Jurisdiction - Hong Kong
Hong Kong – Regulatory Update.

29 December, 2011


Hong Kong regulators maintained a strong momentum for reforms for the financial sector during the last quarter.  These reforms are creating a regulatory blueprint for 2012-2013 that leaves very few areas of business untouched – and certainly no prospect of monotony for legal and compliance teams in the region. 



A. New OTC derivatives regime
The first round of consultation for a new regulatory regime for over-the-counter (OTC) derivatives concluded on 30 November 2011. 
Spearheaded jointly by the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC), the high-level proposals provided much needed clarity on how Hong Kong regulators interpreted the G20 mandate for the local market.
As expected, the initial products to be covered are interest rate swaps and non-deliverable forwards, and the proposed target date for implementation remains end 2012. 
The following table provides a snapshot of the proposals so far:
In addition, the regulators have flagged oversight of other “large players” and higher capital and (possibly) margin requirements for uncleared trades.
Overall, the proposals are fairly balanced and it is evident that the Hong Kong regulators are trying to follow their international counterparts in designing the new OTC derivatives regime. 
Nevertheless, one of the most controversial features of the proposed regime is the suggestion that trades that are “originated or executed” by Hong Kong market participants must be reported and cleared – even if both counterparties are offshore and fall outside the regime (subject to limited relief).  The regulators cite the “unique” Hong Kong offshore booking model as the reason.  However, this is an alarming proposal for a number of reasons: it exceeds international proposals, creates an overwhelming compliance burden and risks overlapping clearing obligations.  Arguably, it would also do little to manage systemic risk in Hong Kong.
There are other aspects of the proposals that need to be ironed out.  For example, the proposed definition of “OTC derivatives transactions” captures privately placed structured products with embedded derivatives – not just derivatives themselves.  The industry is also waiting for more details to emerge in relation to the collateral / margin requirements to facilitate modelling.
B. Short position reporting
A new reporting regime for short positions is expected to be implemented by the end of Q1 2012.  It will sit alongside the existing Hong Kong short selling rules, which generally prohibit naked short sales and regulate covered short sales in specified listed stock.
The proposed new Securities and Futures (Short Position Reporting) Rules (Reporting Rules) impose a weekly reporting obligation where a person has a net short position[4] in shares of a constituent company of the Hang Seng Index or the Hang Seng China Enterprises Index or another specified company, which amounts to (or exceeds) the lower of: (a) 0.02% of the closing price of the total relevant shares issued by that company; or (b) HK$30 million.
The Reporting Rules will only apply to short positions arising from trading on The Stock Exchange of Hong Kong Limited (Exchange) and other trading venues specified by the SFC, and exclude those arising via OTC trading.  The Reporting Rules also empower the SFC to require daily reporting in contingency situations, where the SFC believes that there exist circumstances that threaten (or may threaten) the financial stability of Hong Kong.
Importantly, market makers and offshore investors will be caught by the Reporting Rules.  Agency reporting will be allowed, but (as might be expected) the principal will remain legally responsible for compliance.  The stakes are high: the SFC has proposed making a breach of the new reporting regime a criminal offence and setting the maximum penalties at a level 6 fine and imprisonment for up to two years.
The new reporting regime has already been through several rounds of consultation – the last concluding on 4 November 2011.  In light of the timetable, market participants should start planning for the new regime by updating their reporting systems and procedures.
C. Professional investors
We recently reported (in our September alert) that changes were expected to be made to the accreditation requirements for high net worth professional investors under the Securities and Futures (Professional Investor) Rules (Cap. 571D) (Professional Investor Rules).
Like others, we predicted that the amendments – proposed by the SFC, largely supported by the public and subject only to a negative vetting procedure by the Legislative Council – would be implemented smoothly.  Clearly, we all spoke too soon.
Since our last report, an eight-member Subcommittee of the Legislative Council was formed to examine the draft Professional Investor Rules.  Much to the chagrin of industry participants, several further proposals were mooted (including a possible increase in the minimum portfolio requirement for individuals), but following several question/answer rounds with the SFC, no further changes were recommended by that Subcommittee to the Legislative Council.  
However, a single member of that Subcommittee disagreed, and formally proposed that the qualitative expertise, knowledge and experience requirements for high net worth professional investors under the SFC Code of Conduct (which exempts them from certain know-your-client (KYC) and selling rules) be shifted into the Professional Investor Rules.  The proposal was voted down by the Legislative Council – much to the relief of the wealth management industry, including retail and private banks that rely on selling products without SFC authorisation (under an exemption for professional investors that meet the asset and portfolio requirements Professional Investor Rules) to a retail KYC standard (that is, to investors that have not been accredited under the qualitative SFC Code of Conduct standards).  The elimination of that approach could have made several privately placed product lines unviable.
Ultimately, the proposals we described in September therefore appear unaffected and (dare we say) should be implemented shortly.  However, it is reasonable to expect that the issue of accrediting professional investors will be revisited again – for example, after another Legislative Council subcommittee that is enquiring into Lehman Brothers-related structured products releases its report in around mid-2012.
D. New AML/CTF regime
As of 1 April 2012, Hong Kong will have a new anti-money laundering and counter-terrorist financing (AML/CTF) regime for the financial sector.  The reforms respond to a 2007 “mutual evaluation” of Hong Kong by the global standard-setter, the Financial Action Task Force, which identified a number of systemic weaknesses in Hong Kong’s existing AML/CTF framework.
The new regime will comprise three tiers of regulation:
  • legislation – the Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance (AMLO), which also embodies a new licensing regime for remittance agents and money changers;


  • cross-sectoral guidance – subordinate regulatory guidelines that apply to all types of financial institutions covered by the AMLO; and


  • sector-specific guidance – regulatory guidelines issued by each regulator to deal with situations particular to the sector they supervise.
The guidance is currently in the final stages of consultation and is expected to be issued in final form in January 2012 – effectively allowing less than three months for implementation.
There are still a number of key issues on the table.  Major concerns include the extent of KYC requirements for “connected persons” (beneficial owners, directors, account signatories etc), due diligence on trusts and multiple-layered customer arrangements, and, importantly, the role of risk-based decision-making.  Mallesons is actively engaged with the banking industry in negotiating changes to the guidance to ensure that Hong Kong remains competitive on the international stage. 
E. What else is keeping the industry awake at night?
If the structured products reforms of 2010-2011, the proposed OTC derivatives reform of 2012-2013, the Reporting Rules, the new AML/CTF regime and the professional investor rollercoaster ride are not enough, financial institutions in Hong Kong are also grappling with:
  • client breach reporting – a proposal to require SFC-licensed corporations to report legal and regulatory breaches by their clients;


  • capital reforms – the implications of Basel II.5 and Basel III capital and liquidity reforms on Hong Kong Monetary Authority-regulated banks and SFC-licensed corporations (with formal proposals due early 2012);


  • disclosure – new statutory “inside information” reporting requirements for listed corporations; and


  • offshore developments – FATCA and other offshore regulatory developments that have direct and indirect impacts on Hong Kong financial institutions.
2012 promises to be a fascinating challenge.
[1] The regulators explain “originated or executed” as a situation where an entity has “negotiated, arranged, confirmed or committed to a transaction on behalf of itself or any counterparty…and would therefore include the functions of a relevant sales desk or trading desk involved in the transaction”.
[2] A transaction having a “Hong Kong nexus” has been initially defined to mean (a) an equity or credit derivative with an underlying / reference entity that is established, incorporated or listed in Hong Kong or under Hong Kong law; and (b) another type of derivative with an underlying asset, currency or rate denominated in Hong Kong dollars.
[3] If a single legal entity trades on a trading unit / book basis (each with its own objectives and strategies), it will need to aggregate the net positions of each of those units / books and report a consolidated net short position without any internal netting between those units / books.  That effectively means that a unit / book has a net long position, that position is disregarded in the calculation.
[4] The proposed coverage includes Hong Kong residents, owners of sole proprietorships and partnerships that are based in, operated from or registered in Hong Kong, companies incorporated or registered in Hong Kong, funds managed in or from Hong Kong and other entities established or registered under Hong Kong law.
For further information, please contact:
Richard Mazzochi, Mallesons Stephen Jaques
Urszula McCormack, Mallesons Stephen Jaques



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