Following its initial consultation in 2015 on changes to the Securities and Futures (Financial Resources) Rules (FRR), the Securities and Futures Commission (SFC) has now published its Consultation Conclusions and Further Consultation on Proposed Changes to the Securities and Futures (Financial Resources) Rules (Consultation Conclusions). The initial consultation and the Consultation Conclusions address (1) the financial resources requirements that will apply to corporations licensed for over-the-counter (OTC) derivative activities, once Hong Kong’s OTC derivative license regime is in effect, and (2) other changes to the FRR that will apply to all licensed corporations.
FRR requirements for OTC derivative activities – Welcome reduction for central dealing desks of asset managers
In its initial consultation, the SFC proposed significant capital requirements for dealing in OTC derivative products (part of the new Type 11 regulated activity) and for providing client clearing services for OTC derivative products (the new Type 12 regulated activity). The Consultation Conclusions largely adopt these original proposals. However, there is a welcome reduction in capital requirements for certain asset managers that operate a central dealing desk in Hong Kong and deal in OTC derivative products on behalf of group companies (described as “OTCD central dealing desk dealers”). Such asset managers will need to be licensed for dealing in OTC derivative products (part of the new Type 11 regulated activity).
An asset manager will be an OTCD central dealing desk dealer if it meets all the following conditions:
in respect of any dealing in OTC derivative products (including similar dealing which falls within Type 1, 2 or 3 regulated activity for the purpose of this proposal) it carries out, other than those carried out incidentally to any Type 9 regulated activity for which it is licensed,
- it only handles, in an agency capacity, orders placed by
- an asset management company which is within the same group as it and is licensed for Type 9 regulated activity; or
- an asset management company which is within the same group as it and carries on a business in a specified jurisdiction outside Hong Kong which, if carried on in Hong Kong, would constitute Type 9 regulated activity, under an authorisation (however described) by an authority or regulatory organisation in that jurisdiction;
for client accounts in the course of carrying on the Type 9 regulated activity or that business;
- it does not hold client assets;
- it is not a contracting party to any OTC derivative transactions executed in the course of such dealing, whether as principal or agent;
- it will not incur any liability to the contracting parties to the OTC derivative transactions executed in the course of such dealing except for its own negligence, wilful default or fraud; and
- it does not carry out any market making activity in such dealing itself or on behalf of the asset management company referred to in (i) above or the clients of that asset management company.
For the purposes of condition (i), the SFC proposes that the specified jurisdictions will include Australia, Canada, China, France, Germany, Ireland, Japan, Luxembourg, Malaysia, Netherlands, Singapore, Switzerland, Taiwan, the UK, the US and any other jurisdiction specified by the SFC. For the purposes of conditions (iii) and (iv), the asset manager will not be considered as a contracting party where it signs OTC derivative contracts as agent for its clients.
The SFC proposes to reduce the capital requirements for OTCD central dealing desk dealers to a minimum paid-up share capital requirement of HK$30 million and a minimum required liquid capital of HK$15 million. Whilst these minimum capital requirements are lower than originally proposed, they remain significantly higher than the minimum capital requirements for asset managers that currently operate a central dealing desk for dealing in securities and futures contracts.
FRR requirements for other OTC derivative activities of asset managers
An asset manager that wishes to include OTC derivative products in the portfolios that it manages will need to be licensed for the new (extended) Type 9 regulated activity once Hong Kong’s OTC derivative license regime is in effect. The new Type 9 regulated activity will include the ability to manage a portfolio of OTC derivative products, in addition to managing a portfolio of securities and futures contracts.
In the Consultation Conclusions, the SFC confirmed that:
- An asset manager licensed for the new Type 9 regulated activity will be subject to the same minimum capital requirements as at present; and
- If an asset manager’s dealing in OTC derivative products is incidental to the new Type 9 regulated activity, the asset manager is exempt from licensing for Type 11 regulated activity.
FRR changes for all licensed corporations
On the non-OTC derivative front, the SFC will proceed with most of the proposed changes set out in its initial consultation, such as updating the haircut percentage of certain types of authorised funds / recognised jurisdiction funds (e.g. the haircut percentage for money market funds will be reduced from 20% to 5%) and specifying a 100% haircut discount for illiquid investments. The SFC also requested comment on certain modified and additional proposals, including:
- Allowing licensed corporations to include in their liquid assets client monies received for settling clients’ outstanding securities transactions;
- Adding four Mainland China commodity exchanges to the list of specified exchanges;
- Allowing licensed corporations that act as a main underwriter to include in their liquid assets outstanding underwriting fees receivable, up to a certain amount;
- Allowing licensed corporations to exclude the amount of recognised liabilities arising from a tenancy agreement entered into by the licensed corporation in respect of its business premises from its ranking liabilities, up to a certain amount.
The SFC intends to implement the FRR changes that apply to all licensed corporations first, with the FRR changes relating to OTC derivatives activities to be implemented at a later stage. For this purpose, the SFC has prepared draft amendments to the FRR reflecting the changes that apply to all licensed corporations. The draft amendments are set out in Appendix 1 to the Consultation Conclusions. Licensed corporations should review and assess the impact of these changes on their required regulatory capital.