The Securities and Futures Commission (“SFC”) introduced 2 new regulated activities, namely type 11 regulated activities (“Type 11 RA”) and type 12 regulated activities (“Type 12 RA”), and collectively referred as the “new RAs”, to regulate persons who serve as dealers, advisers or clearing agents etc. in the OTC derivatives market.
For definition of the new RAs and the transitional arrangement to the licensing regime, please refer to our newsletter “Regulating Intermediaries in the OTC Derivatives Market” (April 2017).
Whilst the licensing regime for the new RAs has yet to be in operative, market participants have raised concerns over their regulatory scope and whether certain activities could be carved out from these new RAs.
In response to market comments, the SFC released a consultation paper on 20 December 2017, proposing certain refinements to the scope of the new RAs and new conduct requirements (the “Consultation”). The Consultation has ended on 20 February 2018. This article provides a snapshot to the major proposal contained in the Consultation.
Refinement of the scope of the new RAs
Some of the key proposed refinements and amendments to Schedule 5 of the Securities and Futures Ordinance (Cap.571) (the “SFO”) are summarised as follows:
Corporate treasury activities carve-out –Type 11 RA
The scope of the Type 11 RA is proposed to be narrowed, which corporate treasury activities of non-financial groups as OTC derivatives intermediaries may benefit from the “price taker carve-out” so long as they remain genuine price-taker, i.e. they are not in the business of making markets in or offering price quotes for OTC derivative transactions).
Post-trade multilateral portfolio compression carve-out – Type 11 RA
The provision of compression service serves to reduce both the counterparty credit risk and operational risk, which in turn lessen systemic risk and enhance overall financial market stability. Given that the existing users of portfolio compression services are mostly large market parties with sizeable OTC derivatives portfolios who should have the expertise to evaluate compression proposals put to them by the service providers, the SFC proposes to carve out compression services from both the “dealing” and “advising” limbs of Type 11 RA. However, to the extent that providers of multilateral portfolio compression services also facilitate the termination, modification or replacement of OTC derivative transactions, the SFC considers that such services will not be exempt from the scope of automated trading services.
Carve-out for overseas clearing members of overseas Central Clearing Counterparties (CCPs) – Type 12 RA
Currently, the scope of Type 12 RA excludes, subject to certain pre-requisites (see section 5 of Part 2A, Schedule 5 of the SFO), remote clearing members of a Hong Kong CCP. The SFC considers that the location of CCP should not be the critical factor in deciding the scope of the carve-out. Accordingly, it is proposed by the SFC to the have the carve-out extended to the activities of overseas persons which are clearing members of an overseas CCP, so long as they are able to satisfy the pre-requisites.
Carve-out against certain activities of asset managers– Type 12 RA
Under the Consultation, a fund manager does not need a Type 12 RA license as long as the services they provide are ancillary (e.g. agents of providers of client clearing services marketing the latter’s client clearing services; or licensed or registered fund managers selecting, or passing clearing instructions to, providers of client clearing services and CCPs for funds). Also, to the extent that fund manager provide client clearing services to funds which they themselves manage, the SFC considered such services as being provided solely for the purpose of providing fund management services to their own funds and are thus excluded from the need for Type 12 RA licence.
Other licensing-related requirements
The licensing fees payable to the SFC for Type 11 RA and Type 12 RA will be HK$4,740, which is the same as for other regulated activities (except for Type 3 RA (leveraged foreign exchange trading), where a higher fee is charged (HK$129,730)).
For the new RAs, there will be no regulatory requirement to take out insurance.
Concerning the examination requirements applicable to individuals, the SFC proposes that:
- the existing local regulatory papers (for responsible officer applicants) and recognized industry qualifications papers for Type 2 RA (dealing in futures contracts) and Type 5 RA (Advising on futures contracts) will be expanded to cover Type 11 RA. In other words, Type 2, Type 5 and Type 11 RAs will belong to the same competence group as far as licensing examinations are concerned;
- a new local regulatory paper (for responsible officer applicants) and recognized industry qualification paper will be developed specifically for Type 12 RA. In other words, Type 12 RA will be a standalone competence group; and
- the Hong Kong papers for the existing RAs will be updated where appropriate to cover OTC derivative activities.
Highlighted new conduct requirements
(i) Risk mitigation measures
The SFC proposes that certain risk mitigation requirements to be imposed on licensed corporations (“LCs”) shall be set out in a new Schedule 10 to the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (“Code of Conduct”) (Schedule 10). Some of the requirements are highlighted as follows:
- A LC is required to execute written trading relationship documentation with each counterparty prior to or contemporaneously when executing a non-centrally cleared OTC derivative transaction. The written documentation should include all the agreed material rights and obligations of counterparties, which may include payment obligations, events of default or other termination events, transfer of rights and obligations, processes for valuation, dispute resolution, governing law, etc.
- A LC should establish and implement policies and procedures to ensure that the material terms of all transactions are confirmed in writing by electronic or manual means, as soon as practicable after the execution of the transaction. A LC is also required to track the status of unconfirmed transactions with a view to obtaining proper confirmation of all transactions in a timely manner.
- A LC should agree with its counterparties on the process by which the value of a non-centrally cleared OTC derivative will be determined through the lifecycle of the transaction, from the time it is executed until its termination, maturity or expiration. Such valuation should be performed on a fair value basis by marking to market where practicable.
- A LC should establish and implement policies and procedures to ensurethat the material terms are exchanged and valuations (including variation margin) are reconciled with counterparties in respect of all non-centrally cleared OTC derivative portfolios at regular intervals such that discrepancies (if any) could be identified and handled in a timely manner.
- A LC should regularly assess and, to the extent appropriate, engage in portfolio compression to increase capital efficient and liquidity.
- A LC should agree in writing (for example, could be covered as part of the trading relationship documentation) with its counterparties on the dispute determination mechanism or process for discrepancies in material terms, valuations or margin calls, and how these dispute could be solved as soon as practicable.
(ii) Record keeping and retention requirement
In addition to the present record-keeping obligations, SFC proposed amendments to the Securities and Futures (Keeping of Records) Rules (Cap. 571O) to include new requirements for the LCs to maintain records of the following:
- particulars of all orders or instructions concerning OTC derivative transactions it receives or initiates;
- all agreements relating to non-centrally cleared OTC derivative transactions entered into with counterparties;
- particulars of each executed OTC derivative transaction;
- particulars of all post-trade processing and events relating to each OTC derivative transaction, including, as applicable, termination, netting, compression, reconciliation, valuation, margining, collateralisation and central clearing;
- particulars of all OTC derivative transactions in respect of which it has facilitated the clearing of the transaction;
- particulars of the descriptions and amounts or market values of any collateral held by it and any assets received by it from counterparties to OTC derivative transactions;
- rehypothecation of collateral in respect of OTC derivative transactions;
- particulars, in respect of its counterparty to OTC derivative transactions, of each description of collateral and margin calls; and
- all client clearing agreements and agreements entered into with a CCP relating to each OTC derivative transaction.
It is proposed that the LCs should keep trading relationship documentation, trade confirmations and the valuation processes agreed with counterparties (which are part of the risk mitigation requirements as set out above) for a minimum of five years after the termination, maturity, novation or assignment of OTC derivative transaction.
The above proposals are part of the comprehensive reforms to enhance Hong Kong’s regulatory regime for OTC derivatives activities and to strengthen the management of conduct and financial risks in transactions and business dealings. Whilst there appears to be no proposed timetable for the operation of the new RAs licensing regime, it is anticipated that the SFC will continue to make considerable progress in this aspect. Market participants should be aware of the proposed regime and work closely with their financial, legal and business team to assess and implement the changes as it may be required from time to time.
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This article does not constitute legal advice or a legal opinion on any matter discussed and, accordingly, it should not be relied upon. It should not be regarded as a comprehensive statement of the law and practice in this area. If you require any advice or information, please speak to practicing lawyer in your jurisdiction. No individual who is a member, partner, shareholder or consultant of, in or to any constituent part of Interstellar Group Pte. Ltd. accepts or assumes responsibility, or has any liability, to any person in respect of this article.