivatives activity in both of these markets reflects this fact.
Hong Kong’s OTC derivatives markets are generally well served by OTC Clear, even more so once the acceptance of non-cash collateral and mandatory clearing obligations come into effect (expected during 2014). In the midst of a rapidly changing regulatory environment brought about by international regulations such as EMIR and Dodd Frank, OTC Clear—and by extension Hong Kong--is well poised to handle such complex regulations. OTC Clear intends to apply for recognition under EMIR as a third country CCP.
Singapore’s SGX-DC has made considerable progress to qualify as a DCO for CFTC purposes and its RCM category opens the door for broader membership going forward. The default management procedures and tiered auction structure are state of the art and go over-and-beyond what the global FMI Principles require.
Beyond Hong Kong and Singapore, the extent to which other Asia-Pacific jurisdictions will implement the G-20 OTC derivatives reforms in line with the US and EU approaches is difficult to predict--as is the timing of any such regional reforms. What is clear is that the rest of APAC remains a diverse patchwork of regulators and exchanges, many of which have considerable work to do in order to integrate their regulations with a fast evolving global regulatory system. The rate of regulatory integration within each jurisdiction will directly affect the growth of and product availability in such OTC markets.