On 12 December 2018, the Securities and Futures Commission published the conclusions to its consultation on refinements to the over-the-counter derivatives regime and to require licensed corporations (“LCs”) to properly manage financial exposure to connected persons1. Click here for our client alert on the Consultation Paper.
The proposals in the Consultation Paper were wide-ranging; the consultation conclusions only cover the proposed requirements under the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the “Code of Conduct”). Conclusions on the other requirements proposed in the Consultation Paper which relate to the new Type 11 and Type 12 regulated activities will be published separately. In this Bulletin we discuss the new Code of Conduct requirements.
Key changes to be introduced in the Code of Conduct
Overseas booking model
- LCs adopting the overseas booking model for their OTC derivatives business will be subject to new conduct requirements. Importantly, the booking entity (referred to as the “client facing affiliate” or “CFA”) must be a LC, an authorized institution or a corporation similarly regulated as an OTC derivative dealer or a bank in a “comparable OTCD jurisdiction”. The SFC has indicated a list of deemed comparable OTCD jurisdictions in its preliminary assessment which includes the Mainland. This requirement may be relaxed for clients who are regulated institutions (but not institutional, individual or corporate professional investors).
- LCs would have to amend their client agreements to include a specific risk disclosure statement if the CFA is not a LC.
Risk mitigation requirements for non-centrally cleared OTC derivatives
- LCs will be subject to risk mitigation requirements when they enter into non-centrally cleared OTC derivatives. The SFC has rejected industry calls for the provision of substituted compliance or a phase-in schedule; although a longer transition period is provided to allow the industry more time to prepare for implementation.
Conduct requirements to address risks posed by group affiliates and other connected persons
Introduction of clients to enter into OTC derivative transactions with client facing affiliates
The SFC is introducing certain new conduct requirements as proposed in the Consultation Paper when a LC solicits or recommends clients to enter into OTC derivative transactions with a group affiliate (a CFA) or arranges for OTC derivative transactions to be entered into between a CFA and its clients. These new requirements are:
i. the LC should act in the best interests of its clients (the “best interests requirement”);
ii. the group affiliate with whom the client contracts in OTC derivative transactions (i.e. the CFA) must be a LC, an authorized financial institution or a corporation similarly regulated as an OTC derivative dealer or a bank in a “comparable OTCD jurisdiction” (the “regulated CFA requirement”); and
iii. if the CFA is not a LC, the introducing LC is required to include a specific risk disclosure statement in client agreements reminding clients of the risks of entering into OTC derivative transactions with an unlicensed person (the “risk disclosure requirement”).
The regulated CFA requirement may be relaxed if the client is a regulated institution (i.e. a LC, an authorized financial institution or a corporation similarly regulated as an OTC derivative dealer or a bank in a comparable OTCD jurisdiction). The SFC has rejected calls by some respondents to extend such exemption to professional investors (i.e. experienced individual professional investors, institutional professional investors and corporate professional investors) so LCs dealing with large buy-side clients such as hedge funds will also have to comply with this new requirement.
LCs would be exempt from the risk disclosure requirement if the client is an institutional professional investor or a corporate professional investor whom the LC is exempt from the requirement to enter into a written client agreement with and to provide risk disclosure statements to under paragraph 15 of the Code of Conduct. The form of risk disclosure statement to be included in the Code of Conduct has been amended and now takes into account the transition period for the regulated CFA requirement as described below.
Unsurprisingly, given the widespread use of the offshore booking model by brokers in Hong Kong in the OTC derivatives space, the regulated CFA requirement attracted the most comments from respondents out of the three new requirements proposed in the Consultation Paper. The SFC has decided to push ahead with its proposal on investor protection grounds. This change will affect any financial group which is operating or is thinking of operating its OTC derivatives business in Hong Kong under the “introducing broker” model (i.e. where an entity with the requisite licences from the SFC introduces Hong Kong clients to enter into the OTC derivative transactions with another group affiliate). For those financial groups with an existing OTC derivatives business in Hong Kong, the first action to take now would be to assess whether the CFAs satisfy the SFC’s criteria for compliance with the regulated CFA requirement. If the CFAs do not satisfy the SFC’s criteria for compliance with the regulated CFA requirement, then the issue will become a wider one on how the group should organise its OTC derivatives business in Hong Kong to comply with the new requirement. This may involve moving the booking to another CFA which satisfies the SFC’s criteria, or obtaining new licences for group entities which will become the booking entities for OTC derivatives. These will likely be important decisions affecting how the group organises itself and have to be considered in various angles including the allocation of regulatory capital within the group. A transition period is available for existing CFAs (see below), however firms should start thinking about this new requirement sooner rather than later given the wide organisational impact it is likely to have. Irrespective of whether existing CFAs satisfy the SFC’s criteria for compliance with the regulated CFA requirement, Hong Kong-licensed introducing brokers should comply with the best interests requirement and the risk disclosure requirement when they come into effect.
If an ongoing introduction agreement was not established and in effect between a LC and a CFA before 12 December 2018 (i.e. the CFA is not an existing CFA), then all of the best interests requirement, regulated CFA requirement and risk disclosure requirement discussed here would have to be complied with when the Code of Conduct amendments become effective. It should be noted that the new Type 11 regulated activity has not yet come into effect, so any licensing decisions should be made with this in mind. Depending on the type of OTC derivative activities a LC conducts, an additional licence for the new Type 11 regulated activity may be required when the new licensing requirements come into effect.
In order to assist LCs’ preparation for compliance with the regulated CFA requirement, the SFC has agreed to issue a list of deemed comparable OTCD jurisdictions in the interim.
The long list of comparable OTCD jurisdictions is helpful in assisting LCs with the implementation of the new regulated CFA requirement. LCs should start examining their booking model for OTC derivatives business and make the relevant adjustments as necessary. It should be noted that the SFC has also recently announced a thematic review into booking models generally – it will be interesting to see how the consultation conclusions will fit with those findings.
Comparable OTCD jurisdictions
A comparable OTCD jurisdiction is a jurisdiction which has implemented a regulatory framework on OTC derivative dealing activities comparable to Hong Kong’s. The list of comparable OTCD jurisdictions will be determined with reference to the jurisdictions’ implementation of prudential and conduct requirements for supervising intermediaries conducting OTC derivative dealing.
The SFC is agreeable to issue a list of deemed comparable OTCD jurisdictions in the interim to facilitate LCs’ preparation for compliance with the regulated CFA requirement. If the SFC decides to exclude a deemed comparable OTCD jurisdiction from the final list after its comparability review, it will allow sufficient time for the affected LCs to make the necessary arrangements to comply with the regulated CFA requirement.
The SFC has indicated a list of deemed comparable OTCD jurisdictions based on its preliminary assessment to include the securities, futures and banking regulators in the following countries: Australia, Canada, the Mainland, France, Germany, Italy, Japan, Netherlands, the Republic of Korea, Singapore, Spain, South Africa, Switzerland, the UK and the US.
LCs booking OTC derivative transactions in risk booking affiliates
In order to minimise any spill-over of the default risk of a “risk booking affiliate” or “RBA” (i.e. a group affiliate which has undertaken the risks of a client trade in OTC derivative transactions through back-to-back transactions), a LC who arranges OTC derivative transactions for RBAs who are not LCs, authorized financial institutions or corporations similarly regulated as an OTC derivative dealer or a bank in a comparable OTCD jurisdiction will be required to:
i. ensure the risks undertaken by the RBA in the OTC derivative transactions are properly managed in the case where the LC has responsibility for or oversight of the management of such risks; or
ii. in any other case, take reasonable steps to ensure that the risks undertaken by the RBA in the OTC derivative transactions are covered by a risk management programme whose standards are not less stringent than the risk management standards set by the SFC for LCs, by the HKMA for authorized financial institutions or by a securities, futures or banking regulator in a comparable OTCD jurisdiction for OTC derivative dealers or banks entering into similar transactions.
The SFC confirmed that this requirement would apply even though the client is contracting with a regulated CFA.
Management of financial exposures to group affiliates and other connected persons
As proposed in the Consultation Paper, LCs will be required to properly manage financial exposures to group affiliates and other connected persons according to the same risk management standards they would deploy in respect of financial exposures to independent third parties undertaken by them on an arm’s length basis to minimise interconnectedness risk. This requirement can be overridden by an applicable requirement or exemption under any law, rule or regulation administered or issued by the SFC or the regulators of the group affiliates or other connected persons in respect of the exposure or transaction giving rise to the exposure.
The SFC confirmed that this requirement will apply to all LCs (not just those engaging in OTC derivative activities), but not to registered institutions or inter-branch transactions. Financial exposures include on-balance sheet and off-balance sheet exposures. The SFC also confirmed that risks should be managed at the entity level; risk management at the group level as suggested by some respondents will not suffice for the purpose of this requirement.
Similar to other Code of Conduct requirements, the new requirement is intended to be principles-based and the SFC expects LCs to design and implement control and risk management programmes which are commensurate with the scale and complexity of their operations.
Implementation timetable
The best interests requirement and the risk disclosure requirement will take effect six months after the gazettal of the relevant Code of Conduct amendments. LCs should start amending their client agreements to comply with the risk disclosure requirement where applicable. The SFC has confirmed that the risk disclosure is to be made in respect of each CFA in the client agreement on a one-off basis.
With respect to the regulated CFA requirement, the SFC will allow a transitional period for compliance in respect of dealings with an existing CFA (i.e. one with an ongoing introduction agreement with a LC within the same group that was established and in effect before 12 December 2018) which fall outside the range of regulated persons; such transition period will end with the expiry of the transitional period for the Type 11 regulated activity.
Risk mitigation requirements for non-centrally cleared OTC derivatives
The SFC will introduce risk mitigation requirements for non-centrally cleared OTC derivatives as conduct requirements on LCs to be included in a new Schedule 10 to the Code of Conduct.
Risk mitigation requirements are operational and documentation requirements aimed at reducing the counterparty credit risk and operational risk faced by LCs when they trade non-centrally cleared OTC derivatives. The requirements to be introduced are:
- OTC derivatives trading relationship documentation
- Trade confirmation
- Valuation
- Portfolio reconciliation
- Portfolio compression
- Dispute resolution
The requirements to be introduced by the SFC are the same as the proposals in the Consultation Paper. The risk mitigation requirements are applicable to (i) any LC (regardless of the regulated activity for which it is licensed) which is a contracting party to non-centrally cleared OTC derivative transactions and (ii) a Type 9 LC (i.e. an asset manager) which provides a service of managing a portfolio of OTC derivative products for a collective investment scheme (CIS) managed by it, in respect of non-centrally cleared OTC derivative transactions executed by it on behalf of that CIS, except for any risk mitigation requirement which is handled by the governing body of the CIS or its delegate.
The SFC’s risk mitigation requirements will not apply to registered persons.
The SFC has emphasised that its approach with the risk mitigation requirements is high-level and principles-based. The SFC also thinks that the risk mitigation requirements should have already been implemented by LCs to a certain extent since LCs are subject to the key information management and risk management requirements in the Management, Supervision and Internal Control Guidelines for Persons Licensed by or Registered with the SFC. On this basis, the SFC has rejected the industry’s calls for substituted compliance and a phase-in schedule similar to the one provided for in the HKMA’s rules on similar requirements applicable to authorized institutions. The SFC’s requirements will also apply to all LCs regardless of the size of their portfolio of non-centrally cleared OTC derivatives and the purpose for which the derivative was used (i.e. whether hedging or not). LCs are advised to adopt a risk-based approach when implementing the SFC’s requirements. For LCs incorporated outside Hong Kong, the SFC has said that the risk mitigation requirements are not confined to trades entered into by the LC’s Hong Kong branch, and that it will take a principles-based approach in assessing the LC’s compliance with the requirements.
Given the non-prescriptive nature of the SFC’s risk mitigation requirements and its expectation on LCs to adopt a risk-based approach, LCs should be able to rely on some of the industry documentation published by industry groups (albeit designed for compliance with risk mitigation requirements imposed by other regulators or for other jurisdictions) when implementing the SFC’s requirements. Obviously, before using such industry documentation, LCs should assess its appropriateness by reference to its own OTC derivatives business.
Although the SFC has rejected the industry’s calls for a phase-in schedule, it has provided a longer transition period to allow the industry more time to prepare – the risk mitigation requirements will become effective on 1 September 2019.
Conduct requirements for LCs providing client clearing services
The SFC will introduce the conduct requirements (with respect to (i) segregation and portability, (ii) indirect clearing and (iii) clearing confirmation to clients) on LCs licensed for providing client clearing services for OTC derivative transactions (the new Type 12 regulated activity) as proposed in the Consultation Paper in a new Schedule 10 to the Code of Conduct. These requirements will become effective when the new OTC derivatives licensing regime commences.
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