Hong Kong SFC issues consulation paper on regulating the OTC market

The Hong Kong SFC and the Hong Kong Monetary Authority today issued a joint consultation paper on a proposal to regulate over the counter derivatives in Hong Kong.

The HKMA would regulate banks, the SFC other financial firms and there would be a new category of SFC license for those involved in the OTC market that are not end users.

The proposed changes would be designed to come into effect prior to the end of 2012 subject to similar progress elsewhere in G20 countries.

The deadline for comments regarding the proposals is 30 November.

The full SFC announcement is as follows:

Consultation begins on proposed regulatory regime for OTC derivatives market

The Hong Kong Monetary Authority (HKMA) and Securities and Futures Commission (SFC) have issued a joint consultation paper on the proposed regulatory regime for Hong Kong’s over-the-counter (OTC) derivatives market. The HKMA and SFC have been working on developing a regulatory regime for the OTC derivatives market locally, in accordance with commitments the G20 Leaders made in September 2009 to carry out reform in that area (Note 1). “In line with the objectives of the G20 commitments, the proposed regime aims to improve overall transparency in the OTC derivatives market, reduce interconnectedness of participants, and generally reduce systemic risk in the financial system,” said Mr Eddie Yue, Deputy Chief Executive of the HKMA. The HKMA and SFC are mindful that the local OTC derivatives market is relatively small compared with other major markets and the OTC derivatives market is global in nature. Hence, the focus has been on developing a regime that is on a par with international standards but takes into account local market conditions and characteristics. “Given the cross-border nature of the OTC derivatives market, global effort is required to establish international standards. Hong Kong cannot drive the reform initiatives, but we will continue to coordinate with overseas jurisdictions to address some of the key aspects of the reform,” said Mr Ashley Alder, Chief Executive Officer of the SFC. As key aspects of the OTC regulatory reform are still under discussion in the global arena, the proposed regime for Hong Kong may be subject to further change. The joint consultation paper however sets out the HKMA’s and SFC’s current thinking on how the regime might be cast given the present status of the global reform efforts. In brief, the main proposals in the consultation paper are as follows – The proposed regime will be set out in the Securities and Futures Ordinance (SFO), and will be jointly overseen and regulated by the HKMA and SFC. Essentially, the HKMA will oversee and regulate the OTC derivatives activities of authorized institutions (AIs), while the SFC will oversee and regulate such activities of persons other than AIs (Note 2). OTC derivatives transactions will have to be reported to the trade repository, which is being set up by the HKMA. (Note 3). This reporting obligation will initially apply only to certain interest rate swaps (IRS) and non-deliverable forwards (NDF), but will subsequently be extended to other product classes (such as equity derivatives and other types of interest rate derivatives) after further market consultation. Standardised OTC derivatives transactions will have to be centrally cleared through a designated central counterparty (CCP) (Note 4). This mandatory clearing obligation will also initially be limited to only certain IRS and NDF, and subsequently extended to other product classes after further market consultation. Initially, OTC derivatives transactions will not be required to be traded on an exchange or electronic trading platform. Further study is needed to assess how best to implement such a requirement in Hong Kong. AIs' OTC derivatives activities are already subject to the HKMA's regulatory oversight in respect of capital, liquidity and other relevant requirements and should remain so under the proposed regime. In order to bridge the regulatory gap that would otherwise exist, there is a need to require non-AI entities that engage in OTC derivatives activities (other than as end users) to be licensed for a new Type 11 regulated activity under the SFO. Large players who are not regulated by the HKMA or the SFC may be subject to certain obligations and requirements, such as producing information regarding their OTC derivatives activities, and reducing their OTC derivatives positions, if so requested by the SFC in extreme situations. The HKMA and SFC are working towards meeting the G20 implementation deadline of end- 2012. However, much depends on external factors, including the progress of reform initiatives in other major markets, due completion of the legislative process, and the readiness of relevant market infrastructure and participants. The consultation period will end on 30 November 2011. The joint consultation paper can be downloaded from the HKMA website or the SFC website. Interested parties are invited to submit their comments to the HKMA or the SFC on or before the deadline. End Notes : 1. The G20 Leader’s September 2009 Communique called for all standardised OTC derivatives contracts to be traded on exchanges or electronic trading platforms, where appropriate and cleared through central counterparties by end-2012 at the latest; for all OTC derivatives contracts to be reported to trade repositories, and for non-centrally cleared contracts to be subject to higher capital requirements. 2. AIs refers to institutions that are licensed under the Banking Ordinance and regulated by the HKMA (i.e. banks, restricted licence banks, and deposit-taking companies). 3. The HKMA is in the process of establishing a trade repository for the collection of data relating to OTC derivatives transactions. 4. The HKMA and SFC propose that only clearing houses recognised under the SFO and providers of automated trading services authorised under Part III of the SFO will be eligible to be designated as CCPs under the new regime. The Hong Kong Exchanges and Clearing Limited announced on 10 December 2010 that it had decided to establish a clearing house in Hong Kong for the clearing of OTC derivatives transactions.