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30 August, 2016
On 1 September 2016, the first phase of mandatory clearing of over-the-counter (OTC) derivative transactions (Phase 1 Clearing) will be implemented. The first transactions to be potentially subject to mandatory clearing will be those entered into on or after 1 July 2017. Also on 1 September 2016, mandatory reporting of OTC derivative transactions will apply to central counterparties (CCPs) which are authorised to provide automated trading services (ATS) for clearing such transactions.
As part of the reform to regulate OTC derivative transactions in Hong Kong, the definition of ATS under the Securities and Futures Ordinance (SFO) will be expanded. As a result, CCPs which currently provide or market clearing services for OTC derivative transactions will need to be authorised as ATS providers under the SFO. The Guidelines for the Regulation of Automated Trading Services (ATS Guidelines) will be amended to reflect these changes. Given the inter-connection between the updated ATS framework and the CCPs' clearing obligations, the revised ATS Guidelines will take effect at the same time as Phase 1 Clearing, on 1 September 2016.
This follows the implementation of the first phase of mandatory reporting of OTC derivative transactions (Phase 1 Reporting) on 10 July 2015. The second phase (Phase 2 Reporting) is targeted for 1 July 2017.
For details of the history of the OTC derivatives regulatory reform, please see our previous e-bulletins of 5 August 2014, 12 December 2014, 18 June 2015 and 16 March 2016.
WHAT IS HAPPENING ON 1 SEPTEMBER 2016
A. Phase 1 Clearing
1. Overview
Phase 1 Clearing will cover transactions in certain standardised interest rate swaps (IRSs) only – plain vanilla basis swaps, fixed-to-floating swaps and overnight index swaps.
A prescribed person (ie, authorised institution, licensed corporation or approved money broker) is required to clear a specified OTC derivative transaction with a designated CCP within 1 Hong Kong business day after that transaction is entered into, if the counterparty is:
- also a prescribed person; or
- a financial services provider.
Having said that, for the transaction to be subject to clearing, it also has to exceed a specified clearing threshold.
Phase 1 Clearing will come into effect on 1 September 2016. The first calculation period will be 1 September 2016 to 30 November 2016, and the first prescribed day will be 1 July 2017. The calculation period is used to determine if one's position in the relevant OTC derivative transaction has crossed the clearing threshold. Once the clearing threshold is crossed, the clearing obligation will start to apply to those transactions entered into after the prescribed day. The primary reason for the time gap between November 2016 and July 2017 is to allow the prescribed persons sufficient time to prepare themselves and be ready for the clearing obligation.
Further details on Phase 1 Clearing, such as in relation to clearing thresholds, onus on prescribed persons, record keeping, exemptions to the clearing obligation and substituted compliance, can be found in our e-bulletin of 16 March 2016.
The key subsidiary legislation for implementing Phase 1 Clearing (Securities and Futures (OTC Derivative Transactions – Clearing and Record Keeping Obligations and Designation of Central Counterparties) Rules) will come into effect on 1 September 2016. The following were published in the Gazette on 26 August 2016:
- List of financial services providers; and
- List of comparable jurisdictions for substituted compliance.
CCPs wishing to provide mandatory clearing services for OTC derivative transactions from 1 September 2016 were required to submit their applications for ATS authorisation and CCP designation by 29 April 2016. Guidance on such applications is provided in the revised ATS Guidelines (in Sections E and F).
2. Key issues from 15 July 2016 consultation conclusions
In the recent consultation conclusions of July 2016, the SFC and the HKMA (Regulators) clarified various issues relating to Phase 1 Clearing. They included the following (amongst others):
List of financial services providers: To address industry concerns about the difficulties in determining whether a counterparty is a financial services provider for the purpose of Phase 1 Clearing, the Regulators revised the list of financial service providers, and made it clear that the list comprises entities that:
(a) are members of the largest IRS CCPs in the US, Europe, Japan and Hong Kong as at 5 February 2016; and
(b) belong to a group appearing on the list of global systemically important banks published by the Financial Stability Board in November 2015, and/or on the list of dealer groups which undertook to work collaboratively with CCPs, infrastructure providers and global supervisors to continue to make structural improvements to the global OTC derivatives markets.
Intra-group transactions: The Regulators confirmed that intra-group transactions should be included for the purpose of the clearing threshold calculation.
B. Application of mandatory reporting obligation to CCPs authorised to provide ATS
From 1 September 2016, the mandatory reporting obligation will apply to CCPs which are authorised to provide ATS for clearing OTC derivative transactions (ATS-CCPs). Given Phase 2 Reporting will not be implemented until 1 July 2017, ATS-CCPs will, in the meantime, only be required to report transactions and transaction information falling within the narrower product scope and information scope applicable under Phase 1 Reporting.
C. Revised ATS Guidelines
As mentioned above, the revised ATS Guidelines will come into effect on 1 September 2016.
Revisions to the ATS Guidelines were proposed in November 2015, and aimed to take into account the following:
the implementation of the regulation of OTC derivative transactions;
international standards and best practices since the publication of the current ATS Guidelines in 2003; and
the SFC's experience in regulating ATS since 2003.
An overview of the proposed revisions to the ATS Guidelines can be found in our e-bulletin of 28 January 2016. Following public consultation, the SFC issued consultation conclusions in March 2016 and made a few changes to the ATS Guidelines in light of the respondents' requests for clarification on issues. The final version of the revised ATS Guidelines can be accessed here.
In the March 2016 consultation conclusions, the SFC confirmed that the SFO provides 2 separate regimes for regulating ATS. ATS providers may either be authorised to provide ATS under Part III, or licensed or registered for Type 7 regulated activities under Part V. A Part III authorisation is appropriate for entities which provide ATS as a core function (typically those which offer facilities similar to that of a traditional exchange or clearing house/CCP), whereas a Part V licence/registration is appropriate where the provision of ATS is incidental to the performance of a dealing function and is an added service only.
The following are some of the other matters discussed in the consultation conclusions:
The revised ATS Guidelines apply to both existing authorised ATS providers and new applicants. Whether the ATS Guidelines also apply to middleware providers and others providing services that connect an ATS provider and its participants/members will depend on whether the specific services provided constitute ATS as defined in the SFO.
In response to a comment requesting clarity on the overlap between the core standards of practice under the revised ATS Guidelines (Core Standards) and the existing obligations of Part V ATS providers under the SFO, the SFC has clarified (and added an express statement to the ATS Guidelines) that a Part V ATS provider will normally meet the Core Standards by complying with the applicable SFO provisions. Although the Core Standards are generally intended to apply to all ATS providers, their application to Part V ATS providers will be subject to the relevant SFO provisions.
Under Core Standard 3 of the revised ATS Guidelines, the SFC may require an independent assessment of the integrity of electronic facilities used for the provision of ATS. The SFC has added a definition of "independent assessment", being any formal review, assessment or examination conducted by a party which is independent from the relevant ATS provider and possesses the necessary skills and expertise to conduct such assessment. It may include an assessment conducted by the ATS provider's home regulator.
WHAT IS HAPPENING ON 1 JULY 2017
Phase 2 Reporting will be implemented on 1 July 2017. It will cover all OTC derivative transactions in five key asset classes, ie, interest rate, foreign exchange, equity, credit and commodity derivatives. Phase 1 Reporting only covered certain IRSs and non-deliverable forwards.
The scope of transaction information to be reported is expanded as a result of the expanded product scope. The specific data fields to be completed in respect of each asset class have been updated in the recent consultation conclusions of July 2016, in light of feedback received. The following are examples of the changes/clarifications made:
The data fields titled “Remarks 1” and “Remarks 2” have been renamed. The former will be renamed “Special Terms Indicator”, which is used to indicate whether there are any core economic terms materially affecting the pricing of the transaction which have not been captured via other fields. The latter will be renamed “Hybrid-Other Asset Class”, which is used to specify asset classes that involve hybrid trades.
The data fields on days, periods and pricing will only need to be completed if they are relevant to the product type.
The Regulators have agreed that with respect to transactions with private individuals, only internal code references relating to such persons (and no other counterparty identifying particulars, including their names) should be provided, due to privacy concerns and legal restrictions on disclosure of personal data.
Further details on Phase 2 Reporting, such as in relation to relief from reporting, mandated daily reporting of valuation information and record keeping, can be found in our e-bulletin of 16 March 2016.
The amendments to the key subsidiary legislation for implementing Phase 2 Reporting (Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) (Amendment) Rules 2016) will come into effect on 1 July 2017. The data fields will be published in the Gazette by the same date (this was finalised in the consultation conclusions of July 2016 – see
Appendix C).
In the meantime, the HKMA is preparing for the next phase of system enhancements for the Hong Kong Trade Repository, which is expected to be available for testing by market participants in the first quarter of 2017.
GOING FORWARD
The aspects of the OTC derivatives regulatory regime which remain to be implemented include the following (amongst others):
- further expansion of mandatory reporting and clearing;
- mandatory trading;
- regulation of systematically important participants (SIPs); and
- licensing of intermediaries for carrying out the regulated activities in relation to dealing in, advising on or providing client clearing services for OTC derivative transactions.
The implementation of the licensing regime will also require the amendments to the Securities and Futures (Financial Resources) Rules (FRR). While consultation on the proposed amendments was completed in 2015, the SFC has yet to issue its consultation conclusions. The Government and the SFC envisage that the licensing regime will be put in place in 2017-2018 the earliest.
The SFC is likely to require more time to examine the OTC derivatives information collected from the market and the relevant international standards before formulating suitable proposals to implement the mandatory trading obligation and regulation of SIPs.
Having regard to the time required to work out the details and prepare the necessary subsidiary legislation, implementation of all remaining stages of the regulatory regime will continue to be ongoing and is not expected to be completed until after 2018.
For further information, please contact:
William Hallatt, Partner, Herbert Smith Freehills
William.Hallatt@hsf.com
