Circular to intermediaries and other persons engaging in activities concerning over-the-counter (OTC) derivative products or transactions

This circular is issued to update the market on the implementation of the OTC derivatives regulatory regime, and to highlight the transitional arrangements for market participants who intend to continue with their existing OTC derivatives activities in Hong Kong.

OTC derivatives regulatory regime

The Securities and Futures (Amendment) Ordinance 2014 (Amendment Ordinance) ^[1] was passed by the Legislative Council in March 2014.  Among other things, it introduces a regulatory regime for OTC derivatives in Hong Kong.  The new regime provides –

a)    a framework for introducing reporting, clearing and trading requirements through subsidiary
       legislation (that will require specified OTC derivative transactions to be reported to the Hong
       Kong Monetary Authority (HKMA), centrally cleared through a designated central counterparty,
       and executed on a designated trading platform);

b)    that certain activities relating to OTC derivatives shall be regulated activities (RAs) and thus
       persons carrying on a business in those activities shall be subject to licensing or registration
       under the Securities and Futures Ordinance (SFO); and

c)    a framework for regulating systemically important participants (SIP), i.e. persons who are not
       regulated by either the Securities and Futures Commission (SFC) or the HKMA, but whose
       activities or transactions in OTC derivatives may raise concerns of potential systemic risk.

Aspects implemented since July 2015

The OTC derivatives regulatory regime is to be implemented in phases.  The first phase came into effect on 10 July 2015.^[2]  It introduced mandatory reporting in respect of certain interest rate swaps and non-deliverable forwards, and applies to certain regulated entities including licensed corporations (LCs).^[3]  The reporting obligation applies in respect of both new transactions (i.e. those entered into after 10 July 2015) and old ones that are still outstanding.  A concession period of six months from implementation is provided for reporting entities to set up the necessary system connection for reporting.  After that, new transactions have to be reported on a T+2 basis.  Provision is also made to allow for more time to report old transactions and those entered within the concession period – basically, market participants have until 9 April 2016 to report transactions entered into on or before 9 January 2016.  Details of the mandatory reporting regime for the first phase are set out in the Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules.  The SFC and the HKMA have also issued FAQs on how the Rules will operate and be implemented.^[4]

Aspects proposed to be implemented next

The next phase will focus on: (i) mandating the central clearing of certain standardized interest rate swaps entered into between major dealers; and (ii) expanding the mandatory reporting regime so that it applies in respect of all OTC derivative transactions, and widens the scope of information to be reported, including the reporting of daily valuations.

The SFC and the HKMA have issued a joint consultation paper on the detailed proposals for this next phase (Consultation Paper), which is accessible on both the SFC’s and the HKMA’s website. The proposals will affect LCs and registered institutions (RIs) that engage in OTC derivative transactions, including firms that are not currently subject to the mandatory reporting regime.

In particular, under the currently proposed expanded reporting regime –

a)    All OTC derivative transactions will be reportable, i.e. including transactions in standardized and
       non-standardized rate and FX derivatives, equity derivatives, credit derivatives and commodity
       derivatives. The specific data fields to be completed when reporting are set out in Appendix D
       to the Consultation Paper.

b)    It will be necessary to report the details of new transactions, certain historical transactions,
       subsequent events ^[5] relating to the transactions, as well as daily valuations in respect of the
       transactions.  Additionally, the scope of information to be reported under the proposed expanded
       regime will be wider than the scope under the existing regime.

c)    LCs or RIs who are not active in the OTC derivatives market may be exempted from the reporting
       obligation if they qualify under the proposed criteria for “exempt person” relief. The criteria
       include that their outstanding positions in OTC derivative transactions must, in aggregate, not
       exceed US$30 million.

In addition, as part of the proposed mandatory clearing regime, it is proposed to implement the expanded definition of “automated trading services” under the SFO in so far as it relates to the provision of services or facilities for the clearing of OTC derivative transactions. This means that market participants who currently provide such OTC derivative services will need to be authorized by the SFC under the proposed regime.

LCs and RIs who engage in OTC derivative transactions are urged to review the Consultation Paper for the next phase of implementation. Interested parties are requested to submit their comments, in writing, to the SFC or the HKMA by 31 October 2015, except that comments on the specific data fields to be reported (i.e. those set out in Appendix D to the Consultation Paper) may be submitted by 30 November 2015.

The SFC and the HKMA aim to conclude the consultation by end 2015 or early 2016 and to introduce the relevant subsidiary legislation into the Legislative Council for negative vetting in the first quarter of 2016.

Aspects to be implemented in future phases

Other aspects of the OTC derivatives regulatory regime, including:

• further expansion of mandatory reporting and clearing;
  
  
• implementation of platform trading requirements;
  
  
• implementation of the new SIP regime; and
  
  
• implementation of the licensing regime for new and expanded RAs

will be implemented in phases in the future.

The new licensing regime will become effective after all the corresponding amendments to various related rules, codes and guidelines have been finalized.  In relation to capital and other prudential requirements to be imposed on LCs engaging in OTC derivatives activity, the SFC released a consultation paper in July 2015 on proposed changes to the Securities and Futures (Financial Resources) Rules.  Other related amendments are in progress and will be publicly consulted as soon as practicable.  We do not expect the OTC derivatives licensing regime to be implemented before mid-2016.

New licensing regime

Under the Amendment Ordinance, two new RAs will be introduced:

• Type 11 RA (dealing in OTC derivative products or advising on OTC derivative products); and
  
  
• Type 12 RA (providing client clearing services for OTC derivative transactions).

The Amendment Ordinance will also expand the scope of two existing RAs:

• Type 7 RA (providing automated trading services); and
  
  
• Type 9 RA (asset management),

to cover OTC derivative transactions or products.

When the OTC derivatives licensing regime commences, corporations intending to engage in a business in Hong Kong in dealing in or advising on OTC derivative products, providing client clearing services for OTC derivative transactions, managing portfolios of OTC derivative products, and/or providing automated trading services (ATS) for OTC derivative transactions, will need to be licensed or registered for the new and/or expanded RA(s) unless exempted. ^[6]  Authorized institutions (AIs) and approved money brokers ^[7] will be exempted under certain circumstances, and their OTC derivatives activities will be overseen and regulated by the HKMA.

Corporations and individuals that are already licensed or registered for Type 9 RA will be deemed to be subject to a condition imposed on their licences or registrations restricting them from managing portfolios of OTC derivative products, unless they can satisfy the specified criteria under a notification mechanism (see below).

Existing Type 7 licensees that intend to provide ATS for the trading of OTC derivative products will need to satisfy the specified criteria for Type 11 RA under a deeming mechanism (see below) and notify the SFC of the changes in the scope and operation of their ATS for the trading of OTC derivative products.  The requirement for the OTC derivatives related activities under the expanded Type 7 RA coupling with Type 11 RA is consistent with the current requirement for the securities or futures activities under Type 7 RA coupling with Type 1 RA (dealing in securities) or Type 2 RA (dealing in futures contracts).

Transitional arrangements

Market participants whose existing OTC derivatives activities will trigger the licensing requirements for the new or expanded RA(s), and who intend to pursue these activities, should now prepare for the transition.  The Amendment Ordinance includes the following transitional arrangements: ^[8]

1.   Transitional period

There will be a six-month grace period (Transitional Period) starting from the commencement date of the OTC derivatives licensing regime.  During this period, market participants may continue their activities that fall within the definition of the new or expanded RAs, without the relevant licences or registrations. 

Upon the expiry of the Transitional Period, no entity can engage in a new or expanded RA unless and until it is appropriately licensed or registered or deemed licensed or registered under the transitional arrangements.

2.   Deeming mechanism

      The deeming mechanism applies to market participants that meet specified criteria and apply
      under Part V of the SFO for a licence or registration for the new or expanded RA during the first
      three months of the Transitional Period (Application Period).  After an initial screening by the
      SFC or the HKMA, eligible corporate and individual applicants will be deemed to be licensed or
      registered for the new or expanded RA immediately after the end of the Transitional Period,
      while the SFC or the HKMA will continue to process their applications.  Their deemed licences or
      registrations will continue to have effect until their applications have been approved, refused or
      withdrawn.  In the case of an individual applicant, he will also cease to be deemed licensed if he
      ceases to be accredited to a principal that is licensed or deemed licensed for the relevant new or
      expanded RA.

      If an applicant applies during the Application Period but does not meet the specified criteria, the
      SFC or the HKMA will issue a “no-deeming notice” to notify the applicant that they are ineligible
      to be deemed licensed or registered.  Ineligible corporate applicants and the individual applicants
      who carry on the new or expanded RA for them will have a grace period of three months, starting
      from the date the no-deeming notice is issued, to wind down their existing OTC derivatives
      business, close out existing positions, and/or transfer their business to another corporation that
      is entitled to carry on the relevant activities.

      The specified criteria include:

• Experience requirements – Corporate applicants and their proposed responsible officers (ROs) ^[9] should have been carrying on a business in an activity that would have constituted the new or expanded RA in Hong Kong ^[10]for at least two years immediately before the commencement date of the OTC derivatives licensing regime.
  
  
• Existing licensing and regulatory requirements – As the OTC derivatives licensing regime is an extension of the existing regulatory framework under the SFO, all the existing licensing and regulatory requirements will also be generally applicable to corporate applicants and their proposed ROs (e.g. at least two ROs for each new or expanded RA concerned with at least one being an executive director as defined under section 113 of the SFO). ^[11]
   
• Application documents – Together with their application documents for a licence or registration under Part V of the SFO, a corporate applicant must submit a prescribed form confirming, inter alia, its:

           -     satisfaction of the related experience requirement;

           -     having at least two individuals who have applied to be its ROs ^[12] or executive officers
                 (EOs) (as the case may be) for each new or expanded RA concerned and who satisfy
                 the specified criteria as RO or EO; and

           -     compliance with existing or new requirements under the SFO or the Banking Ordinance
                 (BO) (as the case may be), and related codes and guidelines that are or will be
                  applicable to its OTC derivatives activities. ^[13] 

      The specified criteria for proposed RO and EOs include, inter alia, their submission of relevant
      licence applications under the SFO or applications for consent under the BO, and a confirmation
      that they have satisfied the related experience requirements.  Proposed licensed representatives
      (LRs) are not required to submit any confirmation.

Table: Summary of specified criteria

	Applicant	Experience requirement	Licence Application	Confirmation
New or expanded RA	LC	✔	✔	✔
	RO	✔	✔	✔
	LR	N/A [14]	✔	N/A
Expanded Type 9 RA	RI	✔	✔	✔
	EO	✔	✔	✔

3.    Notification mechanism

       For an existing Type 9 LC or RI to continue its activities that amount to the new component
       of the expanded Type 9 RA (i.e. management of a portfolio of OTC derivative products) (New
        Type 9 activities), it will have to file a prescribed notification form within the Application
       Period, covering:

• a statement of its intention to continue with such activities;
  
  
• a detailed business plan of its New Type 9 activities, internal controls and operational procedures pertaining to such business (including human and technical resources), organizational structure, contingency plans and related matters; and
  
  
• a confirmation that the LC or RI has at least one Type 9 RO or EO (as the case may be) in Hong Kong who has two years of Hong Kong or overseas experience in New Type 9 activities within the six years immediately before the commencement date of the OTC derivatives licensing regime, and that the LC or RI complies, or has arrangements in place to ensure compliance, with the new requirements under the SFO, related codes and guidelines that are or will be applicable to the related OTC derivatives activities.

       The Type 9 RO or EO will also have to file a prescribed notification form within the Application
       Period confirming that he has satisfied the relevant experience requirement.

       Existing Type 9 LCs, RIs, ROs or EOs that do not file a prescribed notification form within the
       Application Period, or that do not fulfil the notification criteria will be deemed to be subject to
       a condition imposed on their licences or registrations restricting them from managing portfolios
       of OTC derivative products upon the expiry of the Transitional Period.

4.   New market participants

Any person can apply for a licence or registration for the new or expanded RAs any time after the OTC derivatives licensing regime commences.  These applications will be processed in the usual manner and the transitional arrangements will not apply.

Next steps

The SFC and the HKMA will further consult the public on various aspects of the OTC derivatives regulatory regime in coming months and will publish updates about the implementation of the new regime when appropriate.  

Licensing Department                                              Supervision of Markets Division
Intermediaries Division                                            Securities and Futures Commission
Securities and Futures Commission                     

Ends