Jurisdiction - Hong Kong
Reports and Analysis
Hong Kong – OTC Derivatives Proposals: What Do They Mean For Asset Managers?

17 August, 2012

 

The Hong Kong Monetary Authority (HKMA) and the Hong Kong Securities and Futures Commission (SFC) are currently consulting on changes to the definition of type 9 regulated activity that will affect all Hong Kong asset managers who use over-the-counter (OTC) derivatives in their portfolios. The consultation ends on 31 August. We encourage you to read the consultation paper. 
 
This article gives a brief summary of the proposals to regulate the Hong Kong OTC derivatives market, asks what the proposals in their current form mean for asset managers and notes key dates to keep in mind.
 
Background – The consultation process
 
In October 2011, the HKMA and the SFC issued a joint consultation paper on their proposals to regulate the OTC derivatives market in Hong Kong (First Consultation Paper), available here. In July 2012, the HKMA and the SFC published their consultation conclusions in response to submissions made on the First Consultation Paper (Consultation Conclusions), available here. They also published a supplemental consultation paper on the proposed scope of new/expanded regulated activities and regulatory oversight of systemically important players (Supplemental Consultation), available here.
 
Summary of current proposals
 
The key elements of the current proposals are:
 
  • Joint regulation by the HKMA and the SFC. The HKMA will oversee and regulate authorised institutions (banks) and approved money brokers. The SFC will oversee and regulate licensed corporations (including asset managers) and others. 
  • The regulatory framework will be set out in the Securities and Futures Ordinance. Detailed requirements on reporting and central clearing, including which types of OTC derivatives are subject to the requirements, will be set out in subsidiary legislation. 
  • A new type 11 regulated activity for persons who deal in or advise on OTC derivatives. 
  • A new type 12 regulated activity for persons who act as clearing agents in the OTC derivatives market. 
  • Requirement to report OTC derivatives transactions of a specified type (reportable transactions). 
  • Mandatory reporting will initially apply to single currency interest rate swaps, overnight index swaps, single currency basis swaps and non-deliverable forwards. 
  • Requirement to clear standardised OTC derivatives transactions of a specified type (clearing eligible transactions) through a designated central counterparty. 
 
What do the proposals mean for asset managers?
 
Do the proposals affect me if I’m an overseas manager?
 
Not directly, but be aware that clients subject to a reporting obligation may ask that you report on their behalf. 
 
Your client will be subject to a reporting obligation if: 
 
  • it is a Hong Kong person 
  • you enter into a reportable transaction on its behalf (i.e. your client is a counterparty to the transaction), and 
  • it has exceeded the reporting threshold. 
 
The following are examples of “Hong Kong persons”:
 
  • Hong Kong unit trusts 
  • Hong Kong-incorporated or registered companies 
  • other corporate entities established under Hong Kong law, such as the universities and statutory corporations 
  • a retirement scheme or charitable trust set up under Hong Kong law 
 
The “reporting threshold” will be defined on a per product class basis, so there are different thresholds for different types of OTC derivative transactions. For the purpose of determining whether the reporting threshold has been exceeded, a Hong Kong person’s exposure will be calculated on a gross basis. The HKMA and the SFC intend to consult on thresholds and their operation in Q4 2012.
 
As a practical matter, you will only be able to determine whether your client has exceeded the reporting threshold if you are the only investment manager (e.g. where you are delegated investment management of the whole of a Hong Kong unit trust) or your client has confirmed that it has not and will not enter into any other reportable OTC derivatives transactions.
 
I don’t enter into proprietary trades and only manage portfolios for others. Are the proposals relevant to me?
 
Yes. The proposals include persons who originate or execute OTC derivatives transactions for others. 
 
The Consultation Conclusions state that you will be regarded as having “originated or executed” an OTC derivatives transaction where:
 
  • you have agreed with the counterparty the normal economic terms of the transaction, either directly or through an intermediary, and 
  • any entity on whose behalf you have full discretion and authority to agree the terms of the transaction (i.e. your client under a discretionary mandate) has been designated to be the final contracting party to the transaction. 
 
None of the OTC derivatives I trade are subject to the proposed mandatory reporting or mandatory clearing requirements. Do I need to do anything?
 
Yes. You will fall within the regulatory framework and will need to apply to modify your licence if you manage a portfolio of OTC derivatives transactions, even if none of the OTC derivatives you trade are subject to mandatory reporting or clearing obligations. 
 
The proposed definition of “OTC derivatives transactions” is very broad. It will be based on the existing definition of “structured product” in the Securities and Futures Ordinance, but will exclude:
 
  • securities and futures traded on recognised exchanges and markets (either in Hong Kong or overseas), 
  • structured products authorised for public offering in Hong Kong, 
  • securitised products, embedded derivatives and similar products (i.e. products offered by a single issuer to a number of investors), 
  • spot contracts, and 
  • certain retail banking products. 
 
The portfolios I manage include OTC derivatives. I’m already licensed with the SFC for type 9 regulated activity (asset management). Will I need to apply to be licensed for type 11 regulated activity (dealing / advising on OTC derivatives) as well?
 
No, but you will need to apply to the SFC to extend the scope of your existing type 9 licence.
 
Proposed licensing framework for asset managers
 
The Supplemental Consultation proposes the following:
 
  • The definition of type 11 regulated activity will have a carve-out for persons licensed or registered for type 9 regulated activity, for the purposes of carrying on that regulated activity. Similar carve-outs already exist in the definitions of “dealing in futures contracts” (type 2 regulated activity), “dealing in securities” (type 1 regulated activity), “advising on futures contracts” (type 5 regulated activity) and “advising on securities” (type 4 regulated activity). 
  • The definition of type 9 regulated activity will be amended to include managing a portfolio of OTC derivatives transactions. 
  • Asset managers who currently include OTC derivatives in their portfolios will need to apply to modify their licence to include the management of portfolios of OTC derivatives transactions as part of their type 9 regulated activity. 
 
Transitional provisions
 
The Supplemental Consultation proposes transitional arrangements so you can continue to include OTC derivatives in the portfolios you manage whilst your application to modify your licence is processed.
 
You will need to:
 
  • submit an application to modify your licence – the Supplemental Consultation proposes a 4-6 week window to submit applications 
  • confirm in your application that you and your responsible officers have engaged in managing portfolios of OTC derivatives in Hong Kong for a specified number of years (a minimum of 2 years is proposed) prior to the date the OTC derivatives regime comes into effect 
 
On submitting your application, your licence will be deemed modified to include managing portfolios of OTC derivatives. This deemed modification will remain in effect until the application is determined. If the SFC determines to reject your application, you will need to cease managing portfolios containing OTC derivatives.
 
I only trade OTC derivatives for hedging purposes. I’ve heard there is an exemption for hedging transactions. Am I subject to the regulatory regime?
 
You will be subject to the regulatory regime. 
 
The Consultation Conclusions state that the HKMA and the SFC are considering an exemption from the mandatory clearing requirements for commercial end users that are non-financial entities and that use OTC derivatives to hedge commercial risks. These transactions will still be subject to the mandatory reporting requirements.
 
When do I need to report OTC derivatives transactions?
 
As a licensed corporation, you will need to report all OTC derivatives transactions you enter into for client portfolios that:
 
  • are reportable transactions, and 
  • have a Hong Kong nexus. 
 
The types of OTC derivatives that constitute “reportable transactions” will be set out in subsidiary legislation. The HKMA and the SFC have indicated that mandatory reporting will initially apply to single currency interest rate swaps, overnight index swaps, single currency basis swaps and non-deliverable forwards. They intend to consult on mandatory reporting requirements in Q4 2012. 
 
The Consultation Conclusions propose that “Hong Kong nexus” be defined as:
 
  1. in the case of equity derivatives and credit derivatives, 
    1. that the underlying entity or the reference entity is listed in Hong Kong, and where there is more than one underlying entity or reference entity, a specified percentage of the entities (and this may be by value or otherwise) are listed in Hong Kong, or 
    2. that the underlying is an index and a specified percentage of the underlying companies (and again, this may be by value or otherwise) are listed in Hong Kong, or 
    3. that the reference entity is, or is wholly owned by, the Government of the Hong Kong Special Administrative Region, and 
  2. in the case of other derivatives, that the underlying asset, currency or rate is denominated in or related to (or includes an asset, currency or rate that is denominated in or related to) Hong Kong dollars or Renminbi.
 
Can I choose which trade repository I report my OTC derivatives transactions to?
 
No. You must report all reportable transactions that have a Hong Kong nexus to the trade repository being established by the HKMA. However, you can appoint a third party (such as a global trade repository) to report on your behalf.
 
Can I use an agent to report OTC derivatives transactions? 
 
Yes. You can appoint a third party (such as a global trade repository) as your agent to report on your behalf. Equally, your clients may appoint you to report transactions on their behalf. The HKMA and the SFC intend to consult on the requirements relating to the appointment of agents in Q4 2012. One issue is the extent to which you will be liable under the penalty provisions of the Securities and Futures Ordinance if your agent fails to report.
 
Some of my clients are central banks and sovereign wealth funds. Do I need to report OTC derivatives transactions I arrange for their accounts?
 
You will need to report all OTC derivatives transactions you enter into for central bank and sovereign wealth fund portfolios that are reportable transactions and have a Hong Kong nexus.
 
The Consultation Conclusions state the HKMA and the SFC are considering an exemption from mandatory reporting requirements for public sector entities involved in the management of public debt. There is no indication the exemption would extend to third parties who manage portfolios for such entities. In fact, the Consultation Conclusions state that the counterparties to OTC derivatives transactions with such entities will still need to report those transactions.
 
Are there situations where I don’t need to report an OTC derivatives transaction but my client(s) need to?
 
Yes, if your client is a Hong Kong person. Generally, a client is not required to report an OTC derivatives transaction where you have already reported that transaction. However, there is a gap between the transactions you are required to report and the transactions that a client who is a Hong Kong person is required to report.
 
You are only required to report a reportable transaction where (i) you have originated or executed the transaction, and (ii) the transaction has a Hong Kong nexus.
 
Your client will be subject to a reporting obligation if:
 
  • it is a Hong Kong person 
  • it is a counterparty to the transaction, whether or not the transaction has a Hong Kong nexus, and 
  • it has exceeded the reporting threshold. 
 
As a result, for clients who are Hong Kong persons, who is required to report depends on whether the OTC derivatives transaction has a Hong Kong nexus. If yes, you will need to report. If no, you do not need to report but your client may need to report. The proposed definition of “Hong Kong nexus” is set out above in the response to When do I need to report OTC derivatives transactions?
 
The following are examples of “Hong Kong persons”:

  • unit trusts established under Hong Kong law 
  • Hong Kong-incorporated or registered companies 
  • other corporate entities established under Hong Kong law, such as the universities and statutory corporations 
  • a retirement scheme or charitable trust set up under Hong Kong law 
 
The “reporting threshold” will be defined on a per product class basis, so there are different thresholds for different types of OTC derivative transactions. For the purpose of determining whether the reporting threshold has been exceeded, a Hong Kong person’s exposure will be calculated on a gross basis. The HKMA and the SFC intend to consult on thresholds and their operation in Q4 2012.
 
I’m the manager of a Hong Kong umbrella unit trust. How do the reporting obligations apply to me and to the sub-funds?
 
If you are licensed for type 9 regulated activity, you will need to report all OTC derivatives transactions you enter into for the sub-funds that are reportable transactions and have a Hong Kong nexus.
 
If the umbrella unit trust is established under Hong Kong law, it will be a Hong Kong person for the purposes of the reporting requirements. As a result, there may be transactions that you are not required to report but that the unit trust is required to report. The HKMA and the SFC intend to consult on the application of the mandatory reporting requirements to funds in Q4 2012. Preliminary indications in the Consultation Conclusions are that:
 
  • the reporting obligation would rest with the legal owner of the assets of the fund e.g. the trustee 
  • each sub-fund should be treated separately for the purposes of the reporting requirements, which means determination of whether the reporting threshold has been met should be made at the sub-fund level 
 
When do the mandatory clearing obligations apply?
 
Subject to limited exceptions, the mandatory clearing obligations will apply where:
 
  • the OTC derivatives transaction is a clearing eligible transaction 
  • one of the counterparties to the transaction is regulated by the HKMA or the SFC or is a Hong Kong person, and 
  • both counterparties exceed the clearing threshold 
 
For asset managers licensed for type 9 regulated activity, that means the mandatory clearing obligations may apply for proprietary transactions and for transactions on behalf of clients who are Hong Kong persons.
 
The HKMA and the SFC have indicated they are considering exceptions from the mandatory clearing obligations for:
 
  • transactions with certain central banks, monetary authorities or public bodies charged with the management of public debt and reserves and the maintenance of market stability, as well as global institutions such as the IMF 
  • intra-group transactions 
  • transactions by end-users that are non-financial entities and that are used to hedge commercial risks 
  • transactions involving participants from “closed markets” – jurisdictions which have a material level of foreign exchange control and/or other local regulatory restrictions that make it impractical to require clearing to take place in any other jurisdiction 
 
The transactions that will constitute clearing eligible transactions and the clearing thresholds and their operation will be the subject of further consultation, intended for Q4 2012.
 
If I enter into clearing eligible transactions for my clients’portfolios, do I need to ensure my clients clear those transactions?
 
No, but you should:
 
  • get representations from the counterparties to the transactions that the counterparties do (or do not) exceed the clearing threshold (as proposed in the Consultation Conclusions) 
  • get agreement from your clients that either (i) they will be responsible for clearing any clearing eligible transactions you enter into for their portfolios, or (ii) if you will be responsible for clearing such transactions, they will immediately notify you if they exceed the clearing threshold. 
 
Can I choose which central counterparty (CCP) I use to clear OTC derivatives transactions?
 
Yes, so long as the CCP is a “designated central counterparty”. Both local and overseas CCPs can apply to the SFC to be approved as a “designated central counterparty”.
 
Can I use an agent to clear OTC derivatives transactions?
 
Yes. The Consultation Conclusions support indirect clearing and recognise that you (or your clients) can appoint clearing agents to clear clearing eligible transactions with a designated CCP. The Securities and Futures Ordinance will need to be amended to provide adequate protections for clients in the event of insolvency. The HKMA and the SFC intend to consult on draft amending legislation later this year.
 
What next?
 
Now  
Read the Supplemental Consultation, available here.
 
31 August 2012
Deadline for responses to the Supplemental Consultation.
 
Q4 2012
Proposed date to introduce bill to Legco, amending the Securities and Futures Ordinance to provide the legislative framework for regulation of OTC derivatives.
 
Q4 2012
HKMA and SFC to conduct public consultation on draft subsidiary legislation, including: 
 
  • reportable transactions 
  • reporting thresholds 
  • clearing eligible transactions 
  • clearing thresholds 
 
End 2012
Proposed date for the start of operations of the central counterparty to start operating.
 
Q2 2013
HKMA trade repository ready to receive trade reports for OTC derivative transactions.

 

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For further information, please contact:

 

Scott Carnachan, Deacons

[email protected]

 
 

 

 

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