5 July, 2018
The Proposed SFC Rules extend the requirement to collateralise uncleared derivatives to licensed corporations and their counterparties. This bulletin explores the proposals and includes a gap analysis listing differences between the HKMA Rules and the Proposed SFC Rules.
Introduction
On 19 June 2018, the Securities and Futures Commission of Hong Kong ("SFC") issued its "Consultation Paper on the OTC derivatives regime for Hong Kong – Proposed margin requirements for non-centrally cleared OTC derivative transactions", setting out the SFC's proposed margin requirements (the "Proposed SFC Rules") for non-centrally cleared OTC derivatives ("uncleared derivatives") (the "SFC Consultation Paper").
Most market participants are already familiar with the requirements for collateral arrangements for uncleared derivatives introduced following the G20 2011 summit in Cannes. These were first implemented in Hong Kong in 2017 by the Hong Kong Monetary Authority ("HKMA"), as set out in Chapter CR-G-14 of the Supervisory Policy Manual issued by HKMA, and titled "Non-Centrally Cleared OTC Derivative Transactions – Margin and other Risk Mitigation Standards" (the "HKMA Rules"). The HKMA Rules apply when one of the parties to an uncleared derivative is a bank or other authorised institution ("AI"). The HKMA Rules therefore resulted in all financial counterparties dealing with an AI, including any licensed corporation ("LC"), being required to agree documentation for variation margin arrangements by September 2017. In addition, in phases until 2020, documentation for initial margin is required for those AIs and their counterparties that meet the relevant threshold requirements. The Proposed SFC Rules will create similar requirements which are directly applicable to LCs.
Implementation timeline
The Proposed SFC Rules will take effect as follows:
Effect on Banks and AIs
In the case of an LC which is part of a group including a Hong Kong AI, it is important to understand both the Proposed SFC Rules and the HKMA Rules because they are both directly applicable to different entities within the group. If a banking group consists of AIs and LCs, the policies and procedures that are in place for the group must be adequate for both the AIs and the LCs.
To ensure that the split regulatory regime in Hong Kong does not result in conflicting requirements, the Proposed SFC Rules expressly state that they and the HKMA Rules will be deemed to be compatible. LCs that have agreements with an AI that comply with the HKMA Rules will be deemed to have complied with the Proposed SFC Rules. Hopefully the HKMA will take the same approach for any new agreements that comply with the Proposed SFC Rules.
Troublingly though, the SFA includes a caveat for its asset eligibility requirements and haircuts. If the SFC proposes stricter asset eligibility and valuation requirements without substituted compliance under the HKMA Rules, this raises the prospect of a further repapering exercise by the industry amending the terms of the agreements put in place last year to reflect these requirements. This may be easier to achieve, because of its more limited scope, but will impose requirements on the financial system in Hong Kong that are not matched elsewhere and will be a distraction from the significant time and investment required to ensure that on-going IM requirements are met as the deadlines for subsequent phases get closer.
The proposed substituted compliance framework also raises other questions as regards the interaction between the HKMA Rules and the Proposed SFC Rules, which will require further consideration and analysis. For example, the HKMA Rules require AIs to exercise discretion over whether extending those rules to offshore banking subsidiaries. If neither party is subject to an absolute requirement to comply with the HKMA Rules, can a collateral arrangement agreed by an LC be documented so that it complies with the HKMA Rules and the LC still consider this as deemed compliance with the Proposed SFC Rules? Does this apply to other entity types where no requirement exists?
Hong Kong Subsidiaries
Both the HKMA Rules and the Proposed SFC Rules include exemptions for intragroup transactions. This relieves a Hong Kong subsidiary from the requirement to collateralise transactions with an offshore or mainland parent company, provided that certain requirements are met. These requirements include a consolidated treatment of the different entities from an accounting perspective, and central management of the group's risk evaluation, measurement and control procedures. As a result, other concerns, such as legal enforceability issues within the group, will not need to be addressed for the Proposed SFC Rules. Having said this, to the extent that there is relief from capital requirements or exposure limits for an LC, collateralisation will still be a benefit and so some affiliate may opt to put collateral arrangements in place.
Impossibility Opinions
The HKMA Rules and the Proposed SFC Rules include exemptions for derivative transactions with counterparties incorporated in or operating out of a jurisdiction where netting arrangements or arrangements for segregation of collateral are not legally enforceable. The requirements are subject to internal credit and country limits, but are less prescriptive than requirements in other jurisdictions in not setting specific quantitative limits, or indeed the risk-enhancing expedient of imposing collateral requirements on a gross basis. The test for this assumption is based on an internal assessment based on the contents of an "external legal opinion in writing". This may be difficult to apply in practice, depending on what substantive issues need to be addressed in the legal opinion. It also leaves open the conflict of laws issues, such as the extent to which it is necessary to address the treatment of offshore as well as onshore collateral under domestic laws on a default.
Securitisation and Covered Bonds
The HKMA Rules and the Proposed SFC Rules include an exemption for securitisation vehicles for hedging purposes but otherwise categorise them as financial counterparties. The discussion in relation to variation margin for currency transactions in the Proposed SFC Rules acknowledges the proposals for certain reforms in Europe in relation to EU Regulation 648/2012 on OTC derivatives, central counterparties and trade repositories ("EMIR"). At one stage, these included securitisation, but any such requirements will instead be included in separate dedicated legislation about securitisation. Under the Proposed SFC Rules, a securitisation company will be a financial counterparty, but one which is allowed to treat hedging transactions as exempt. This contrasts with EMIR in terms of approach, but achieves the same result. To the extent relevant, the same logic should apply to repackaging vehicles.
There is no definition of "hedging" currently proposed, but the current language does not require an accounting test and is broad enough to include hedging of assets and liabilities.
On the other hand, whereas EMIR includes an express exemption for covered bonds, there is no equivalent provision under the HKMA Rules or the Proposed SFC Rules for covered bonds.
This is a nascent market in Asia, and a number of different structural approaches are possible for a covered bond issuance. In some cases, the preferred approach is to set up a special purpose company, in a similar manner to a securitisation. Arguably, this should benefit from the proposed exemption. Alternatively, a bank may issue covered bonds directly and encumber assets on its balance sheet to create the cover pool. In this case, no hedging exemption will be possible.
Funds and Fund Managers
The Proposed SFC Rules will apply to transactions between an LC and any covered entity, defined to include any collective investment scheme, any mandatory provident fund scheme, any occupational retirement scheme, and any person carrying on business outside Hong Kong as an asset manager. A collective investment scheme is stated (in a footnote) to include hedge funds, pension funds and mutual funds. A broadly similar approach is taken in the HKMA Rules.
On the other hand, in relation to a business outside Hong Kong, this is said, in setting out the scope of the FX exemption, to be a reference to the manager rather than the fund. In practice, most fund managers will contract uncleared derivatives as agent for the underlying funds – which will be the principal. The Proposed SFC Rules acknowledge the distinction and that the requirements for collateral will not apply to the agent. The definition of "group" in the context of a fund is not discussed.
Collateral Eligibility
The tests for collateral eligibility mainly apply objective criteria that require additional haircuts depending on the liquidity and level of risk. It is assumed that collateral will be determined on a portfolio basis, although there are restrictions on doing so across asset classes for IM. There is a requirement that collateral should not be inversely correlated to the value of the underlying uncleared derivatives ("wrong-way round risk"). On the other hand there is no recognition of "right-way round risk" where the collateral is the same as the underlying for the uncleared derivative and so positively correlated with the exposure. Under the Proposed SFC Rules, the same haircut will still apply.
Rehypothecation and Ring-fencing
The Proposed SFC Rules allow title transfer or a security arrangement with a right of use for VM but require segregation of IM. There are provisions allowing rehypothecation of IM to a limited extent where this is for hedging purposes but subject to continued segregation from the assets of the collateral holder. These mirror the arrangements for cleared derivatives (and, for example, may be relevant if that is how the transaction is hedged). Individual segregation must be offered to those counterparties that want it.
Some differences discerned
As expected, the HKMA Rules and the Proposed SFC Rules are broadly similar. However, there are also some differences between the two, and we summarise the main areas of difference in the table in the Appendix.
Feedback on Consultation Paper
The SFC Consultation Paper may be accessed here. There are various questions in the SFC Consultation Paper which SFC has specifically sought views on and the closing date for submission of written comments is 20 August 2018. If you would like to discuss the SFC Consultation Paper or provide feedback, feel free to contact any of your Ashurst contacts.
APPENDIX
For further information, please contact:
Christopher Whiteley, Partner, Ashurst
christopher.whiteley@ashurst.com
