The Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) have published consultation conclusions on the draft rules for mandatory reporting of over-the-counter (OTC) derivatives and related record keeping. The draft rules have been amended, taking into account the comments received and providing greater clarity to the proposed regulatory regime.
Among others, the implementation of the reporting requirements on “Hong Kong persons” and asset managers has been deferred, and the record keeping period has been shortened from 7 years to 5 years. Market participants will also welcome the extension of the concession period for setting up a reporting channel to the HKMA and the grace period for backloading historical transactions, both by three months.

In the paper setting out the consultation conclusions, the HKMA and the SFC further consult on three ancillary issues, requesting comments by 23 December 2014.

The draft rules are targeted to be introduced into the Legislative Council (LegCo) during the first quarter of 2015, to come into effect in the same quarter. The HKMA and the SFC also aim to launch the initial consultation on mandatory clearing and related record keeping requirements at around the same time.

A. BACKGROUND

The Securities and Futures (Amendment) Ordinance 2014 (Amendment Ordinance) was enacted in April 2014 to amend the Securities and Futures Ordinance. The amendments provide the framework for the regulation of the OTC derivatives market in Hong Kong. The Amendment Ordinance has yet to come into effect pending the drafting of detailed rules for mandatory reporting, clearing and trading of OTC derivative transactions.

In July 2014, the HKMA and the SFC issued a consultation paper to invite the public to comment on the draft of the first set of detailed rules, the Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules (Reporting Rules).

The HKMA and the SFC have now published a paper setting out the conclusions reached from the consultation as well as further consultation on three ancillary issues (November Paper). This briefing provides an overview of the key matters discussed in the November Paper.

B. CONSULTATION CONCLUSIONS AND AMENDMENTS TO THE DRAFT REPORTING RULES

The following are the key conclusions reached by the HKMA and the SFC following the consultation.

1. Product coverage – phased approach confirmed and clarification provided

There was general support for a phased approach in implementing mandatory reporting and related record keeping obligations, beginning with certain types of interest rate swaps (IRS) and non-deliverable forwards (NDF). The HKMA and the SFC currently intend to cover other interest rate and foreign exchange derivatives and certain equity derivatives in the next phase of implementation. Other equity derivatives and credit and commodity derivatives will be covered in subsequent phases.

Relevant definitions in the Reporting Rules have been amended for better clarity in response to comments received, including amendments to ensure that precious metals / commodities are not included in the initial phase of mandatory reporting.

The HKMA and the SFC have also clarified in the November Paper that the definition of IRS covers overnight index swaps but not forward rate agreements, and that structured products with embedded NDF components will not be subject to mandatory reporting.

2. Persons subject to reporting – asset managers and “Hong Kong persons” excluded from the initial phase of implementation; meaning of “conducted in Hong Kong” clarified

The original draft of the Reporting Rules imposed reporting obligations on:

• authorised Institutions (AIs), approved money brokers (AMBs) and licenced corporations (LCs), for (a) transactions to which they are a counterparty, (b) transactions “conducted in Hong Kong” on behalf of affiliates, and (c) transactions entered into on behalf of a counterparty in their capacity as persons licensed/registered to carry on type 9 regulated activity, ie, asset management (Regulated Asset Managers);
• central counterparties (CCPs) that operate in Hong Kong as recognised clearing houses (RCHs) or are authorised to provide automatic trading services (ATS-CCPs); and
• “Hong Kong persons”, being Hong Kong residents, entities established under Hong Kong law, and overseas companies registered or required to be registered under the Companies Ordinance.

Regulated Asset Managers and “Hong Kong persons”

In view of comments received during the consultation, the HKMA and the SFC have decided to defer the implementation of mandatory reporting and related record keeping requirements in respect of Regulated Asset Managers and “Hong Kong persons” to a later time.

• With regards to Regulated Asset Managers, feedback has indicated that there are reporting difficulties particular to the fund industry which will require time to address.
• As for “Hong Kong persons”, the HKMA and the SFC agree with the feedback that the reporting obligation should be implemented in phases by the type of reporting entity in line with the approach taken in other jurisdictions, commencing with the more significant players in the market (such as AIs and LCs).

This will enable the initial phase of implementation of the reporting obligation to be progressed without delay and any teething problems to be addressed before such obligation is extended to the wider population.

“Conducted in Hong Kong”

The November Paper provides further explanation on what constitutes a transaction “conducted in Hong Kong” by an AI/AMB/LC on behalf of an affiliate. The HKMA and the SFC reiterate that their intention is to capture transactions where the decision to enter into the transactions is made by a Hong Kong trader and that consequently, purely sales activities will not be caught. They also clarified (among other things) that both junior and senior traders are regarded as “traders” under the Reporting Rules.

In addition, explanations have been provided in relation to three specific scenarios, where transactions are: (a) booked in a global book, (b) executed on an electronic trading platform, and (c) subject to an order routing arrangement.

The HKMA and the SFC have indicated that they will provide further guidance on transactions “conducted in Hong Kong” in the form of FAQs.

3. Exemption for less active AIs, AMBs and LCs (Exempt Person Relief) – criteria amended

Under the original draft of the Reporting Rules, a number of criteria have to be met in order to qualify for the Exempt Person Relief. The two criteria which demonstrate that an AI, AMB or LC is less active are that it has a maximum of five outstanding OTC derivative transactions at any time, and that the outstanding transactions amount in total to a gross notional value of no more than US$30 million. The former criterion has been removed in view of comments received during consultation that the latter criterion alone is sufficient.

The HKMA and the SFC have maintained that once this exemption is lost, it cannot be revived.

4. Concession period and grace period for compliance extended

In view of comments received during consultation, the concession period for setting up a reporting channel to the HKMA’s electronic reporting system (HKTR) has been extended from 3 months to 6 months, to allow market participants more time to prepare for the implementation of the reporting requirements. The grace period of 6 months (which includes the concession period) for backloading of historical transactions has consequently been extended to 9 months.

5. Form, manner and content of reports – clarification provided

The HKMA will be publishing directions and instructions regarding the reporting of transactions to the HKTR. The draft Reporting Rules have been amended to make it clear that a transaction is to be regarded as duly reported if it is reported in accordance with such directions and instructions.

A number of amendments have been made to Schedule 2 of the draft Reporting Rules for better clarity. Schedule 2 sets out the transaction information and particulars to be included when reporting. The amendments relate to, among other things, the reporting of transaction information relating to subsequent events, and the reporting of valuation transaction information.

6. Masking relief – slightly revised to give market participants more time to seek counterparty consent

The original draft of the Reporting Rules proposed a “masking relief”, whereby certain counterparty identifying information can be masked when reporting transaction information, if one of the following criteria is met:

• the laws of, or a regulator/authority in, an overseas jurisdiction (to be designated by the SFC with the HKMA’s consent) prohibit disclosure of such information; or
• in the case of historical transactions only, the disclosure of the particulars requires consent of the counterparty, and consent cannot be obtained despite reasonable efforts.

The HKMA and the SFC have proposed (and are further consulting on) a list of 18 designated overseas jurisdictions for the purpose of the first criterion for the masking relief (legal barriers to disclosure).

In response to requests that the second criterion for the masking relief (absence of counterparty consent) be extended to new transactions, the HKMA and the SFC stated its firm view that this would not be permitted given that barriers which prevent reporting of counterparty identifying information are against the G20’s objectives. However, in order to provide market participants with more time to seek counterparty consent, the HKMA and the SFC will allow the masking relief to cover new transactions entered into within the first six months of the implementation of Reporting Rules. Thereafter, the expectation is that no new transactions should be entered into with counterparties which refuse to provide the relevant consent.

7. Period of record keeping shortened

In view of concerns that the 7-year period for record retention is too long, the period has been shortened to 5 years in the revised draft of the Reporting Rules.

8. Fees for reporting to the HKMA via the HKTR to be increased

The proposed monthly fee for reporting transactions via the HKTR (to be set out in subsidiary legislation) will be increased from HK$3.00 to HK$4.50 for each transaction outstanding on the last business day of each month, and the proposed annual cap will be increased from HK$1 million to HK$1.5 million. This is stated to be necessary due to the need for system enhancements to the HKTR as a result of new regulatory developments.

C. FURTHER CONSULTATION

In the November Paper, the HKMA and the SFC also conduct further consultation on the three ancillary matters. The deadline for comments on these matters is 23 December 2014.

1. Details on the requirement to report daily valuation transaction information

This requirement will apply to AIs, AMBs, LCs and CCPs only. It is intended to be implemented at a later stage, in around the first quarter of 2016.

2. Proposed list of jurisdictions for the masking relief

As discussed above, the HKMA and the SFC have proposed a list of 18 designated overseas jurisdictions, where the disclosure of counterparty identifying information is prohibited under the laws or by the regulators/authorities of the jurisdictions.

3. Proposed list of markets and clearing houses to be excluded from the OTC derivatives regulatory regime

The HKMA and the SFC have proposed a list of overseas markets and clearing houses which are to be excluded from the OTC derivatives regime, on the basis that they are already subject to regulation under their home jurisdiction.

D. LOOKING AHEAD

The November Paper has provided welcome clarification to various issues and queries raised during the consultation. The decision to defer the implementation of mandatory reporting in relation to “Hong Kong persons” and Regulated Asset Managers, pending consideration of the outstanding issues, will enable the initial phase of implementation on active market participants (such as AIs and LCs) to be progressed without delay. It will also enable any teething problems to be addressed before the reporting obligation is extended to the wider population.

The HKMA and the SFC intend to introduce the Reporting Rules into LegCo during the first quarter of 2015, with a view to implementing the Reporting Rules in the same quarter. This first phase of implementation will apply to AIs, AMBs, LCs and RCHs (ATS-CCPs will not be subject to mandatory reporting until mandatory clearing is implemented).

In addition to the remaining phases of the implementation of mandatory reporting, further consultations are being planned in relation to detailed rules for other aspects of the OTC derivatives regulatory regime, including mandatory clearing and mandatory trading. With regards to the detailed rules for mandatory clearing and related record keeping, two rounds of consultation are being planned and are currently targeted to take place during the first to third quarters of 2015. Implementation is expected to take place no earlier than the fourth quarter of 2015, to initially apply to dealer-to-dealer trades only. Application to trades involving non-dealers are expected to take place no earlier than 2016.

Market participants should take note of the draft Reporting Rules and review their internal reporting and record keeping policies to ensure that they comply with the Reporting Rules when such rules come into effect. The Reporting Rules are largely finalised, pending consultation on the three ancillary matters mentioned above, and review by the Department of Justice and the LegCo. Market participants should also take note of the impending consultations on mandatory clearing and mandatory trading and the potential impact on their OTC derivatives businesses.

Appendix 1: Highlights of key changes to the draft Reporting Rules following consultation