Update on Hong Kong OTC Derivatives Regulatory Regime

New reporting and clearing requirements

On 27 June 2018, the Hong Kong Monetary Authority (HKMA) and Securities Futures Commission (SFC) published joint consultation conclusions on their March 2018 consultation on OTC derivatives reporting, clearing and platform trading obligations. As set out in the consultation conclusions:

  1. Effective April 1, 2019, reporting entities (those subject to the Hong Kong OTC derivatives reporting regime) will need to use Legal Entity Identifiers when reporting to the Hong Kong Trade Repository (a) information on new trades, and (b) daily valuation information for existing outstanding trades.
  2. Standardized Australian dollar interest rate swaps will be subject to the Hong Kong mandatory clearing regime – this change is expected to take effect around Q4 of 2019, 12 months after the revisions to the Securities and Futures (OTC Derivative Transactions – Clearing and Record-Keeping Obligations and Designation of Central Counterparties) Rules are gazetted.
  3. An updated list of financial services providers for the mandatory clearing regime will be gazetted. 

Proposed margin requirements

On June 19, 2018, the SFC also issued a consultation paper on proposed margin requirements for non-centrally cleared OTC derivative transactions. The proposed margin requirements will be relevant to:

  • SFC licensed corporations that are counterparties to non-centrally cleared OTC derivative transactions; and
  • collective investment schemes that enter into non-centrally cleared OTC derivative transactions with SFC licensed corporations and that have an average aggregate notional amount of non-centrally cleared OTC derivatives exceeding HK$15 billion.  

The consultation paper proposes that, from September 1, 2019, an SFC licensed corporation that is a counterparty to a non-centrally cleared OTC derivatives transaction will be required to exchange margin in relation to the transaction where (i) the other counterparty is a “covered entity”, and (ii) certain thresholds are met. Subject to the consultation conclusions, the proposed margin requirements will be reflected in a new Part II of Schedule 10 to the SFC Code and Conduct.

The proposed margin requirements mean that an SFC licensed corporation will need to:

  • monitor the average aggregate notional amount of non-centrally cleared OTC derivatives of itself and of the group of which it forms part;
  • where it manages one or more collective investment schemes and such collective investment schemes enter into non-centrally cleared OTC derivative transactions with SFC licensed corporations, monitor the average aggregate notional amount of non-centrally cleared OTC derivatives of each such collective investment scheme (to determine whether such collective investment schemes are “covered entities”); and
  • for transactions to which it is a counterparty, (i) determine whether its counterparty is a “covered entity”, and (ii) if yes, obtain information from the counterparty on the average aggregate notional amount of non-centrally cleared OTC derivatives of the counterparty and of the group of which it forms part.

Meaning of “covered entity”

“Covered entity” includes a wide range of financial counterparties and significant non-financial counterparties, but excludes sovereigns, central banks, public sector entities and multilateral developments banks.

“Financial counterparty” includes:

  1. banks, brokers, asset managers, insurers and money lenders regulated in Hong Kong;
  2. entities that carry on business outside Hong Kong predominantly in one or more of banking, securities or derivatives business, insurance, asset management, money changing / remittance services or lending;
  3. mandatory provident fund schemes and occupational retirement schemes;
  4. collective investment schemes, including regulated and unregulated funds,

that have (or the group to which the relevant entity belongs has) an average aggregate notional amount of non-centrally cleared OTC derivatives exceeding HK$15 billion.

A “significant non-financial counterparty” is a counterparty other than a financial counterparty that has (or the group to which it belongs has) an average aggregate notional amount of non-centrally cleared OTC derivatives exceeding HK$60 billion.

Transactions covered

The proposed margin requirements apply to non-centrally cleared OTC derivative transactions, other than (i) transactions that are indirectly subject to the margin requirements of a central counterparty, (ii) physically settled FX forwards and FX swaps, (iii) excluded currency contracts, (iv) physically settled commodity forwards, and (v) on or before February 29, 2020, non-centrally cleared single-stock options, equity basket options and equity index options.

Thresholds to trigger margin requirements

The consultation paper sets out requirements for both initial margin and variation margin.

The obligation on an SFC licensed corporation to exchange initial margin with a covered entity only arises where both the licensed corporation and the covered entity have an average aggregate notional amount of non-centrally cleared OTC derivatives exceeding HK$60 billion.

The obligation on an SFC licensed corporation to exchange variation margin with a covered entity only arises where the licensed corporation has (or the group of which it is part has) an average aggregate notional amount of non-centrally cleared OTC derivatives exceeding HK$15 billion.

Other provisions

The consultation contains proposals relating to the method and frequency of calculation of initial and variation margin, the timing for the exchange of margin, the types of assets that may be used as margin (including haircuts, where relevant), how margin should be held and minimum transfer amounts.

The consultation proposes that an SFC licensed corporation may only rehypothecate, repledge or reuse initial margin for hedging the licensed corporation’s derivative positions arising out of transactions with the counterparty for which the initial margin was collected. Rehypothecation is also subject to several other proposed conditions relating to consent, segregation and eligibility of the entities that receive the rehypothecated assets.

The SFC proposes to permit substituted compliance where a transaction complies with the margin requirements of a comparable foreign jurisdiction (as determined by the SFC or the HKMA). The SFC proposes to deem member jurisdictions of the Working Group on Margin Requirements as comparable jurisdictions for this purpose.

Deadline for submissions on proposed margin requirements

Comments on the proposals in the consultation paper must be submitted to the SFC on or before August 20, 2018. 

Jurisdictions: 

Consultant, Deacons, Hong Kong

Senior Associate, Deacons, Hong Kong