A New World? Hong Kong’s response to G20

Linklaters discusses key themes of the upcoming Hong Kong OTC derivatives regulatory reforms.

A New World? Hong Kong’s response to G20
The Securities and Futures (Amendment) Bill 2013 was published to enable Hong Kong to keep pace with global OTC derivatives regulatory reforms. It marks a sea change in how OTC derivatives business will be conducted in the city.

On 28 June 2013, the Securities and Futures (Amendment) Bill 2013 (the "Bill") was published to enable Hong Kong to keep pace with global OTC derivatives regulatory reforms, which implement commitments made by G20 leaders at the 2009 Pittsburgh summit. This marks a sea change in how OTC derivatives business will be conducted in Hong Kong.

OTC derivatives are bilaterally traded derivatives contracts that are entered into by counterparties for many reasons, including hedging, risk management, speculation and investment.  Prior to the global financial crisis (GFC) of 2008, this market was comparatively lightly regulated, both in Hong Kong and elsewhere. Because of the private nature of these contracts, not much was known about how such contracts led to the concentration of risk in certain market participants.  The GFC also made it apparent how interconnected OTC derivatives market participants were, such that the fall of one major market participant (eg Lehman Brothers) could have serious knock-on consequences throughout the financial system. The GFC also made it apparent how much better prepared global leaders would need to be to deal with another financial crisis of this nature.

The G20 commitments require that all standardised OTC derivative contracts be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs); that parties to OTC derivative contracts report key information to trade repositories; and that non-centrally cleared contracts be subject to higher capital and higher margin requirements.

In the US and in the EU, major legislative reforms (See note 1) have been under way to implement the G20 commitments. Similar reforms are also in various stages of consultation and implementation in other countries, including in Asia. In addition, regulators are moving towards greater and more comprehensive regulation of derivatives market participants and are mandating good trade hygiene for OTC derivatives such as timely confirmation of trades and improved dispute resolution techniques.

In line with these international developments, the Securities and Futures Commission (SFC)  and the Hong Kong Monetary Authority (HKMA) are now seeking to amend the Securities and Futures Ordinance (Cap. 571) (the SFO) to put in place a new Hong Kong framework for OTC derivatives.

The main amendments to the SFO as set out in the Bill are as follows:

1. Regulation of activities in “OTC derivative products”
Under the existing SFO, OTC derivatives activities are regulated only insofar as they are caught by the scope of other regulations pertaining to securities, futures contracts, leveraged foreign exchange trading, etc.. The introduction of two new regulated activities of dealing in OTC derivatives and advising in OTC derivatives represents a broadening of the existing regulatory framework.  Market participants that currently conduct such activities may have to obtain a new license and have to comply with stringent code of conduct and other requirements.

This broadening can also be seen in the introduction of a wide new definition of “OTC derivative transaction”, which forms a cornerstone of the new regime. “OTC derivative transaction” will be defined by reference to the existing broad definition of “structured product”, but excluding exchange-traded securities and futures, structured products that are offered to the public (already subject to a separate regime) and short-tenor spot contracts.  The scope of this definition will be further refined by means of carve outs and regulators may tailor the term differently for different obligations. 

The new regulatory regime is to be under the joint oversight of the HKMA and SFC, with the HKMA regulating the OTC derivatives activities of locally and overseas incorporated banks and inter-dealer brokers who are licensed and regulated by HKMA as approved money brokers, and the SFC regulating that of “licensed corporations” (i.e. brokers) and Hong Kong persons. Both HKMA and SFC are given expanded supervisory and investigatory powers relating to the regulation of OTC derivatives transactions.

2. Mandatory reporting
Reporting is the process by which parties to an OTC derivative transaction report key information about such trades to a trade repository.  The data is used by regulators for market transparency and to monitor the build-up of risk in the financial system.

The HKMA has set up a trade repository (HKMA TR) that became operational for voluntary reporting in August 2013 and which is readying itself for mandatory reporting. 

The Bill sets out the scope of the mandatory reporting obligation: “prescribed persons” must report specified OTC derivative transactions to the HKMA TR.  “Prescribed persons” are banks,  licensed corporations and approved money brokers and may include other persons prescribed in subsidiary legislation.  The precise scope of the reportable transactions will be set out in subsidiary legislation, but is expected to be single currency interest rate swaps, overnight index swaps, single currency basis swaps and non-deliverable forwards. 

The subsidiary legislation will also set out further detail as to how this obligation will be defined, including the applicable reporting thresholds. In addition, the proposal was initially for reportable transactions with a “Hong Kong nexus” (e.g. where the underlying asset is denominated in Hong Kong dollars) that are not only booked in Hong Kong, but also “originated and executed” in Hong Kong to be mandatorily reportable.  Singapore and Australia have framed reporting obligations in a similar manner (See note 2). In all three jurisdictions, there is still debate about a practical way of framing the requirement.  For example, what if a trade is executed by a dealer who is normally resident in Hong Kong but happens to be outside Hong Kong? Is it possible to pinpoint the individual dealer or should one look to the trading desk? Should residency of the individual dealer be used to define the scope of the obligation or where the dealer is licensed?  It is to be hoped that regulators in these three major Asian jurisdictions take a similar approach to defining the reporting obligation.

The mandatory reporting obligation will potentially have extra territorial effect: Hong Kong banks will have to report reportable transactions entered into by their overseas subsidiaries to HKMA TR and, depending on how the reporting obligation is defined, trades executed in Hong Kong that are booked outside Hong Kong may also have to report such trades to HKMA TR.

Voluntary reporting has already commenced and when mandatory reporting becomes effective, the Hong Kong derivatives markets will become more transparent.

3. Mandatory clearing
In the clearing process, a CCP interposes itself between the parties to an OTC derivative transaction, acting as the seller to every buyer and buyer to every seller.  CCPs have in place robust risk management procedures and also take collateral from market participants.  They are hence seen as subject to less insolvency risk than ordinary market counterparties.

Under the new Hong Kong regime, banks, approved money brokers, licensed corporations and persons designated in subsidiary legislation must clear “specified OTC derivative transactions” through a “designated CCP”.  The scope of the specified OTC derivative transactions will be defined in the subsidiary legislation, but it is anticipated that these will be interest rate swaps and non-deliverable forwards initially. 

A “designated CCP” must either be a recognized clearing house (RCH) approved by the SFC or a CCP that has obtained a local automated trading services (ATS) license, and in addition satisfy additional requirements for a designated CCP. Details of the additional requirements will be set out in subsidiary legislation, but are expected to be in line with standards published by the international body of regulators known as CPSS-IOSCO. HKEx has set up a local clearing house, OTC Clearing Hong Kong Limited, an RCH for clearing OTC derivative contracts.  OTC Clear is being readied for operation and it is anticipated that it will comply with the CPSS-IOSCO standards and will be stringently regulated. It is also anticipated that other major international clearing houses will become recognized ATS providers in due course.

The clearing threshold and the exemptions will be set out in the subsidiary legislation. Under consideration are exemptions for:

  • central banks, monetary authorities and certain public bodies and global institutions (such as IMF and BIS);
  • intra-group transactions;
  • non-financial entities using derivatives to hedge commercial risks; and
  • transactions involving participants from “closed markets”.

 

Where either party is exempt from clearing, neither party would be required to clear.

The mandatory clearing obligation will potentially have extra-territorial scope and the framework in the Bill contemplates that regulators can make provision for substituted compliance in the subsidiary legislation.

In addition, regulators are conscious that only market participants that fulfill stringent criteria can actually become members of a CCP.  The majority of market participants (for example, buy side players) will have to access central clearing by becoming clients of clearing members.  To this end, the Bill also modernizes the insolvency protections given to RCHs under the SFO to take into account that RCHs may offer client clearing (that is, providing end clients indirect access to clearing through its clearing members).  Under the modernized framework, rules and proceedings of an RCH that relate to contracts between end clients and its clearing members will have the benefit of the SFO insolvency protections.  The SFO insolvency protections currently given to rules of an RCH that deals with the default of a clearing member will also be amended to expressly contemplate default arrangements specific to client clearing, such as the transfer (or porting) of transactions relating to clients to a replacement clearing member and the separate netting of amounts owing between the RCH and the defaulted clearing member for its own account and for the account of its clients.

When voluntary and mandatory clearing commences, it is to be hoped that the combination of a well-maintained local CCP as well as a robust regulatory framework will create a safer market environment for cleared derivatives.

4. Supervision of “Systemically Important Participants”
The Bill introduces a new category of “Systemically Important Participants” (SIPs) – entities that are not otherwise regulated by the SFC or HKMA but who will now be subject to regulation.  SIPs will be required to make notifications to the SFC when their OTC derivatives trading activity reaches a designated threshold and may be required to take certain actions (such as unwinding positions) where the SFC determines that the SIP’s OTC derivatives activities poses a systemic risk to the market.  The thresholds for SIP classification and scope of information to be reported will be set out in separate rules. 

Timing

The Secretary for Financial Services and the Treasury has given notice to present the Bill to the Legislative Council for its first reading on 10 July 2013.  The Bill will then have its second reading debate and third reading before becoming enacted into legislation, which is expected sometime in 2014.   Consultation on subsidiary legislation is expected to take place in October 2013.

Other related developments - Margin for uncleared trades

In addition to the Bill, Hong Kong is a member of the Basel Committee of Banking Supervision and is likely to adopt its proposals regarding margin requirements for uncleared OTC derivatives trades. All OTC derivatives not cleared by a CCP will potentially be subject to onerous margin requirements, namely the two-way posting of initial margin and variation margin, with collateral being held in a way that is immediately available in the collateral provider’s default and in a manner that protects the collateral provider in the collateral taker’s default.  The uncleared OTC derivatives margin proposal is meant to complement the mandatory clearing requirement under the Bill by encouraging market participants to clear OTC derivatives where possible. However, it is also likely to make it extremely expensive to enter into non-cleared derivatives, both in Hong Kong and elsewhere.

Conclusion

The framework in the Bill, when enacted, represents a sea change in the way market participants in Hong Kong will conduct their OTC derivatives activity. It is expected that in the coming year or so, market participants will have to quickly familiarise themselves with the Bill and the related subsidiary legislation to follow, and prepare their systems ahead of the implementation of changes to the SFO. While this will mean increased costs to the market, it is hoped that the Bill and related regulatory changes will achieve the underlying objectives of the G20 commitments in increasing transparency, mitigating systemic risk and minimising market abuse in the OTC derivatives market, and ensure that Hong Kong remains a safe and competitive place to do business.

 

For further information contact:

Karen Lam (karen.lam@linklaters.com)

I-Ping Soong (i-ping.soong@linklaters.com)

Victor Wan (victor.wan@linklaters.com)

Chong Liew (chin-chong.liew@linklaters.com)

 

Notes:

1) In the form of the Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (more commonly known as European Market Infrastructure Regulation or EMIR) in the EU and the Dodd-Frank Wall Street Reform and Consumer Protection Act in the US.

2) The Australian ASIC Derivative Transaction Rules 2013 defines the obligation by reference to where trades are “entered into” and the Securities and Futures (Reporting of Derivative Contracts) Regulations 2013 in Singapore by reference to whether such derivatives are booked or traded in Singapore.

 

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