New conduct requirements for licensed corporations relating to OTC derivatives

The Securities and Futures Commission (SFC) issued its Consultation Conclusions on (1) the OTC derivatives regime for Hong Kong – Proposed requirements in relation to OTC derivative risk mitigation and client clearing; and (2) Proposed conduct requirements to address risks posed by group affiliates (Conclusions) on 12 December 2018. The Conclusions impose new conduct obligations relating to:

1. managing financial exposure to group affiliates and other connected persons;

2. risk mitigation measures when entering into non-centrally cleared OTC derivative transactions;

3. the provision of client clearing services in relation to OTC derivative transactions (the new type 12 regulated activity); and

4. soliciting or recommending clients enter into OTC derivative transactions with a group affiliate, or booking OTC derivative transactions with a group affiliate.

This article relates to items 1 and 2. Type 9 licenced corporations should note that they will be subject to the requirement to apply risk mitigation measures when entering into non-centrally cleared OTC derivative transactions in certain circumstances.

The Conclusions are available here: (https://www.sfc.hk/edistributionWeb/gateway/EN/consultation/conclusion?refNo=17CP9). 

New general obligation – Manage financial exposure to group affiliates and other connected persons

The Conclusions contain an amendment to the Code of Conduct for Persons Licensed By or Registered with the Securities and Futures Commission (Code of Conduct) that requires all licensed corporations to manage financial exposure to group affiliates and other connected persons. It is set out in the new paragraph 20.1 of the Code of Conduct, which come into effect on 14 June 2019:

20.1 A licensed corporation should manage financial exposures to group affiliates and other connected persons, namely its shareholders, directors and employees, according to the same risk management standards it would apply in respect of financial exposures to independent third parties undertaken by it on an arm’s length basis, except where doing so would have the effect of overriding an applicable requirement or exemption under any law, rule or regulation administered or issued by the Commission or the regulators (if any) of the group affiliates or other connected persons in respect of the exposure or transaction giving rise to the exposure. 

Licensed corporations should satisfy themselves that their current financial oversight procedures are sufficient to meet this new requirement.

New risk mitigation requirements relating to non-centrally cleared OTC derivatives

The Conclusions contain amendments to the Code of Conduct that require a licensed corporation which enters into non-centrally cleared OTC derivative transactions to implement specified risk mitigation requirements. The general obligation is set out in a new paragraph 4.3A of the Code of Conduct. The licensed corporations subject to the requirements and the specified risk mitigation requirements are set out in a new Schedule 10 to the Code of Conduct. The final form of paragraph 4.3A and Schedule 10 are on pages 34 to 37 of the Conclusions.

The new paragraph 4.3A and Schedule 10 will come into effect on 1 September 2019.

Who needs to comply

The obligation to comply with the specified risk mitigation requirements will apply to:

1. a licensed corporation (regardless of the regulated activity for which it is licensed) which is a contracting party to OTC derivative transactions that are not centrally cleared; and

2. a type 9 licensed corporation (Asset Manager) where it is managing a collective investment scheme “in respect of non-centrally cleared OTC derivative transactions executed by it on behalf of the collective investment scheme managed by it, except to the extent that the risk mitigation requirements are handled by the governing body of the collective investment scheme or its delegate”. Asset Managers should note that the definition of “collective investment scheme” in the Securities and Futures Ordinance is broad and includes retirement schemes and other arrangements, in addition to investment funds. 

The SFC clarified in the Conclusions that the risk mitigation requirements do not apply:

• if an Asset Manager executes transactions on the instructions of its overseas affiliates e.g. is performing a dealing activity, rather than an asset management activity (paragraph 35 of the Conclusions);

• to discretionary accounts, although the SFC encourages Asset Managers to adopt the risk mitigation requirements for discretionary accounts to the extent practicable (paragraph 39 of the Conclusions). 

Where an Asset Manager enters into a non-centrally cleared OTC derivative transaction on behalf of a collective investment scheme and the trade is executed by another group company then the SFC expects the Asset Manager to review whether appropriate procedures are in place to achieve a similar risk mitigation outcome (paragraph 35 of the Conclusions).

Risk mitigation requirements

The risk mitigation requirements are set out as high level principles. They include requirements for:

1. trading relationship documentation;
2. trade confirmations;
3. valuation (only applicable to the extent that the Asset Manager is “responsible for the overall operation” of the collective investment scheme);
4. portfolio reconciliation;
5. portfolio compression; and
6. dispute resolution. 

Actions required

Licensed corporations that are contracting parties to OTC derivative transactions that are not centrally cleared should review their policies and procedures for compliance with the risk mitigation requirements in Schedule 10 to the Code of Conduct. 

Asset Managers that manage collective investment schemes should, in respect of non-centrally cleared OTC derivative transactions executed by it on behalf of the collective investment schemes managed by it:

1. review their policies and procedures for compliance with the risk mitigation requirements in Schedule 10 to the Code of Conduct;

2. for each collective investment scheme:
   

a. identify and document which of the risk mitigation requirements (if any) are handled by the governing body of the collective investment scheme or its delegate (other than the Asset Manager); and
b. ensure that the Asset Manager complies with the risk mitigation requirements that are not handled by the governing body of the collective investment scheme or its delegate (other than the Asset Manager). 

Asset Managers should also consider the extent to which it is practicable to apply the risk mitigation requirements for their management of discretionary accounts.

Key Contacts

Scott Carnachan

Consultant | Financial Services

Email or call +852 2825 9265