Jurisdiction - Hong Kong
Reports and Analysis
Hong Kong – Regulatory Update.

25 November, 2012

 

Legal News & Analysis – Asia Pacific – Hong Kong – Regulatory & Compliance

 

Derivatives
 
HKMA launches matching and confirmation services for OTC derivatives In September, the Hong Kong Monetary Authority (HKMA) announced that it intends to launch in December 2012 a trade repository (HKMA TR) by providing matching and confirmation services for market participants in respect of their over-thecounter (OTC) derivatives transactions which have been transmitted to the Hong Kong Exchanges and Clearing Limited (HKEx) central counterparty clearing facility (HKEx CCP) for voluntary clearing. 
 
As regulations making the reporting and clearing of the OTC derivatives transactions a mandatory requirement in Hong Kong are not expected to take effect until mid-2013 at the earliest, the matching and confirmation services will, when launched, support OTC derivatives transactions transmitted to the HKEx CCP on a voluntary basis. Market participants are advised to read the reference manual, instructions and technical specifications in connection with the matching and confirmation services provided by the HKMA in order to properly prepare for the
implementation.
 
Consultation conclusions on proposals to regulate the OTC derivatives markets
 
In July 2012, the HKMA and the Securities and Futures Commission (SFC) released their conclusions following consultation on proposals to regulate the OTC derivatives markets. The two regulators also released a supplemental consultation paper on the proposed scope of new regulated activities to be introduced for OTC derivatives, and the regulatory oversight of systemically important players. A separate consultation on the subsidiary legislation to be enacted for detailed requirements under the new regulatory regime will be launched this quarter.
 
The conclusions propose a regulatory regime regarding OTC derivatives as follows:
 
  • Legislative framework: The new OTC derivatives regulatory regime will be set out in the Securities and Futures Ordinance (SFO) and the subsidiary legislation under the SFO. There will be a separate consultation on detailed provisions to be contained in subsidiary legislation. The new regime will introduce the mandatory reporting and clearing of many OTC derivatives transactions and the supervision of key players in the OTC derivatives market.
  • Joint oversight by HKMA and SFC: The new regime will be jointly overseen by the HKMA and SFC, with the division of responsibility depending on the type of the regulated entity. The HKMA will regulate the OTC derivatives activities of authorised institutions (AI) (i.e. banks) and interdealer brokers who are licensed and regulated by HKMA as approved money brokers (AMB). The SFC will regulate licensed corporations (LC) and all other “Hong Kong persons” if their positions exceed a specified threshold.
  • Scope of the new regime – “OTC derivatives transaction”: “OTC derivatives transaction” will be defined by reference to the term “structured product” (as defined in the SFO) but there will be carve-outs for exchange-traded derivatives, SFC authorised structured products, securitised products and spot contracts. There will be a power for the regulators to include or exclude any specified transaction as an OTC derivative transaction.
  • Products subject to mandatory reporting and clearing: The mandatory reporting and clearing obligations will initially cover certain types of interest rate swap (IRS) and non-deliverable forwards (NDF), but may subsequently be extended to cover other types of transaction in the future.
  • Mandatory reporting obligation: HKMA TR will be the only designated trade repository for the purposes of the mandatory reporting obligation, which will apply to a reportable transaction that a HK regulated party (i) is a counterparty to or (ii) has originated or executed and the transaction has a “Hong Kong nexus”. A “HK regulated party” means an AMB, a Hong Kong-incorporated AI, the Hong Kong branch of an overseas incorporated AI, an LC or a Hong Kong person who exceeds the reporting threshold. In order to reduce the compliance burden, the reporting obligation is discharged if either party reports the transaction to the HKMA TR. Transactions entered into by central banks, monetary authorities and global institutions (such as IMF and BIS) are exempt.
  • Mandatory clearing obligation: The mandatory clearing obligation will apply to a HK regulated party (for an overseas-incorporated AI only if the trade is booked through its Hong Kong branch) in a clearing eligible transaction when both the HK regulated party and the counterparty exceed the clearing threshold, and neither party is exempt from the clearing obligation. Central banks, monetary authorities and global institutions (such as IMF and BIS) will be exempt, as well as intragroup transactions. Both Hong Kong and overseas central counterparties (CCP) may become designated CCPs for the purposes of the mandatory clearing obligation provided that the CCPs are either a recognised clearing house (RCH) or an authorised automated trading service (ATS) provider under the SFO. 
  • Mandatory trading obligation: Hong Kong will not require trading of OTC derivatives on exchanges or electronic platforms at the outset, but the regulators will conduct further study to assess the implementation of this requirement in Hong Kong. 
  • Penalties for breach: Fines for breach of the mandatory obligations will be set at levels comparable to those in other major jurisdictions. Additionally, the powers of the regulators under the SFO will be expanded to enable them to take disciplinary action against AIs, AMBs and LCs. The regulators are also considering how best to address in the legislation market concerns on the validity and enforceability of transactions if mandatory obligations have been breached. 
  • Capital and margin requirements: The regulators intend to impose  higher capital and margin requirements for non-cleared OTC derivatives transactions and they will put forward specific proposals for consultation after IOSCO and BCBS have issued final proposals on the requirements for non-cleared derivatives. 
  • Regulation of intermediaries: Two new types of Regulated Activities (RA) will be introduced: (i) a new Type 11 RA with respect to the activities of dealers and advisers, and (ii) a new Type 12 RA with respect to the activities of clearing agents. The scope of the existing Type 9 RA (asset management) will also be expanded to cover the management of portfolios of OTC derivatives. There are discussions in the supplemental consultation on the scope of the new and expanded RAs, carve-outs to address overlaps with the existing RAs and transitional arrangements to minimise disruptions to OTC derivatives activities.
  • Oversight of systemically important players (SIP): The regulators also propose to regulate players who are not licensed by or registered with the HKMA or SFC but whose positions or activities may raise concerns of potential systemic risk. This may include imposing obligations on SIPs to notify the SFC, entering names and details of SIPs into a register of SIPs, and granting power to the HKMA and SFC to require SIPs to provide information and take specific action when directed to do so. 
 
Financial services
RQFII physical A-share ETF
 
We have in the last issue of Regulatory Radar reported that in June the SFC authorised the world’s first Renminbi Qualified Foreign Institutional Investor (RQFII) physical A-share ETF for listing in Hong Kong. The RQFII physical A-share ETF is the first ETF issued outside of China that seeks to track an A-share index by using offshore RMB through the RQFII quota to invest in a portfolio of A-shares in order to replicate the performance of the underlying A-share index. 
 
In an FAQ in connection with the Code of Unit Trusts and Mutual Funds (Code) released by the SFC in June, the SFC highlighted that only those SFC-licensed fund management companies who have RQFII licences and quotas are eligible to launch such an ETF in Hong Kong. In addition, in assessing a fund manager acting for an authorised RQFII physical A-share ETF, the SFC required that the fund manager shall have the operational experience and infrastructure to implement the necessary physical investment in China shares or the replication strategy. The SFC considers  that the fund manager’s parent company in China will be important as the fund manager can tap into the parent’s infrastructure and expertise in managing the RQFII physical A-share in Hong Kong.
 
The SFC released the FAQ in connection with the Code in order to provide basic information to fund managers, trustees/custodians and other market practitioners. The Code sets out the requirements for authorising public funds in Hong Kong. The Code also prescribes post-authorisation obligations with which authorised
funds must comply.
 
First dual counter security listed in Hong Kong On 12 October 2012, Harvest MSCI China A Index ETF, the fourth RQFII physical A-share ETF so far, was listed on the Stock Exchange of Hong Kong. This is the first dual counter (DC) security listed in Hong Kong. A DC security offers two counters for trading and settlement purposes; for example, a renminbi (RMB) counter and a Hong Kong dollar (HKD) counter. The two counters are of the same class and holders of shares or units of the counters are treated equally. Investors can generally buy and sell shares or units in the same counter of a DC security. They can also buy shares or units of one counter and sell them in the other counter provided that their brokers offer such service. DC securities provide the flexibility for investors to trade in either one of the two currencies. Issuers of DC securities may also benefit from a wider base of potential investors. Investors who want to trade in a DC security but do not have the RMB can use the RMB Equity Trading Support Facility (TSF) of the HKEx provided that the security to be purchased iseligible for such facility.
 
TSF is a back-up facility to enable investors to buy RMB-traded securities in the secondary market with HKD, in order to solve the problem of the uncertainty of RMB liquidity in Hong Kong. Currently, TSF supports securities such as shares and equity-related ETFs and REITs (i.e. real estate investment trust) that are traded in RMB in the secondary market. TSF does not support non-equity-related ETFs (e.g. RMB Gold ETF), derivatives warrants and callable bull/bear certificates
(CBBC). Investors should note that TSF is operated on a “HKD in and HKD out” principle. When investors sell the RMB-traded shares previously bought under the support of the TSF, they have to return the RMB sale proceeds to the TSF for the equivalent amount of the HKD. The mechanism aims to ensure that RMB funding stays in the TSF and is recycled in the secondary market. TSF is operated by Hong Kong Securities Clearing Company Limited (HKSCC), which sources RMB funding from one or more banks in Hong Kong.

 

 










For further information, please contact:

 

Gareth Hughes, Partner, Ashurst

gareth.hughes@ashurst.com

 

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