19 June, 2015
The Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) are on course to implement the first phase of the new over-the-counter (OTC) derivatives regime in July 2015. This includes:
- the implementation of the broad framework of the new regulatory regime under the Securities and Futures Ordinance (SFO); and
- the introduction of mandatory reporting requirements and related record keeping obligations, via the Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules (Reporting Rules), for a specified range of OTC derivative products, namely, certain types of interest rate swaps and non-deliverable forwards.
The Reporting Rules and other related subsidiary legislation have been tabled before the Legislative Council and are targeted to come into effect on 10 July 2015, together with the relevant provisions of the SFO.
It is intended that this first phase of implementation will apply to the regulated entities, ie, authorised institutions (AIs), approved money brokers (AMBs), licensed corporations (LCs) and central counterparties (CCPs) operating in Hong Kong.
Breif History Of The Reform
A common consensus that came out of the G20 Leader’s September 2009 Communique was that an OTC regulatory regime should be developed to improve overall transparency in the OTC derivatives market, reduce inter-connectedness of participants, and generally reduce systemic risk in the financial system.
In line with this objective, the HKMA and the SFC conducted two rounds of consultation in 2011 and 2012, respectively. The responses received during the consultation formed the basis of amendments to the SFO to provide a framework for the new OTC derivatives regulatory regime. The Securities and Futures (Amendment) Ordinance 2014 was enacted in April 2014 but is yet to come into effect.
The HKMA and the SFC then commenced consultation in July 2014 to seek views on its draft Reporting Rules, and published their conclusions in November 2014. Please refer to our e-bulletins ofAugust 2014 and December 2014 for further details in this regard.
In their November 2014 paper, the HKMA and the SFC invited further comments from the public on three ancillary matters relating to the Reporting Rules. The consultation conclusions were recently published on 15 May 2015.
Conclusions On The Three Ancillary Matters
In brief, the HKMA and the SFC sought further views from the public on the following three matters:
- the proposed requirements for reporting valuation transaction information, including the proposed reporting timeframe, implementation timetable and approach;
- the proposed list of jurisdictions to be designated for the purposes of the masking relief; and
- the proposed list of markets and list of clearing houses to be prescribed by the Financial Secretary for the purposes of the definition of “OTC derivative product”.
1. Reporting Of Valuation Transaction Information
The HKMA and the SFC have proposed that valuation information on transactions should be reported on a daily basis. However, given the concerns that a CCP’s valuation determination may not be available to the reporting entities in time, it was decided that the requirement to submit daily valuation reports would be deferred to a later stage after additional consultation.
2. Designation Of Jurisdictions For Masking Relief
The HKMA and the SFC also sought views on the proposed list of jurisdictions to be designated for the purposes of the masking relief. A counterparty’s identifying information can be masked when reporting transaction information, if certain criteria can be met.
Despite suggestions by industry participants to add three additional jurisdictions (ie Saudi Arabia, Brunei and Kuwait) to the list on the basis that the application of local privacy and confidentiality rules in these jurisdictions is uncertain, the HKMA and the SFC have concluded that the list will remain unchanged, as no legal opinion was provided to support these specific additions.
Moreover, readers of this e-bulletin should be mindful that the masking relief is only intended as a temporary measure and that it will ultimately be withdrawn in line with global efforts to remove barriers to reporting.
Likewise, while there were concerns that a counterparty’s consent for making the relevant disclosures may not be obtained in the first six months after commencement of the Reporting Rules, the HKMA and the SFC have taken the view that such period should not be further extended since the six-month concessionary period is already sufficient to allow flexibility in securing consents from counterparties.
3. Prescription Of Markets And Clearing Houses
With respect to the proposed list of stock and futures markets, and the proposed list of clearing houses to be prescribed for the purposes of the definition of “OTC derivative product”, the HKMA and the SFC agreed to incorporate a further 15 operations to the proposed lists. The final list of markets and clearing houses to be prescribed is set out in Appendix C of the May 2015 consultation conclusions. Products traded on or cleared through these entities will not fall within the new regulatory regime.
At present, the HKMA and the SFC do not propose to include US swap execution facilities and EU multilateral trading facilities, which are operations more commonly used for executing OTC derivative transactions. However, the HKMA and the SFC have indicated that they will reassess and revisit the suitability of the OTC products that are excluded from the first phase of the implementation once they gain a better understanding of activities in the OTC derivatives market.
Other Issues
Below are some of the other major clarifications and clarificatory amendments that arose from this further consultation exercise:
1. Futures And Options Contracts
There were queries on whether the definition of “future and options contracts” covers “off market” and “back-to-back transactions”.
The HKMA and the SFC clarified that, so long as the futures or options contract is executed or registered on a prescribed market and cleared through a prescribed clearing house, the related “off market” and "back-to-back transaction" will not be subject to mandatory reporting.
2. Definition Of “Affiliate”
Notwithstanding the HKMA’s and the SFC’s decision to defer the implementation of the fund manager reporting obligation (ie the obligation on AIs and LCs that are registered or licensed to carry out the Type 9 regulated activity to report transactions that they have entered into in their capacity as fund managers), there were concerns that this was not fully reflected in the Reporting Rules.
The HKMA and the SFC have acknowledged this concern and proposed to address this by amending the definition of “affiliate” so that it expressly excludes collective investment schemes.
3. Timeframe For Reporting Transactions “Conducted In Hong Kong”
There were concerns that it may be difficult to put in place systems for identifying transactions “conducted in Hong Kong” by early July 2015, when the Reporting Rules are targeted to commence.
The HKMA and the SFC remain of the view that transactions executed after the commencement of the Reporting Rules should be reported.
Moreover, the HKMA and the SFC have already prepared a set of draft Frequently Asked Questions to assist market participants in understanding, and complying with, the Reporting Rules. These will be finalised when the new regime comes into effect.
Although the reporting regime is yet to be implemented, licensed banks have since 2013 been required by the HKMA to report specified OTC derivatives transactions to the HKMA’s trade repository under an interim arrangement (which is essentially a simplified version of the proposed new reporting requirements). To this end, the HKMA has issued a circular on 11 June 2015 to licensed banks advising them that the interim reporting requirements will cease to apply upon commencement of the Reporting Rules. The circular also attaches a Supplementary Guidance regarding the transition from interim arrangement to the new reporting regime.
4. Record Keeping Obligations
After hearing the industry’s concerns, the HKMA and the SFC now propose to only require records to be kept in a manner that enables them to be readily accessible. There will be no requirement for records to be readily searchable and identifiable by reference to a particular transaction and counterparty.
The proposed requirement on firms to keep records that evidence the communications and instructions which resulted in a transaction being executed has also been removed.
The Way Forward
The HKMA and the SFC are working on the next phases of the regulatory regime, developing detailed rules for:
- extending the mandatory reporting obligation to cover all types of interest rate derivatives and foreign exchange derivatives not covered in the first phase, as well as all other classes of OTC derivative products; and
- the mandatory clearing of and related record keeping in respect of dealer-to-dealer transactions.
Further consultations in respect of (1) will likely take place in late Q2 or early Q3 of 2015, while the SFC plans to consult the market more generally on (2) later this year.
For further information, please contact:
William Hallat, Herbert Smith Freehills
william.hallatt@hsf.com
Jojo Fan Herbert Smith Freehills
jojo.fan@hsf.com
Valerie Tao, Herbert Smith Freehills
valerie.tao@hsf.com
