At Issue
1/18/2012 3:44:07 AM EST
The proposed regulatory regime for the OTC derivatives market in Hong Kong
Chin-Chong Liew and I-Ping Soong review the proposed regulatory regime for the over-thecounter derivatives market in Hong Kong, which is a response to regulatory reform commitments following the 2008 global financial crisis.
Posted by LexisNexis

The global financial crisis in 1998-99 prompted calls for the reformof the global over-the-counter (OTC) derivatives market. On17 October 2011, the Hong Kong Monetary Authority (HKMA) andthe Securities and Futures Commission (SFC) jointly published theConsultation paper on the proposed regulatory regime for the overthe-counter derivatives market in Hong Kong (the ‘ConsultationPaper’) to consult the public on a proposed new regime for OTCderivatives transactions in Hong Kong. The comment periodconcluded on 30 November 2011.

The proposed regime is clearly a response to the G20 leaders’regulatory reform commitments following the global financial crisis in2008, which require the implementation of the following obligations:

• the mandatory reporting of OTC derivative transactions to traderepositories (TRs),
• the mandatory clearing of standardised OTC derivativetransactions to central counterparties (CCPs) by the end of 2012;
• the mandatory trading of standardised OTC derivative transactionson exchanges or trading platforms, where appropriate; and
• the imposition of higher capital requirements in respect of OTCderivative transactions that are not centrally cleared.

In addition to the imposition of the mandatory clearing,reporting and trading obligations, the proposed new OTC derivativesregulatory regime also goes further and addresses how the financialintermediaries that play a key role in the OTC derivatives market willbe regulated. This aspect presents some interesting questions as tohow the proposed new regulated activity will interact with the scope of the existing regulated activities under the Securities and FuturesOrdinance (Cap 571) (SFO).

In Asia Pacific, Hong Kong is one of the first jurisdictions toaddress these issues in a public consultation. This is the first oftwo consultations and relates to the framework of the new OTCderivatives regime. A second consultation, expected to take place in thefirst quarter of 2012, will focus on the detailed changes to regulationsto implement the regime and it is only after this second consultationwill a clearer picture of the new regime emerge.


Legislative framework
The proposal is to set out the new legislative framework in the SFO,which will cover OTC derivative transactions in addition to securitiesand futures. At present, Hong Kong does not have a single andcohesive regime for parties seeking to carry out derivatives businessand one effect of the new proposals will be that such a regime may becreated.

The advantage of leveraging off the existing SFO legislativeframework, rather than creating a new piece of legislation specificallyto regulate OTC derivatives, is that legislative changes will beminimised. However, adapting the existing regime to fit OTCderivatives could lead to inconsistencies, as will be explored below.

The Consultation Paper proposes giving wide powers to the SFCand HKMA to develop the new regime through subsidiary legislation.This will be implemented by setting out the framework of the regimein the primary legislation, leaving details of the regime (such as thetypes of products covered by the mandatory obligations and theconditions of CCP designation) to be set out in subsidiary legislation.This approach has the advantage of providing flexibility for futuremarket changes, and takes into account the still-evolving internationalregulatory landscape.

‘OTC derivatives transactions’
The proposal is to expand the scope of the SFO via the new conceptof ‘OTC derivatives transactions’. This definition is doubly significant because it will delineate the widest possible scope of the mandatoryobligations and because it will determine who needs to be licensedwith the SFC for the purpose of the proposed new Type 11 regulatedactivity.

The Consultation Paper’s proposed approach is to adopt a verywide definition of ‘OTC derivatives transactions’ in the primarylegislation. In terms of the mandatory obligations only, the scope ofthese would be narrowed by the subsidiary legislation.

‘OTC derivatives transactions’ is to be defined using the existingall-encompassing ‘structured products’ definition in the SFO, but withcarve outs for transactions in securities and futures contracts that aretraded on a recognised exchange company (ie Hong Kong Exchangesand Clearing Limited); retail structured products authorised by theSFC; and transactions in currency-linked, interest rate-linked andcurrency and interest rate-linked instruments offered by authorizedinstitutions to the public.

This approach to drafting is hardly elegant and it would bepreferable to define ‘OTC derivatives transactions’ by reference to whatderivatives are, rather than what they are not. For example, the draftEuropean legislation defines ‘OTC derivatives’ as ‘derivative contractswhose execution does not take place on a regulated market, as definedby Art 4(1) point 14 of Directive 2004/39/EC’: The Proposal for theRegulation of the European Parliament and of the Council on OTCderivatives, central counterparties and trade repositories COM (2010)484/5, Art 2.

In addition, the second and third carve-outs relate to the marketing of derivatives, ie how derivatives and their documentationare authorised when offered for sale. This is a distinct issue from the licensing of intermediaries carrying on the business of dealing in OTCderivatives transactions. Since the ‘OTC derivatives transactions’definition is used to determine who needs to be licensed for theproposed Type 11 regulated activity, this would lead to some strangequirks. For example, a dealer engaging in private placements ofderivatives would require licensing for the new regulated activity, buta dealer engaging in the public offer of derivatives would not needto because it falls within a carve-out. This is certainly not how thesecurities business is currently regulated – the licensing of securities business does not depend on whether the securities are offered on thebasis of private placement or public offer.Given the central role played by the term ‘OTC derivativestransactions’, it is critical that the term is defined as clearly as possible.

The proposed mandatory obligations

The Consultation Paper proposes the introduction of mandatoryreporting and mandatory clearing requirements for certain types of OTC derivatives transactions. A mandatory trading obligation willnot be imposed at the outset, but the SFO may be amended to allowfor such an obligation to be introduced in the future if consideredappropriate.

Mandatory reporting 
One of the lessons learned from the global financial crisis is thatthe OTC derivatives market can be opaque, making it difficult forregulators to properly assess the build up of risk. The imposition of a mandatory reporting obligation for OTC derivativestransactions helps ensure the transparency of the OTCderivatives market.

As anticipated, the Consultation Paper proposesintroducing a mandatory reporting obligation in relation tocertain specified OTC derivatives transactions over a certainthreshold. At the same time, on the bricks-and-mortarlevel, the HKMA is in the process of setting up a nationalTR to enable the SFC and HKMA to assess and manageany systemic risk created by OTC derivatives transactions.The current thinking is that this will be the only TR to berecognised in Hong Kong, so as to better enable Hong Kongregulators to monitor OTC derivatives transactions.

What transactions are reportable?
The Consultation Paper contemplates a phased approachto reporting, with only certain classes of OTC derivativestransactions to be reportable initially. Of the most commonlytraded product types in Hong Kong, the largest market shareis taken up by foreign exchange (FX) derivatives, followedby interest rate swaps (IRS) and non-deliverable forwards(NDFs). The Consultation Paper notes that FX derivativesare of a short tenure and are mostly cleared through theContinuous Linked Settlement system, lessening the riskof these types of transactions. The mandatory reportingobligations will hence initially apply to IRS (single currencyIRS, overnight index swaps, single currency basis swaps) andNDFs.

Who needs to report?
The mandatory reporting obligation will apply in differentways to the following entities:

• licensed corporations (LCs);
• authorized institutions (AIs), both overseas-incorporatedand locally-incorporated; and
• Hong Kong persons, being individuals who are HongKong residents, the owners of sole proprietorships orpartnerships based in, operated from or registered in HongKong, companies that are incorporated or registered inHong Kong, funds that are managed in or from HongKong or any other entity established or registered underHong Kong law.

LCs and locally-incorporated AIs will be required toreport reportable transactions either: (i) to which they are acounterparty; or (ii) which they have originated and executed.This obligation applies irrespective of whether the AI hasconducted its activities through the Hong Kong branch or anoverseas branch.

Overseas-incorporated AIs will be required to report both:(i) reportable transactions that they are counterparty to, orhave originated or executed, in either case through their HongKong branch; and (ii) reportable transactions that they are acounterparty to and which have a ‘Hong Kong nexus’.

Trades will have a ‘Hong Kong nexus’ if, in the case of equity andcredit derivatives, the underlying entity is the reference entity which isestablished, incorporated or listed in Hong Kong or under Hong Kong law and, in the case of other derivatives, the underlying asset, currencyor rate is denominated in (or includes one that is denominated in) HKD. It will be interesting to see what other trades could potentially have a Hong Kong nexus, for example, trades denominated in offshore RMB?

Hong Kong persons will be required to report reportable transactions to which they are a counterparty if the specified reporting threshold has been exceeded. The reporting threshold only applies toHong Kong persons and not LCs or AIs.

It is currently not proposed to subject overseas persons (ie personsthat are not an AI, LC or Hong Kong person) to mandatory reporting.

Exemptions or qualifications to the reporting obligation
To reduce the reporting burden on Hong Kong persons, it is proposedto exempt Hong Kong persons from mandatory reporting if anAI or LC is also subject to a reporting obligation in respect of thattransaction. However, no exemption is available in the situation wheremore than one AI or LC is involved in the reportable transaction. In such case, all AIs or LCs involved will have to report.

It is also proposed that an AI or LC will have discharged itsreporting obligation in respect of a reportable transaction if ithas originated or executed the transaction on behalf of one of the counterparties and such counterparty has confirmed to the AI or LC that the transaction has been reported to the HKMATR.

Mandatory clearing
One of the lessons learned from the global financial crisis was howthe insolvency of one counterparty can have a rapid contagion effect throughout the financial system. The clearing of OTC derivativestransactions through a CCP is an important way to minimise suchsystemic risk as it interposes the CCP as counterparty to each trade.The proposal in the Consultation Paper is to introduce a requirementthat clearing eligible transactions must be cleared through a designatedCCP. Mindful of the costs involved in mandatory clearing, theConsultation Paper frames the mandatory clearing obligation morenarrowly than the mandatory reporting obligation.

What transactions need to be cleared?
The mandatory clearing obligation is proposed only to apply to‘clearing eligible transactions’. At the outset, clearing eligibletransactions are proposed to cover the same classes of transactions asreportable transactions (ie NDFs and IRSs), although this is not yetconfirmed.

Who needs to clear?
In general, if an AI, LC or Hong Kong person is either a counterpartyto a clearing eligible transaction or has originated or executed sucha transaction, and if both counterparties have exceeded the specifiedclearing threshold, then such transaction would need to be cleared.

The mandatory clearing obligation applies slightly differently tolocally-incorporated AIs and overseas-incorporated AIs. For locallyincorporated AIs, mandatory clearing will apply in respect of allactivities in clearing eligible transactions, irrespective of whether suchtransactions are carried out through the Hong Kong branch or froman overseas branch. For an overseas-incorporated AI, its involvementin the relevant transaction must be through its Hong Kong branch.

Exemptions to the clearing obligation 
Significantly, to mitigate the burden of having to clear an OTCderivative transaction through multiple CCPs, an exemption isproposed where both counterparties are overseas persons and wherethe transaction is either subject to or exempt from mandatory clearingunder the laws of an acceptable overseas jurisdiction. The SFC andHKMA have yet to identify which are acceptable overseas jurisdictions,but these are anticipated to be where the reporting, clearing andtrading of OTC derivatives are on a par with international standardsand practices.

This exemption will be important in the situation where a HongKong AI or LC originates or executes a clearing eligible transactionbetween two entities that are not an AI, LC or Hong Kong person.

Conflicting international obligations
An important challenge with mandatory clearing is the possibility ofconflicting clearing obligations. This may occur where OTC derivativetransactions are entered into on a cross-border basis. For instance, ifa Hong Kong counterparty transacts with a UK counterparty, bothmay be subject to mandatory clearing obligations in their respectivejurisdictions. As the transaction can only be cleared through one CCP,there must be a mechanism for resolving this conflict. The issue mayalso arise as a result if laws have extra-territorial impact, for instance, ifa mandatory clearing obligation were to catch transactions engaged inby an overseas branch of an entity, and that branch was also subject to asimilar obligation under the law of the jurisdiction of its establishment.

The proposed Hong Kong mandatory clearing obligation containssome limits to its territorial scope. There is the exemption describedabove for transactions between two overseas persons, and in addition,the clearing obligation applies only to transactions originated orexecuted by the Hong Kong branch of overseas AIs. However, therestill remains scope for potential conflict with clearing obligations inother jurisdictions. A possible solution to this is to permit a personto satisfy his/her mandatory obligations by clearing on an overseasplatform. The Consultation Paper indeed contemplates the licensingof overseas platforms in Hong Kong.

Other possible international solutions include the mutualrecognition of CCPs. Mutual recognition involves one jurisdictionrecognising CCPs regulated by another jurisdiction so that regulatedpersons in the first jurisdiction may satisfy their mandatory clearingobligations by clearing through CCPs regulated in the secondjurisdiction. Such CCPs may or may not be licensed or have a presencein the first jurisdiction. A framework for mutual recognition can onlybe established by international co-operation and it is still not clearto what extent regulators internationally are co-operating to devisepractical solutions to these issues.

Designation and regulation of CCPs

It is proposed that clearing eligible transactions must be clearedthrough a designated CCP. Designated CCPs are anticipated to berecognised clearing houses (RCHs) or an automated trading services(ATS) provider authorised under Part III of SFO (subject to expansionof the relevant definitions to cover OTC derivatives transactions). Thisopens up the possibility of overseas CCPs obtaining authorisation asan ATS provider and providing clearing services in Hong Kong.

Regulation of OTC derivatives market participants

Regulation of financial intermediaries
The Consultation Paper proposes adding a new ‘Type 11’ regulatedactivity to the SFO, which would impose a licensing requirement onany person, other than an authorized institution, who carries on abusiness of dealing in or advising on OTC derivatives transactions.The scope of Type 11 is likely to be similar to the existing dealing/advising regulated activities; that is, it would reach persons who induce,advise on, intermediate, arrange or otherwise facilitate transactions,but would be likely to exclude persons who are trading on a purelyprincipal basis (although such persons may be subject to regulationas ‘large players’). Presumably, as with the current regulated activities,the licensing obligation will fall on a person who carries on a businessin Hong Kong or who actively markets the service to the Hong Kongpublic on a cross-border basis.

Given the broad reach of this definition, the new Type 11definition could impose a licensing requirement on a significantnumber of firms in Hong Kong, including firms that are currentlyarranging OTC derivatives transactions on an unlicensed basis.

Scope of regulated activity
It would appear that there will be significant overlap between thenew Type 11 regulated activity and existing regulated activities,such as dealing in securities (Type 1) or leveraged foreign exchangetrading (Type 3). For example, a firm that is trading in equityoption and swap transactions would potentially require licensing forType 1 as well as the new Type 11 regulated activity. The ConsultationPaper invites feedback on how such an overlap can be reconciled.The Consultation Paper mentioned two possible approaches. Onepossibility is that the Type 11 requirement would apply only toactivities not caught by the existing regulated activities, the scope ofwhich would remain unchanged. The regulation of OTC derivativestransactions would be split between Type 1, Type 3 and Type 11regulated activities. The second approach is to amend the scope of theexisting regulated activities so as to exclude activities falling withinthe scope of the new Type 11 regulated activity. Whichever approachis taken, it is important that the categories of regulated activity shouldbe well thought through as this will have an impact not only on whatexceptions apply but who the applicable regulator is. It is also currentlyunclear what exceptions, if any, will apply to the new Type 11 regulatedactivity.

Oversight of intermediaries
The proposed regime will also create some complexity in the oversightregime for OTC derivatives transactions with the HKMA and the SFC having joint oversight of the new regime. It will be important toensure a level playing field between authorized institutions and otherregulated entities.

Oversight of ‘large players’
Regulators are considering whether to impose a limited degree ofregulatory oversight over ‘large players’ in the OTC market. Suchentities will not be subject to a licensing requirement but may berequired to report their positions above a certain threshold.

Capital charges and margin requirements

The Consultation Paper indicates that the Hong Kong regulatorsare considering how capital charges and margin requirements willbe determined for non-cleared trades and will have regard to theproposals by the international standard setters in determining what isappropriate.


Internationally, the Dodd-Frank Act in the US has created a newworld for OTC derivatives and European regulatory efforts are not farbehind. The proposals in the Consultation Paper are a step in the rightdirection and are in line with global efforts. However, the devil is inthe detail and it remains to be seen how the detailed areas of the newproposal will be clarified.



Chin-Chong Liew


I-Ping Soong
Managing Associate



Chin-Chong Liew及I-Ping Soong探討有關香港場外衍生工具市場監管制度建議,該建議乃回應2008年全球金融危機後所承諾作出的監管制度改革。


• 強制性向交易資料儲存庫(下稱「儲存庫」)匯報場外衍生工具交易;

• 於2012年底前強制性通過中央交易對手結算標準化場外衍生工具交易;
• (因應適當情況)強制性在交易所或交易平台進行標準化場外衍生工具交易;及
• 對非中央結算的場外衍生工具交易實施較高的資本要求。










上述的草擬方法未算盡善盡美,而根據衍生工具的特徵(而非根據不屬於衍生工具的特徵)來正面定義「場外衍生工具交易」則屬明智之舉。例如歐洲法例的草擬本將「場外衍生工具」定義為「並非於受規管市場執行交易之衍生工具合約(有關定義見Art 4(1) point 14 of Directive 2004/39/EC)」:歐洲議會及委員會對場外衍生工具、中央交易對手及交易資料儲存庫的規管建議COM (2010) 484/5,第2條(The Proposal for the Regulation of the European Parliament and of the Council on OTC derivatives,
central counterparties and trade repositories COM (2010) 484/5, Art 2)。




《諮詢文件》建議就若干類別的場外衍生工具交易引入強制性匯報及強制性結算的規定。雖則不會在初期便推行強制性交易責任,但《證券及期貨條例》可能會於日後適當時候作出修訂以引入強制性交易責任 。



《諮詢文件》建議分階段實施匯報責任,初期僅要求就若干類別的場外衍生工具交易作出匯報。香港市場交易最頻繁的產品種類中,佔市場份額最多的是外匯衍生工具,其次是利率掉期及不交收遠期外匯。《諮詢文件》指出,外匯衍生工具屬短期及大多數通過持續聯繫結算及交收系統交收,從而減少上述各種交易的風險。故此,強制性匯報責任初期將適用於利率掉期(單一貨幣利率掉期、隔夜指數掉期、單一貨幣息率基準掉期 )及不交收遠期外匯。


• 持牌法團;
• 認可機構(無論是境外註冊還是本地註冊);及
• 香港人士,即屬香港居民的個體、總部設於香港、從香港運作或在香港註冊的獨資或合夥經營企業的擁有人、在香港成立為法團或註冊的公司、在香港或從香港管理的基金或根據香港法律設立或註冊的任何其他實體。


境外註冊認可機構將須於以下情況匯報︰(i)它們是其中一方交易對手或發起或執行該交易,而該交易通過其香港分行成為須予匯報交易;及(ii)它們是交易對手,而有關交易因「與香港有關連」成為須予匯報交易 。

























國際方面,美國《多德-弗蘭克保護法》(Dodd-Frank Act)已為場外衍生工具翻開新一頁,歐洲方面的監管制度亦緊隨其後。《諮詢文件》的建議標誌著朝正確方向邁出的一步,與全球各國群策群力。然而,有關建議知易行難,我們拭目以待新建議的詳細部份將如何予以闡明。



Chin-Chong Liew


I-Ping Soong

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