16 March, 2016
With the enactment of the Securities and Futures (Amendment) Ordinance 2014 in April 2014 and the implementation of the Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules (Reporting Rules) on 10 July 2015, the first phase of the over-the-counter (OTC) derivatives regulatory regime introduced mandatory reporting in respect of certain interest rate swaps (IRSs) and non-deliverable forwards (NDFs).
These requirements essentially apply to authorized institutions (AIs), licensed corporations (LCs), approved money brokers (AMBs) and central counterparties (CCPs) which are required to report both new transactions (ie, those entered into after 10 July 2015) and existing ones that are still outstanding. For details of the history of the regulatory reform and developments, please see our previous e-bulletins dated 5 August 2014, 12 December 2014 and 18 June 2015.
On 30 September 2015, the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) (together, Regulators) issued a joint consultation paper (CP) to invite the public to comment on the proposals for the first phase of mandatory clearing obligations (phase 1 clearing) and an expanded second phase of mandatory reporting obligations (phase 2 reporting). Separately, the SFC also issued a circular on 22 October 2015 to summarise the implementation of the OTC derivatives regulatory regime to date and the CP proposals.
On 6 February 2016, the HKMA and SFC published the conclusions of the joint consultation (Conclusions Paper). This e-bulletin provides a high level overview of the key requirements which will apply to firms in light of the conclusions reached.
A. PROPOSALS FOR PHASE 1 MANDATORY CLEARING
Below is a summary of the key points in relation to the phase 1 clearing obligation. Readers of this e-bulletin may refer to the revised draft Securities and Futures (OTC Derivative Transactions – Clearing and Record Keeping Obligations and Designation of Central Counterparties) Rules (Draft Clearing Rules) in Appendix B of the Conclusions Paper for further details.
1. Proposed scope of the phase 1 clearing obligation
a. Product types to be covered
The proposed phase 1 clearing obligation only covers transactions in certain standardised IRSs in Hong Kong (plain vanilla basis swaps, fixed-to-floating swaps and overnight index swaps). Non-deliverable forwards and forward rate agreements will not be covered by phase 1 clearing.
The Regulators also intend to publish a set of “Frequently Asked Questions” in due course which will set out their view on queries regarding certain product types.
b. Only dealer-to-dealer transactions covered in phase 1 clearing
Phase 1 clearing focuses on transactions which pose the greatest systemic risk, so only transactions between major dealers will be subject to mandatory clearing.
A transaction will be a dealer-to-dealer transaction and therefore subject to phase 1 clearing when a prescribed person enters into a transaction with either:
- another prescribed person, where the transaction is entered into on or after the relevant day on which both counterparties exceed a specified threshold in respect of their outstanding OTC derivative positions (Clearing Threshold); or
- a “financial services provider”, where the transaction is entered into on or after the relevant day on which the prescribed person exceeds the Clearing Threshold.
Where the prescribed person is an overseas-incorporated authorized financial institution or AMB, the phase 1 clearing obligation will only apply to it if the transaction is booked in its Hong Kong branch.
The definition of “financial services provider” now refers to a list of firms prescribed by the SFC (with the HKMA’s consent) to be published in the Government Gazette, and no clearing threshold will apply to financial services providers. The HKMA and SFC are consulting on the proposed list of financial services providers, included at Appendix D of the Conclusions Paper.
c. Clearing Thresholds
The table below summarises the revised Clearing Thresholds proposed under phase 1 clearing:
|
Clearing Threshold for local AI, AMB or LC (taking account of its outstanding positions globally) |
Clearing Threshold for overseas AI, AMB or LC (taking account of only outstanding positions booked to its Hong Kong branch) |
Clearing Threshold for financial services provider |
|
US$20 billion |
US$20 billion |
No clearing threshold (see section (b) above). |
Following the consultation, the approach has been amended so that for prescribed persons incorporated overseas, only positions booked in Hong Kong will count towards the Clearing Threshold. The threshold amount is US$20 billion for both overseas-incorporated and local firms, and the calculation period remains at 3 months.
All OTC derivative transactions (excepting only deliverable FX forwards and deliverable FX swaps) will be taken into account when determining if the Clearing Threshold has been crossed. A person’s average position during a calculation period will determine if it has crossed the Clearing Threshold for that period.
d. Commencement of phase 1 clearing
Respondents to the consultation raised concerns on whether sufficient CCPs would be designated by the Regulators in time for the original commencement date for phase 1 clearing (1 July 2016). To address these concerns, the commencement of the clearing rules will be delayed until 1 September 2016.
2. Compliance with the clearing obligation
a. Onus on prescribed persons
To discharge the clearing obligation, the Regulators expect prescribed persons to confirm the nature of its counterparty and whether it or its counterparty have crossed the Clearing Threshold for the latest or any previous calculation period. The Regulators expect firms to obtain written confirmation from their counterparties on these points.
Upon determining that a transaction is subject to the clearing obligation, the prescribed person should then take all reasonable steps to ensure that the transaction is actually cleared by a designated CCP or terminated (as appropriate).
b. Timeframe for clearing
Transactions subject to mandatory clearing must be cleared within 1 Hong Kong business day after they are entered into (T+1).
c. Record keeping
A prescribed person must also keep records of all OTC derivative transactions to which the clearing obligation applies for at least 5 years following maturity or termination.
3. Exemptions and substituted compliance
There will be three exemptions to the clearing obligation covering (i) intra-group transactions, (ii) transactions booked in one or more pre-identified overseas jurisdictions and (iii) transactions resulting from a multilateral portfolio compression cycle. The requirements of these exemptions can be quite technical and will likely need to be looked at in further detail.
Substituted compliance will be available in relation to cross-border transactions which are centrally cleared under a comparable jurisdiction through a designated CCP. The list of comparable jurisdictions currently includes Australia, Brazil, Canada, member states of the European Union, Japan, Singapore, Switzerland and the United States.
B. PROPOSALS FOR PHASE 2 MANDATORY REPORTING
The Regulators have expanded the scope of products subject to reporting and the transaction information required to be reported, and mandated daily reporting of valuation information.
The detailed scope of the phase 2 reporting proposal is set out in the revised draft Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules (Draft Expanded Reporting Rules) in Appendix C of the
Conclusions Paper.
1. Expanded product scope
Phase 2 reporting requires reporting of transactions in all OTC derivative products in the five key asset classes – interest rate, FX, equity, credit and commodity derivatives.
The Regulators have confirmed that all FX forwards, FX NDFs, FX swaps and FX options should generally be caught unless they can be shown to fall within an exemption to the definition of OTC derivative product.
2. Commencement of phase 2 reporting
The Regulators have increased the deferral period to 12 months, meaning that Phase 2 reporting will commence on 1 July 2017.
3. Application of reporting obligation to CCPs authorised to provide automatic trading services
The mandatory reporting obligation will now also apply to CCPs that are authorised to provide automatic trading services (ATS) for clearing OTC derivative products (ATS-CCP). The mandatory reporting obligation will apply to ATS-CCPs from the implementation of phase 1 clearing (1 September 2016). Given phase 2 reporting will not yet be implemented by that time, ATS-CCPs will only be required to report transactions and transaction information falling within the narrower product scope and information scope applicable under phase 1 reporting.
Readers of this e-bulletin should also note that the SFC has conducted a consultation on certain proposed changes to the Guidelines for the Regulation of Automated Trading Services(ATS Guidelines). The conclusions of that consultation have now been published, and the SFC has made a few drafting changes to the ATS Guidelines in light of the feedback received.
4. Relief from phase 2 reporting
The concepts of product classes and product types have been removed from the Draft Expanded Reporting Rules. This means that the trigger level for exempt person relief will remain at US$30 million, but it will apply across all asset classes (not on a per product class basis).
The Regulators have confirmed that the masking relief in respect of transactions that require counterparty consent will not be extended further.
The other forms of relief provided in respect of phase 1 reporting will continue to apply under phase 2.
5. Expanded scope of transaction information to be reported
Under phase 2 reporting, the scope of transaction information to be reported is expanded as a result of the expanded product scope.
As the transaction information to be reported is highly technical and complex, the Draft Expanded Reporting Rules only set out, in broad terms, the categories of information that have to be reported. Specific data fields to be completed in respect of each category are proposed to be published separately by notice in the Gazette. The SFC plans to publish its response to feedback on the proposed data fields for reporting in a separate conclusions paper shortly.
6. Reporting of valuation information
Daily valuation information on OTC derivative positions will need to be reported to the HKMA. Each report shall be made within 2 days of the valuation.
7. Record keeping for phase 2 reporting
The record keeping requirements remain the same as under phase 1 reporting. However, these will now be expanded to apply in respect of the expanded product scope under phase 2.
C. TIMELINE
Subject to the legislative process, it is now expected that phase 1 clearing will be implemented on 1 September 2016, meaning the first transactions to potentially be subject to mandatory clearing will be those entered into on or after 1 July 2017. Phase 2 reporting will commence on 1 July 2017.
D. OTHER ASPECTS TO BE IMPLEMENTED IN FUTURE PHASES
Amongst others, the following aspects of the OTC derivatives regulatory regime remain to be implemented in future phases:
- further expansion of mandatory reporting and clearing;
- implementation of the new systematically important persons regime; and
- implementation of the licensing regime for new and expanded regulated activities to cover OTC derivative transactions or products (ie, introduction of the new Type 11 and Type 12 licences, and expansion of the Type 7 and Type 9 licences).
The OTC derivatives licensing regime, in particular, is not expected to be implemented before mid-2016.
For further information, please contact:
William Hallatt, Partner, Herbert Smith Freehills
William.Hallatt@hsf.com
