Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives

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1 30 December 2015 Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives Introduction On 3 December 2015, the Hong Kong Monetary Authority ( HKMA ) issued a consultation paper (the HKMA Consultation Paper ) on the proposed margin and risk mitigation rules for non-centrally cleared OTC derivatives ( non-cleared derivatives ), together with the draft chapter of the Supervisory Policy Manual implementing such proposals 1. The HKMA is seeking public feedback and the deadline for comments is 15 January The rules are expected to be in place by 1 September 2016, subject to phase-in arrangements. Overview The HKMA Consultation Paper proposes margin and risk mitigation standards applicable to authorized institutions ( AIs ). Unlike mandatory reporting and clearing of OTC derivatives, the proposals will not be implemented by amending the Securities Futures Ordinance (Cap. 571) ( SFO ). The HKMA proposed rules do not apply to licensed corporations ( LCs ), as they are not supervised by the HKMA. However, it is anticipated that the Securities and Futures Commission will impose similar requirements on LCs by way of its Code of Conduct in due course. Since the margin rules are expected to apply to AIs and LCs by way of supervisory policies only and not by way of legislation, AIs and LCs would need to give effect to such supervisory policies by transposing the margin requirements into contracts with their counterparties. Contents Introduction... 1 Overview... 1 Scope of Application... 2 Cross-border application of margin rules... 4 Margin Standards... 7 Risk Mitigation Standards. 8 Conclusions... 9 Further information While the HKMA s draft Supervisory Policy Manual is broadly in line with global efforts to implement the Margin requirements for non-centrally cleared derivatives agreed by the Basel Committee on Banking Supervision ( BCBS ) and the International Organisation of Securities Commissions ( IOSCO ) in September 2013 (the BCBS-IOSCO Final Report ), there are certain key differences. In particular: Intragroup transactions: are exempted, but the HKMA would have the power to bring them in scope in certain circumstances. 1 Consultation paper entitled Non-centrally Cleared OTC Derivative Transactions Margin and Other Risk Mitigation Standards : Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives 1

2 Guaranteed Transactions: that is, in-scope transactions guaranteed (but not entered into) by an AI, could be subject to the Hong Kong margin requirements this is broader than the proposals in other jurisdictions. Partial compliance: is proposed to minimise the possibility of conflicting margin requirements applying to the same trades, but may not eliminate such conflicts and may be complex to implement. Counterparties in non-netting jurisdictions: would be required to post (but not collect) initial margin ( IM ), and exchange variation margin ( VM ) with AIs on a gross basis this could stop counterparties in non-netting jurisdictions from trading in-scope transactions with AIs. Scope of Application What products are in scope? The proposed margin and risk mitigation rules apply to all OTC derivative products (as defined in the SFO) between an AI and a covered entity that are not centrally cleared through a qualifying central counterparty ( QCCP ). The status of a QCCP is primarily determined by the home regulator of the CCP. The following products are excluded from some or all margin requirements: Excluded Products Physically-settled FX forwards and swaps, FX legs of cross currency swaps Repurchase agreements and securities lending transactions Indirectly cleared derivatives Intragroup transactions Remarks Exempted from IM only. VM requirements will apply. Out of scope. Exempted, provided that the non-member customer is subject to the margin requirements of the clearing house and provides margin accordingly. Exempted, but HKMA proposes to have the power to bring intragroup transactions into scope of the margin rules if: (i) one or more group companies is in financial distress; (ii) the group s centralised risk management policies for non-cleared derivatives are inadequate or ineffective; or (iii) it is prudent to do so for supervisory purposes. Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives 2

3 Which entities are in scope? The proposed margin and risk mitigation rules apply to both Hong Kongincorporated and overseas-incorporated AIs 2 when entering into in-scope derivatives with a covered entity. Covered entities are proposed to be financial counterparties or significant non-financial counterparties that are not excluded entities: Covered entities Financial counterparties AIs Type 1, 2, 3, 4, 5, 6, 8, 9, 11, and 12 LCs Mandatory provident fund schemes and occupational retirement schemes Insurers Remittance agents, money changers and money lenders Entities carrying on business outside Hong Kong that would require licensing under one of the above categories if it were carrying on business in Hong Kong Securitisation SPVs Collective investment schemes Private equity funds Significant nonfinancial counterparties Entities which have (on individual or group basis) noncleared derivatives in an aggregate notional amount exceeding HKD 60 billion for a one year period from 1 September to 31 August of the following year. Excluded entities Sovereigns, central banks, public sector entities, multilateral development banks and the Bank for International Settlements. Guaranteed Transactions In-scope trades entered into by two non-ai covered entities can still be subject to the proposed margin rules if at least one of the covered entities benefits from a guarantee from an AI, and certain conditions are satisfied ( Guaranteed Transactions ). The conditions include: the guarantee covers liabilities of the guaranteed covered entity in respect of non-cleared derivatives of at least HKD 60 billion; and, for overseas AIs, the guarantee is booked in its Hong Kong branch. 2 Non-AI subsidiaries of an AI are excluded, unless (1) the HKMA considers it necessary for the subsidiary to be subject to the margin provisions on the basis that the subsidiary transacts a significant amount relative to the AI as a whole and is not subject to effective margin standards in its jurisdiction or (2) the subsidiary enters into a Guaranteed Transaction. Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives 3

4 When will an AI be subject to the proposed margin requirements? An AI should exchange ( post and collect ) IM and/or VM if it has non-cleared derivatives with a covered entity over a certain threshold. VM is calculated on a net basis and delivered by the party owing the net amount to the other party, whereas IM is calculated on a portfolio basis and the IM amounts calculated for each counterparty to the trade are not netted, so both parties would have to post IM to each other. The exchange of VM is proposed to be phased in as follows: Dates From 1 September 2016 to 28 February 2017 Aggregate average notional amount 3 (or AANA) of non-cleared derivatives of both the AI and covered entity HKD 24 trillion 1 March 2017 All non-cleared derivatives The exchange of IM is proposed to be phased in as follows: Dates From 1 September 2016 to 31 August 2017 From 1 September 2017 to 31 August 2018 From 1 September 2018 to 31 August 2019 From 1 September 2019 to 31 August 2020 On a permanent basis from 1 September 2020 for each subsequent12 month period AANA of non-cleared derivatives of both the AI and covered entity HKD 24 trillion HKD 18 trillion HKD 12 trillion HKD 6 trillion HKD 60 billion Once the applicable threshold is reached by both the AI and the covered entity, they should comply with the proposed margin rules in respect of new in-scope contracts only. Genuine amendments to existing contracts will not count as new contracts. An AI has an obligation to inform its counterparties if it has exceeded the applicable thresholds, and is responsible for checking whether its counterparties have exceeded applicable thresholds. Cross-border application of margin rules Hong Kong nexus For locally-incorporated AIs, the proposed margin requirements extend to all its branches. This is broader than the Singapore policy consultation which proposes to apply margin requirements to trades booked in the Singapore 3 The aggregate average notional amount ( AANA ) refers to the average of the total gross notional amount of all non-cleared derivatives (including physically settled FX forwards and swaps) of month-end positions for March, April and May preceding the applicable 1 September start date, calculated on a group level. Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives 4

5 branch only. For non-locally incorporated AIs, the margin requirements apply only to trades booked in its Hong Kong branch. Conflicting margin requirements Given the broader cross-border application of HKMA s proposed margin requirements, the HKMA proposes to allow substituted and/or partial compliance to address the risk of conflicting margin requirements. Substituted compliance means that an entity that is otherwise subject to Hong Kong margin requirements can satisfy such requirements by complying with equivalent standards in another jurisdiction. Partial compliance is proposed to be a more limited form of substituted compliance. Substituted and partial compliance are available only if HKMA has issued a comparability determination in respect of the relevant home jurisdiction standards. The HKMA proposes to follow an outcome-based approach to determine comparability (that is, whether the overseas margin standards adequately reflect the BCBS-IOSCO Final Report and lead to outcomes which are comparable to the HKMA rules). Partial compliance Under the proposed partial compliance rules, a locally-incorporated AI may follow the rules of the home jurisdiction of a counterparty that is a covered entity incorporated overseas in respect of the timing, eligible collateral and haircut for VM and IM posted by the locally-incorporated AI only. In other respects, the locally-incorporated AI has to follow Hong Kong margin rules. On the other hand, an overseas-incorporated AI that trades with a locallyincorporated AI can follow the margin rules of its home jurisdiction, except for timing, eligible collateral and haircut for VM and IM posted by the overseasincorporated AI for its Hong Kong-booked trades, which must comply with Hong Kong rules. Comments have been raised as to whether such partial compliance will be effective in minimising conflicts in margin rules, or whether it would be too complex to implement? Substituted compliance Under the proposed substituted compliance rules, if an overseas AI s counterparty is: (1) a non-ai covered entity incorporated in Hong Kong; or (2) a covered entity incorporated outside Hong Kong, then the overseas AI can, instead of following the HKMA margin rules, either: (i) follow the margin requirements applicable to its counterparty, if the covered entity is required to comply with the margin standards of its home jurisdiction; or (ii) follow the margin standards of its home jurisdiction. Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives 5

6 The proposed substituted and partial compliance regimes are summarised in the table below. AI type Covered entity Which margin rules apply? Locally incorporated AI (all branches) Overseasincorporated AI (Hong Kong branch) Locally incorporated AI Covered entity incorporated in Hong Kong Covered entity incorporated outside Hong Kong Locally incorporated AI (all branches) Non-AI covered entity in Hong Kong / covered entity outside Hong Kong Hong Kong rules apply Hong Kong rules apply Partial Timing, eligible compliance collateral and haircut for VM and IM posted by the locally-incorporated AI: Home jurisdiction rules of counterparty can apply Other margin rules: Hong Kong rules apply Partial Timing, eligible compliance collateral and haircut for VM and IM posted by the overseasincorporated AI: Hong Kong rules apply Other margin rules: Home jurisdiction rules of counterparty can apply Substituted compliance: Either the counterparty s or AI s home jurisdiction margin rules can apply Counterparties in non-netting jurisdictions The HKMA proposes: (1) that an AI should exchange VM on a gross basis with respect to transactions with a covered entity located in a jurisdiction where netting is not legally enforceable, i.e. on a transaction-by-transaction basis; and Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives 6

7 (2) that an AI should only collect but not post IM from such covered entity, and that the IM should be calculated on a gross or transaction-by-transaction basis, so no offsetting within the portfolio of transactions would be permitted in the IM calculation. The risk is that counterparties from non-netting jurisdictions will refuse to trade on this basis. The HKMA also proposed to consider the feasibility of a de minimis threshold, such that an AI would be subject to margin standards only if its aggregate exposure to covered entities located in non-netting jurisdictions exceeds the threshold. In our view, such threshold would be preferable to minimise disruption to the market. Counterparties not subject to margin rules The HKMA proposes that an AI only needs to collect (and not post) IM if: (i) the covered entity is located in a jurisdiction where the BCBS-IOSCO Final Report has not been implemented; or (ii) the covered entity is a locally-incorporated covered entity other than an AI that is not subject to margin standards, and the AI is not satisfied that the covered entity s arrangements sufficiently protect the posting AI in the event of its insolvency. Margin Standards Timing of exchange of VM and IM Under the HKMA proposals, VM should be calculated on a daily basis. IM shall be recalculated and called when: a new contract is executed with a counterparty or an existing contract with a counterparty expires within the relevant netting set; or the IM model is recalibrated. IM may be calculated using either a standardised margin schedule or (subject to approval by the HKMA) an internal model approach. Different approaches can be used for different asset classes but should be made consistently for that asset class. Subject to any applicable IM threshold and minimum transfer amount (each may not be set at higher than HKD 3.75 million), both VM and IM should be called within T+1. Once called, both VM and IM should be collected no later than T+2 after the margin call. This effectively means that any securities which settle on a T+3 (or longer) basis will not be eligible. Treatment of IM HKMA proposes that IM should be held pursuant to legally enforceable collateral arrangements in such a way that it is immediately available 4 to the collecting party in the event of the posting party s insolvency, and the posting 4 The accompanying footnote suggests that this requirement is complied with so long as the collateral is available to the surviving counterparty as soon as legally possible. Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives 7

8 party is protected in case of the collecting party s insolvency. An AI should perform an independent legal review to verify that IM can be promptly returned to the surviving counterparty in the event of other party s insolvency. IM should be segregated from the assets of the collecting party and may be held with third party custodians. Posting parties should be offered the option of (but are not required to have) individual segregation. Limited reinvestment of cash IM is permitted. Similar to the EU, but unlike the BCBS-IOSCO Final Report and Singapore policy consultation, no rehypothecation is to be permitted. Risk Mitigation Standards Consistent with other jurisdictions, the HKMA has proposed the following risk mitigation standards for non-cleared derivatives. Trading relationship documentation An AI should execute written trading relationship documentation with its counterparties upon or before executing a non-cleared derivative transaction, and retain such documentation for at least five years after the termination, maturity or assignment of any non-cleared derivative which is subject to such documentation. Trade confirmation An AI should confirm the material terms of its non-cleared derivatives transactions as soon as practicable after the transactions are executed, in writing via non-rewritable, non-erasable automated methods where reasonably practicable (or fax or where such automated methods are not reasonably practicable). Generally, the confirmation should be executed within the following timeframe: Product Type Applicable Period Timeframe Interest rate swaps and credit default swaps Other product types From and after 1 September 2016 By T+1 From 1 March 2017 to 31 August By T From and after 1 September 2017 By T+1 Valuation An AI should agree with its counterparties on the valuation process for noncentrally cleared derivatives in a predictable and objective manner for the purpose of exchanging margin, and document such process in the trading relationship documentation or trade confirmation. The valuation documentation should include an alternative valuation process in the event of the unavailability of any inputs required to value the transaction. Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives 8

9 Portfolio reconciliation The AI should agree on the portfolio reconciliation method with its counterparties, which should ensure an accurate record of the material terms and valuations of all non-cleared derivatives (both collateralised and uncollateralised) in the portfolio, and to identify and resolve discrepancies in a timely manner. The frequency of reconciliation depends on the counterparty and the number of trades outstanding between the AI and the counterparty: Counterparty Financial or significant non-financial counterparty Other counterparties Number of trades outstanding between the AI and the counterparty 500 or more outstanding noncentrally cleared derivatives Between 51 and 499 outstanding non-centrally cleared derivatives at any time during the week 50 or less outstanding noncentrally cleared derivatives at any time during the quarter More than 100 outstanding noncentrally cleared derivatives at any time during the quarter 100 or less outstanding noncentrally cleared derivatives Frequency Each business day Once per week Once per quarter Once per quarter Once per year Dispute resolution An AI should agree with its counterparties on and document dispute identification and resolution procedures, including a specific process for disputes that remain unresolved within five business days (with escalation to an appropriate level of senior management at the AI). Material disputes in excess of HKD 100 million (or equivalent) should be reported to the HKMA if not resolved within 15 business days. Conclusions Given the short time before implementation of the margin and risk mitigation rules, AIs will need to review their existing documentation and determine what amendments are required to give effect to such rules. They would also need to put in place arrangements for disclosure between themselves and all their counterparties of their respective status and whether they have exceeded applicable margin thresholds. AIs will also need to assess the impact of such rules on their existing businesses, such as their non-cleared derivatives trades with counterparties in non-netting jurisdictions. Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives 9

10 Further information If you would like to discuss the HKMA Consultation Paper or provide feedback, feel free to contact Chin-Chong Liew, Victor Wan, I-Ping Soong, Karen Lam, Stephen Song or Derek Chua, or any of your other Linklaters contacts. Contacts For further information please contact: Andrew Malcolm Partner (+852) Chin Chong Liew Partner (+852) Victor Wan Partner (+852) I-Ping Soong Counsel (+852) Karen Lam Counsel (+852) Stephen Song Managing Associate (+852) Author: Karen Lam, I-Ping Soong This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters. All Rights reserved 2015 Linklaters Hong Kong is a law firm affiliated with Linklaters LLP, a limited liability partnership registered in England and Wales with registered number OC It is a law firm authorised and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of the LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com. Derek Chua Managing Associate (+852) derek.chua@linklaters.com 10th Floor, Alexandra House Chater Road Hong Kong Telephone (+852) Facsimile (+852) / Linklaters.com (+852) Hong Kong Proposes Margin and Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives 10