Saturday, July 21, 2012

Hong Kong Regulators Revise Legislative Proposal for OTC Derivatives Oversight to Address Concerns Over Cross-Border Reach


In light of public comment, the Hong Kong Monetary Authority and Securities and Futures Commission have revised a joint legislative proposal for a regulatory regime for Hong Kong’s over-the-counter (OTC) derivatives market. Significantly, the revision narrowed the cross-border reach of the derivatives regulatory regime. The regulators reacted to widespread concern about the extraterritorially reach of the proposed mandatory reporting and clearing obligations. In particular, there was concern about extending these obligations in respect of transactions that are only originated or executed in Hong Kong or that have a tenuous Hong Kong nexus.

The regulators originally proposed that an overseas-incorporated financial institution should report a transaction if it has become a counterparty to the transaction through its Hong Kong branch,  it has originated or executed the transaction through its Hong Kong branch, or the transaction has a Hong Kong nexus and the financial institution has become a counterparty to it, albeit not through its Hong Kong branch.

The revised proposal narrows the reporting obligation of overseas-incorporated financial institutions so that it only applies where the firm has become a counterparty to a reportable transaction through its Hong Kong branch, or the firm has originated or executed a reportable transaction through its Hong Kong branch and the transaction has a Hong Kong nexus. Thus, the original proposal to require reporting where the Hong Kong branch has become a counterparty to the transaction will remain. However, the original proposal to require reporting where the Hong Kong branch has originated or executed the transaction will be tightened by adding a requirement for the transaction to have a Hong Kong nexus. The concept of originated or executed itself will also be tightened. The original proposal to require reporting where the Hong Kong branch is not involved at all was removed

The important concept of Hong Kong nexus was introduced in the proposed legislation to define the reporting obligation of an overseas-incorporated financial institution. The definition of Hong Kong nexus was fine-tuned in the revised proposal to mean, in the case of equity derivatives and credit derivatives, that the underlying entity or the reference entity is listed in Hong Kong, and where there is more than one underlying entity or reference entity, a specified percentage of the entities are listed in Hong Kong, or that the underlying is an index and a specified percentage of the underlying companies are listed in Hong Kong, or that the reference entity is, or is wholly owned by, the Government of the Hong Kong Special Administrative Region. In the case of other derivatives, there will be a Hong Kong nexus if the underlying asset, currency or rate is denominated in or related to (or includes an asset, currency or rate that is denominated in or related to) Hong Kong dollars or Renminbi.

With regard to the specified percentages used in the revised proposal, the regulators said that they are considering several options and promised to provide more details in the fourth quarter of 2012.

Further, the regulators explained that it was important to include Renminbi within the scope of the Hong King nexus because Hong Kong is a major offshore Renminbi business center and many financial institutions are active in conducting Renminbi deliverable and non-deliverable derivatives transactions. Thus, there is a need for the SFC and the Monetary Authority to monitor the exposure of financial institutions to these transactions as well as any systemic risk that such transactions in aggregate might pose.

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