Saturday, December 10, 2011

Hedge Fund Industry Comments on Proposed Hong Kong OTC Derivatives Regulatory Regime

The US hedge fund industry has asked Hong Kong authorities to require mandatory access to OTC derivatives clearing for all eligible market participants that desire to clear on a voluntary basis as part of the derivatives regulatory regime being erected in Hong Kong. In a letter to the Hong Kong Monetary Authority and the Securities and Futures Commission, the Managed Funds Association asked the regulators to ensure that any imposed margin requirements permit legally enforceable netting, allow the use of a variety of margining approaches that are transparent and consistent, and include liquidation horizons that are consistent with the related cleared products.

The regulators should also require each central counterparty to segregate client initial margin in accounts that are separate and apart from the assets of the clearing member, central counter party or their affiliates. Importantly, the MFA urged that the Hong Kong derivatives regime be harmonized with the regulatory regimes in other jurisdictions.

Broadly, the MFA supports the effort to reduce systemic risk by transitioning appropriate OTC derivatives transactions to a mandatory clearing regime. The hedge fund group believes that mandatory clearing is essential to reducing systemic, operational and counterparty risk. While the association expects a bilateral market to remain for limited customized business and risk management needs, mandatory clearing is a key first step that will offer increased regulatory and market efficiencies, greater market transparency and competition.

Once clearing is available for any product, noted the MFA, there should be mandatory access to clearing for all eligible market participants that desire to clear on a voluntary basis. Encouraging market participants to clear derivatives transactions voluntarily will help to facilitate the development of a clearing infrastructure that takes into account the views of many types of market participants.

Regarding the proposed mandatory clearing obligation, the MFA is concerned about the inclusion of a specified clearing threshold as a determinant of whether the rules require a market participant to clear a transaction. While aware that the threshold is designed to limit the scope of the mandate so as to minimize the impact on the market, the MFA believes that the application of this threshold is contrary to the goal of incentivizing greater clearing. The MFA urged the SFC to eliminate the specified clearing threshold and impose a mandatory clearing obligation based solely on the type of market participants that are parties to the transaction.

In addition, while recognizing the desire of the SFC not to impose mandatory clearing on smaller entities, the MFA believes that there are other options for addressing this issue. For example, the association pointed out Sections 723 and 763 of the Dodd-Frank Act of 2010, which require market participants to clear any swap that a clearing agency will accept for clearing, but excludes a swap transaction if one of the counterparties to the swap is not a financial entity and is using swaps to hedge commercial risk.

Similarly, the MFA is concerned about a specified reporting threshold the SFC proposes to adopt for reporting derivatives transactions to a repository. As with the specified clearing threshold, the MFA believes that the specified reporting threshold should be dropped.

The SFC is hesitant to allow central counterparties (CCPs) organized outside of Hong Kong to become designated CCPs for purposes of any mandatory clearing obligation in Hong Kong. The MFA is concerned that if the SFC does not permit foreign CCPs to become designated CCPs, there is a potential that the derivatives market will become fragmented along jurisdictional lines. This segmentation could cause significant harm to the markets by impeding competition, impairing portability and eventual interoperability, limiting participant access to clearing and their ability to operate in certain jurisdictions, and ultimately creating artificial barriers across a global marketplace.

The SFC could resolve its concerns through coordination with regulators in the relevant CCPs’ jurisdictions on the designation procedures, said the MFA, with a view toward encouraging cross-border efficiency and consistency. For that reason, the MFA encourages the HKMA and SFC to allow designation of CCPs organized outside of Hong Kong for purposes of the mandatory clearing obligation, and request that such CCP designations do not become unreasonably difficult to obtain.

The MFA appreciates the HKMA’s and SFC’s recognition of the global nature of the OTC derivatives markets and their efforts to ensure that Hong Kong financial market regulation is on a par with international standards. The MFA supports an internationally coordinated approach to regulation that ensures consistent regulation, reflects the global nature of the OTC derivatives markets, and promotes competition and innovation. In that vein, the MFA urged Hong Kong policymakers to coordinate with their counterparts in other jurisdictions to ensure that any regulatory reform is consistent, where applicable, and addresses counterparty and systemic risk, while promoting competition and limiting duplicative regulation.

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