Hong Kong – SFC Consults On Margin Requirements For Non-Centrally Cleared OTC Derivatives.

Phase-in 

1 September 2019 to 31 August 2020 

HKD 6 trillion 

Permanent 

From 1 September 2020 onwards for each subsequent 12-month period 

HKD 60 billion 

Entity scope 

Entities directly subject to the margin rules (“in-scope entities”) 

Authorized institutions (“AIs”) under the Banking Ordinance (Cap. 155, Laws of Hong Kong) 

Corporations licensed by the Securities and Futures Commission under the Securities and Futures Ordinance (Cap. 571, Laws of Hong Kong) for any type(s) of regulated activities (“licensed corporations” or “LCs”). 

Counterparty types that an in-scope entity must face for the margin rules to apply (“covered entities”) 

(i) Financial counterparties; (ii) significant non-financial counterparties and (iii) entities designated by the HKMA, excluding exempt counterparties. 

AANA thresholds apply to financial counterparties and significant non-financial counterparties. Broadly speaking, an entity will be a financial counterparty or a significant non-financial counterparty (as the case may be) for a one-year period (from 1 September each year to 31 August of the following year) if its group AANA exceeds HK$15 billion (financial counterparties) or HK$60 billion (significant non-financial counterparties). 

(i) Financial counterparties; (ii) significant non-financial counterparties and (iii) entities designated by the SFC, excluding exempt counterparties. 

AANA thresholds apply to financial counterparties and significant non-financial counterparties in the same way as the HKMA margin rules. 

Covered entities: financial counterparties 

LCs which are licenced solely for the Type 7 (providing automated trading services) or the Type 10 (providing credit rating services) regulated activity are excluded from the “LC limb” of the definition of “financial counterparty”. 

All LCs are included as a “financial counterparty” type. 

One of the financial counterparty types is “a special purpose entity as defined in section 227 of the Banking (Capital) Rules, except where and to the extent that the special purpose entity enters into non-centrally cleared derivatives transactions for the sole purpose of hedging.” 

The equivalent is referred to in the proposed SFC margin rules as “a special purpose vehicle or a securitisation vehicle, except where and to the extent that the special purpose vehicle enters into non-centrally cleared OTC derivative transactions for the sole purpose of hedging.” 

Commentary: “Special purpose entity” as defined in section 227 of the Banking (Capital) Rules is confined to vehicles set up for traditional or synthetic securitisation transactions. Vehicles set up for other structured finance transactions (e.g. repackaging vehicles) do not fall under the definition of 

“special purpose entity” under the Banking (Capital) Rules and thus will be “significant non-financial counterparties” if the relevant criteria are met. 

It appears that the inclusion of “special purpose vehicles” under the proposed SFC margin rules as one of the financial counterparty types will capture those vehicles set up for structured finance transactions other than securitisation transactions (e.g. repackaging vehicles) if the relevant criteria are met. 

Exempt counterparties 

(i) Sovereigns, (ii) central banks, (iii) public sector entities, (iv) multilateral development banks and (v) the Bank for International Settlements. 

“Public sector entity” is defined by section 2 of the Banking (Capital) Rules. 

The list of exempt counterparties is the same, although a different definition is used for public sector entities. 

“Public sector entity” is defined to mean “any agency of HKSAR or of a central government that is incorporated or established for non-commercial purposes”. 

Commentary: The definition of “public sector entity” under the proposed SFC margin rules looks at the purpose for which the entity was established. On the other hand, the definition under the HKMA margin rules (which cross-referred to the definition in the Banking (Capital) Rules) looks at the capital treatment for foreign public sector entities and includes an exhaustive list of domestic public sector entities. The two definitions may yield different results. 

Product scope 

Physically settled FX forwards and FX swaps, and the “FX transaction” embedded in cross-currency swaps associated with the exchange of principal 

Exempt from IM and VM requirements. 

Exempt from IM requirements. 

VM requirements apply to these instruments when they are “inter-dealer trades”, i.e., when they are entered into by an in-scope LC with a covered entity which is (i) an AI, (ii) another LC or (iii) an entity that carries on a business outside Hong Kong and is engaged predominantly in any one or more of these activities: (x) banking, (y) securities or derivatives business and (z) asset management. 

HKMA margin rules 

(Proposed) SFC margin rules and our commentaries 

FX security conversion transactions to facilitate the purchase or sale of foreign securities (with a T+7 days’ cap on settlement) are exempt from IM and VM requirements. 

Initial margin requirements 

Use of IM models: approval or authorisation requirements by regulatory authority 

An in-scope AI has to notify the HKMA prior to using an industry-wide standard IM model such as the ISDA SIMM. 

Use of an internally developed IM model or a model sourced from a third-party (other than an industry-wide standard model) has to be formally approved by the HKMA before its use. 

Where an in-scope LC wishes to use a quantitative portfolio margin model to calculate IM, it is required to obtain prior approval in writing from the SFC. This is irrespective of whether the model is an internally-developed or a third-party IM model (including an industry-wide standard IM model). 

Rehypothecation, repledging and reuse of IM 

Prohibited under the HKMA margin rules. 

IM collected from a counterparty may be rehypothecated, repledged or reused with a third party only for the purpose of hedging the in-scope LC’s derivative positions arising out of transactions with the counterparty for which IM was collected, and must be subject to the reuse conditions as set out in the proposed SFC margin rules. 

Commentary: The conditions for reuse are similar to those contained in the report Margin requirements for non-centrally cleared derivatives published by BCBS/IOSCO in March 2015. The conditions are very stringent (e.g. the counterparty cannot be a “market maker” in derivatives, collateral must be treated as client assets by the IM collector and also the third party to which the collateral has been rehypothecated, rehypothecation may only be done once) so the right of reuse may not be useful in practice. 

Variation margin requirements 

Applicable threshold for the exchange of VM 

In-scope AIs are required to exchange VM when they transact with a covered entity; no threshold applies to the in-scope AI. 

In-scope LCs are required to exchange VM with a covered entity for a one-year period from 1 September each year to 31 August of the following year when the in-scope LC has a group average aggregate notional amount (AANA) of non-centrally cleared OTC derivatives exceeding HK$15 billion. 

Commentary: The application of the AANA threshold may lead to certain complications. 

E.g. 1: when an LC trades with an AI and both exceeded the HK$15 billion AANA threshold, the LC will be an in-scope LC for VM under the proposed SFC margin rules and the AI will be an in-scope AI under the HKMA margin rules. VM requirements under both sets of rules will apply to in-scope trades. 

E.g. 2: when an LC trades with an AI and only the LC has exceeded the HK$15 billion AANA threshold, the LC will not be subject to VM requirements under the proposed SFC rules since the AI does not qualify as a covered entity. On the other hand, the AI will be an in-scope AI under the HKMA margin rules facing a covered entity. The AI therefore has to exchange VM with the LC under the HKMA margin rules. 

The industry will certainly benefit from a clarification from the regulators on how and whether substituted compliance can be applied in the two examples above. 

Margin calls and transfers 

Timing for margin calls and transfers 

The HKMA margin rules contain prescriptive timings for margin calls and transfers. 

Specifically, IM to be called by the end of the business day (i.e. before 11:59pm Hong Kong time) following (i) the day of execution of a transaction or (ii) any of the events requiring IM to be re-calculated (i.e. IM to be called by T+1). 

VM to be called no later than the end of the business day (i.e. before 11:59pm Hong Kong time) following the trade date (i.e. VM to be called by T+1). 

IM and VM to be collected within two business days after the call date. 

The SFC proposed that no prescriptive timing be imposed on when margin has to be called and transferred. 

The proposed SFC margin rules provide for IM to be called at the earliest time possible after either execution of a transaction or a change in measured potential future exposure requiring a re-calculation of IM. 

VM to be called at the earliest time possible after the trade date. 

Both IM and VM to be collected as soon as practicable within the standard settlement cycle for the relevant collateral type. 

Eligible collateral and haircuts 

List of eligible collateral 

The items of eligible collateral listed under the HKMA margin rules are slightly different from those in the proposed SFC margin rules. 

As for HKMA margin rules. 

Commentary: These differences will have to be reflected in both legal documentation and collateral management systems of groups with both AIs and LCs where both the HKMA margin rules and the proposed SFC margin rules apply (if no substituted compliance). 

Netting and segregation 

Requirement for legal opinions 

IM and VM exchange is not required where the counterparty is located in a non-netting jurisdiction. IM is not required where there are issues with collateral enforceability. 

An assessment (to be supported a legal opinion) on the enforceability of the netting agreement and the collateral arrangements (as the case may be) is required in order to rely on the exemption. 

The HKMA allows the legal opinion to be obtained from an independent internal unit or an external independent legal counsel; opinions obtained on an industry-wide basis by industry associations from external independent legal counsel are also acceptable. 

The position on non-netting and non-segregation jurisdictions is the same under the proposed SFC margin rules. The SFC also requires an assessment (supported by a legal opinion) to be made on the enforceability of the netting agreement and the collateral arrangements (as the case may be) in order to rely on the exemption. For this purpose, the SFC requires an external legal opinion in writing. 

Commentary: It would be helpful if the SFC can clarify that industry-wide legal opinions can be used to satisfy the requirement. 

Substituted compliance 

When can substituted compliance be relied upon 

Substituted compliance is permitted to be applied to cross-border transactions with (i) a “deemed comparable jurisdiction” (i.e. one of the WGMR member jurisdictions) until such time as a comparability assessment has been completed by the HKMA for that jurisdiction or (ii) a jurisdiction for which the HKMA has issued a comparability determination. 

Substituted compliance is permitted in three scenarios: 

1. (i) an in-scope AI may follow the margin requirements applicable to its counterparty (in their entirety) instead of the HKMA margin requirements if the 

Substituted compliance is available if the SFC or the HKMA has issued a comparability determination or the respective foreign jurisdiction is deemed comparable. 

Where a comparability determination has been issued by the HKMA in respect of a given jurisdiction’s requirements, LCs may elect to adhere to such requirements, subject to such modification or restriction as the SFC may specify. 

Commentary: It would be helpful to the industry if the SFC can clarify the scenarios under which substituted compliance may be relied upon (e.g. will an in-scope LC only be able to rely on substituted compliance to follow the 

1. counterparty is required to comply with such foreign margin requirements and the counterparty jurisdiction is a comparable jurisdiction; 
2. (ii) a non-Hong Kong incorporated in-scope AI may follow the margin requirements of its home jurisdiction (in their entirety) instead of the HKMA margin requirements if the home jurisdiction is a comparable jurisdiction; and 
3. (iii) in justified cases, a non-Hong Kong-incorporated in-scope AI may follow the margin standards of a foreign jurisdiction (other than its home jurisdiction) in their entirety where (x) the foreign jurisdiction is a comparable jurisdiction for the purpose of the Hong Kong margin rules and the in-scope AI’s home margin rules and (y) the in-scope AI is able to substantiate how and the extent to which the foreign standards are relevant to its situation. 

margin requirements applicable to its counterparty (to the extent that the counterparty jurisdiction is a comparable jurisdiction), or can the in-scope LC comply with comparable margin requirements applicable to its other group entities). 

Comparability between HKMA and SFC margin rules 

The HKMA has deemed the margin requirements of “an authority other than the HKMA in Hong Kong” as comparable. 

An in-scope AI (subject to the HKMA margin rules) facing an LC counterparty which is directly subject to the SFC margin rules can apply substitute compliance and follow the SFC margin rules in their entirety if the covered entity (i.e. the LC counterparty) is required to comply with the SFC margin rules. 

The SFC considers the HKMA’s current margin requirements to be comparable to the SFC’s proposed requirements, except that margin collected by LCs should be subject to the asset eligibility requirements and collateral haircuts set by the SFC. 

Commentary: The asymmetrical application of substituted compliance between HKMA and SFC margin rules will create complications (both operationally and documentation-wise) when AIs trade with LCs and both sets of rules apply. It would be helpful if a consistent approach can be adopted by both regulators for substituted compliance.