Regulatory authorities in Hong Kong have started consulting market participants on over-the-counter (OTC) derivatives reform and have committed to aligning new rules with ongoing initiatives in other jurisdictions.
The framework for the consultation – which will run until 30 November 2011 – was released jointly by the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) and is based on the guidelines presented by leaders of the Group of 20 (G20) in September 2009.
The G20 leaders said that by the end of 2012, all OTC derivatives that can be standardised should be traded on exchange and cleared through central counterparties with all contracts reported to central repositories. The G20 also said that derivatives that are not centrally cleared should be subject to higher capital requirements.
“The proposed regime aims to improve overall transparency in the OTC derivatives market, reduce interconnectedness of participants, and generally reduce systemic risk in the financial system,” said Eddie Yue, deputy chief executive of the HKMA.
The main proposals in the paper call for a new regime to be set out in Hong Kong’s Securities and Futures Ordinance, the overarching legislative framework for Hong Kong’s financial markets enacted in March 2002, with joint oversight by the HKMA and SFC. The HKMA will be responsible for establishing a trade repository, with reporting obligations initially applying to interest rate swaps (IRSs) and non-deliverable forwards (NDFs) before being extended to other types of swaps after further market consultation. IRSs and NDFs will also be the first instruments that are made eligible for central clearing.
The regulators added that OTC derivatives would not initially be traded on exchange, as further assessment is required on how best to implement such a requirement.
“We need to look further into the liquidity level and number of trading venues in our market before we can assess how best to implement a mandatory trading obligation,” read the consultation paper.
Both regulators said they were mindful that the OTC derivatives market in Hong Kong is small compared to some others and that its focus would be on developing a new regulatory regime that is “on a par with international standards but takes into account local market conditions and characteristics”.
“Given the cross-border nature of the OTC derivatives market, global effort is required to establish international standards,” said Ashley Alder, CEO of the SFC. “Hong Kong cannot drive the reform initiatives, but we will continue to coordinate with overseas jurisdictions to address some of the key aspects of the reform.”
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The issue of extraterritoriality, i.e. the ability for regulators to impose rules outside of its normal boundaries, has been a concern in the US and Europe, which are both in the process of devising their own rules for OTC derivatives reform, also based on the G20 commitments.
The Hong Kong consultation plans to deal with this on the clearing side by offering a limited exemption for mandatory clearing if a trade is already subject to similar requirements from another jurisdiction.
The consultation document explains that the objective is “to avoid overregulation and alleviate to some extent concerns about market players being potentially subject to conflicting regulatory obligations, with the result that they either risk breaching the laws of one jurisdiction or have to forgo the trade.”
The HKMA and SFA said they are working towards the G20 implementation deadline of end-2012, but added that much depends on external factors such as the progress and reform of initiatives in other markets.
The US and Europe have experienced a number of delays relating to their OTC derivatives reform, partly because of political issues.
In Europe, OTC reform is being handled by both the European markets infrastructure regulation (EMIR), which sets out clearing and reporting obligations, and MiFID II, which lists conditions for operating derivatives trading venues. European authorities are working towards finalising EMIR by the end of this year, while a final MiFID II proposal is expected in the coming days from the European Commission.
In the US, new rules governing OTC derivatives are part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. But the deadline for finalising the new rules – which has been delegated to US regulators, the Securities and Exchange Commission and Commodity Futures Trading Commission, has been continually delayed from initial implementation date of July this year, most recently until Q4 2012.
Up until now, the Singapore Exchange has led OTC derivatives reform in Asia, most recently consulting on enhancing its default management framework for all derivative contracts.