The Securities and Futures Commission (SFC) has recently published a consultation paper (Consultation) that proposes refinements to the scope of regulated activities and new conduct requirements relating to over-the-counter (OTC) derivatives. These changes are intended to take effect on or before the commencement of the Hong Kong licensing regime for OTC derivative-related activities. The Consultation is open for comment until 20 February 2018.
Refinements to scope of regulated activities
The Securities and Futures (Amendment) Ordinance 2014 made the following changes to the Hong Kong licensing regime:
- Expanded type 7 regulated activity (type 7 RA, providing automated trading services) to include automated trading services related to OTC derivatives (expanded type 7 RA
- Expanded type 9 regulated activity (type 9 RA, asset management) to include “OTC derivative products management”, defined as “providing the service of managing a portfolio of OTC derivative products for another person” (expanded type 9 RA
- Created a new type 11 regulated activity (type 11 RA), dealing in OTC derivative products or advising on OTC derivative products; and
- Created a new type 12 regulated activity (type 12 RA), providing client clearing services for OTC derivative transactions.
The Consultation proposes a number of changes to the Hong Kong licensing regime that are beneficial to asset managers:
- The scope of expanded type RA 9 will be refined to exclude the management of OTC derivatives products for wholly-owned group companies.
- It will be made clear that an asset manager that deals in forex derivatives as part of its asset management strategies will not need to be licensed for type 3 regulated activity (leveraged foreign exchange trading) if it (i) is licenced for type 9 RA; (ii) is permitted by its licence to manage portfolios of OTC derivatives products for another person; (iii) deals in forex derivatives solely for the purposes of managing OTC derivative products; and (iv) such dealing constitutes an OTC derivatives dealing act.
- The provision of client clearing services by an asset manager for the funds it manages will be carved-out from type 12 RA. In addition, the definition of type 12 RA will be amended to clarify that providing ancillary services to facilitate client clearing will not fall within type 12 RA. However, if an asset manager is a clearing member or a client of a clearing member, and provides clearing services to its clients, it will need to be licensed for type 12 RA.
Asset managers should note that they will need to be licensed for type 11 RA if they operate a central dealing desk in Hong Kong for their group’s OTC derivative trading activities.
The Consultation also proposes additional exemptions from the licensing regime for corporate treasury activities of “non-financial groups”, for certain trade compression services and certain overseas clearing members of overseas central counterparties.
Other licensing-related requirements
The Consultation proposes that:
- the fees payable to the SFC for type 11 RA and type 12 RA will be the same as for other regulated activities (except type 3 regulated activity);
- there will not be any regulatory requirement to take out insurance for expanded type 7 regulated RA, expanded type 9 RA, type 11 RA or type 12 RA;
- in respect of the need for licence applicants to pass local regulatory papers, the existing local regulatory papers for types 2 and 5 regulated activities will be expanded to cover type 11 RA, there will be a new local regulatory paper for type 12 RA and the Hong Kong papers for type 9 RA will be updated to include expanded type 9 RA activities; and
- certain existing market participants will be grandfathered, subject to completing a post-licensing refresher course after being deemed licensed or registered.
New conduct requirements for non-centrally cleared OTC derivatives
The Consultation proposes new conduct requirements, as set out in the table below:
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New conduct requirements:
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Applicable to:
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1.
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Risk mitigation measures relating to trading relationship documentation, trade confirmations, valuations, portfolio reconciliations, portfolio compression and dispute resolution
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- licensed corporations that are contracting parties to non-centrally clearly OTC derivative transactions
- licensed corporations that execute non-centrally cleared OTC derivative transactions on behalf of any collective investment scheme (CIS) they manage during the course of type 9 RA, except to the extent that the required measures are handled by the governing body of the CIS or its delegate (trustee, custodian etc.)[1] [2]
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2.
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Measures to address risks posed by transactions with group affiliates and other connected persons
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- licensed corporations that have dealings with or financial exposure to group affiliates and other connected persons in relation to OTC derivative transactions
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3.
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Record-keeping
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- licensed corporations that are contracting parties to OTC derivative transactions
- licensed corporations that execute OTC derivative transactions on behalf of any CIS they manage during the course of type 9 RA, except to the extent that the required measures are handled by the governing body of the CIS or its delegate1
- licensed corporations that provide client clearing services for OTC derivative transactions
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4.
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Segregation, portability and clearing confirmation
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- licensed corporations that provide client clearing services for OTC derivative transactions
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5.
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Client money and client securities
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- licensed corporations that provide client clearing services for OTC derivative transactions
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The SFC’s Code of Conduct imposes a requirement that client agreements include a “suitability clause” to the effect that any financial products sold or recommended must be reasonably suitable for the client. This requirement will extend to the sale or recommendation of OTC derivative products when the new OTC derivatives licensing regime commences.
The SFC intends to make the new conduct requirements for risks posed by transactions with group affiliates and other connected persons effective within six months after gazettal of the amended Code of Conduct. The other conduct requirements will be effective when the new OTC derivatives licensing regime commences.
[1] Note: If another group company is responsible for executing the transactions, the required requirements do not apply directly, but the SFC expects the licensed corporation to review whether appropriate procedures are in place to achieve a similar outcome.
[2] For other discretionary mandates, the nature and extent of risk mitigation measures and the party that will be responsible for them will be a matter for agreement between the asset manager and its client.
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