Wednesday, October 19, 2011

Proposed Legislation Would Create Regulatory Regime for Hong Kong OTC Derivatives Market

The Hong Kong Monetary Authority and Securities and Futures Commission have issued a joint proposal for a regulatory regime for Hong Kong’s over-the-counter (OTC) derivatives market. The Authority will oversee and regulate the OTC derivatives activities of authorized institutions, while the SFC will oversee and regulate such activities of persons. OTC derivatives transactions will have to be reported to the trade repository being set up by the Authority.

Standardized OTC derivatives transactions will have to be centrally cleared through a designated central counterparty (CCP). The clearing and reporting obligations will initially be limited to interest rate swaps and non-deliverable forwards, but will subsequently be extended to other product classes such as equity derivatives. Initially, OTC derivatives transactions will not be required to be traded on an exchange or electronic trading platform. Further study is needed to assess how best to implement such a requirement in Hong Kong.

The regime will not regulate financial institutions, commercial entities and others that are essentially end users, although if their activities are significant enough, they may qualify as large players. The authorities are still considering to what extent large players should be regulated under the regime.

The mandatory clearing obligation would apply only if either an authorized institution, licensed corporation or Hong Kong person is a counterparty to the transaction or an authorized institution has originated or executed the transaction and both counterparties have exceeded a specified clearing threshold. In the case of an overseas-incorporated authorized institution, its involvement as a counterparty or the person originating or executing the transaction must be through its Hong Kong branch.

Overseas persons will therefore be affected by the mandatory clearing obligation only if an authorized institution, licensed corporation or Hong Kong person is also involved in the transaction. Additionally, to reduce the compliance burden, a transaction will be exempted from mandatory clearing if both counterparties are overseas persons, and the transaction has been cleared through a central counterparty in accordance with the laws of an acceptable overseas jurisdiction8 or is exempt from central clearing under those laws.

The proposed mandatory clearing obligation will require clearing eligible transactions to be cleared through designated central counterparties The authorities propose that only CCPs that are either a recognized clearing house or an authorized automated trading services provider should be eligible to be designated for this purpose. They are considering whether to impose a location requirement for certain products that are considered systemically important to the Hong Kong financial market, such as whether only local CCPs should be permitted to clear products that are regarded as being of systemic importance.

Unlike in the US and EU, much of the OTC derivatives activity conducted in Hong Kong is not booked in Hong Kong. The Hong Kong arm is in most cases the sales desk or trading desk rather than the client facing entity. Its role is therefore to negotiate, arrange, confirm or commit to a transaction on behalf of the group client facing entity, rather than to enter into the transaction as counterparty itself.
Given this unique feature of Hong Kong’s market, reasoned the authorities, no mandatory obligation would be effective if it were imposed only on counterparties to the transaction. The proposed legislation would thus also covers others who are involved in making the transaction happen, such as the mandatory reporting obligation would be applied to authorized institutions and licensed corporations that originate or execute the transaction.