The Securities and Futures Commission (SFC) has published its consultation conclusions on the proposed refinements to the scope of regulated activities and competence requirements relating to the over-the-counter (OTC) derivatives licensing regime (the Consultation Conclusions) contained in its consultation paper dated 20 December 2017 (the Consultation Paper), following feedback from industry associations, market participants, professional services firms and other stakeholders (the Respondents). In short, the Respondents were generally supportive of the relevant proposals contained in the Consultation Paper, which will be adopted subject to certain amendments.
The SFC released its consultation conclusions on the primary legislation for the regulation of OTC derivatives in September 2013. In 2014, the Securities and Futures (Amendment) Ordinance 2014 (SFAO) was enacted, which introduced an OTC derivatives regulatory framework in Hong Kong. This framework included the creation of an OTC derivatives licensing regime (which has not yet taken effect) and the addition of two new regulated activities (RAs), namely (i) a Type 11 RA of dealing in OTC derivative products or advising on OTC derivative products; and (ii) a Type 12 RA of providing client clearing services for OTC derivative transactions.
To obtain views from market participants on potential issues under the OTC derivatives licensing regime, the SFC issued the Consultation Paper in December 2017, seeking feedback on the following topics:
- refinements to the scope of regulated activities (Part II of the Consultation Paper);
- proposed requirements in relation to OTC derivatives in the areas of risk mitigation, client clearing, client money, client securities and record keeping (Part III to V of the Consultation Paper);
- proposed conduct requirements to address risks posed by group affiliates and other connected persons (Part VI of the Consultation Paper); and
- proposed licensing fees, insurance, competence and continuous professional training (CPT) requirements under the new OTC derivatives licensing regime (Part VII of the Consultation Paper).
The Consultation Conclusions recently published (in June 2020) covers the matters set out in the first and fourth bullet points above. The SFC has noted that conclusions on the remaining proposals in the Consultation Paper (those not yet dealt with) will be released separately in due course.
(ii) Consultation Conclusions
We have outlined below some high-level points on the consultation conclusions, as well as some of the notable comments. The most significant change from the proposals contained in the Consultation Paper is the decision to expand the carve-out for corporate treasury activities of non-financial groups to cover Type 12 RA. Other proposals remained broadly the same, save for some fine-tuning.
Refinements to the scope of regulated activities under the OTC derivatives licensing regime
Corporate treasury activities
- Respondents generally supported the proposal to carve out corporate treasury activities of non-financial groups from the scope of the expanded Type 9 RA and the new Type 11 RA. While some respondents suggested extending the proposed carve-out to financial groups, the SFC has decided that it will not do so.
- The SFC intends to clarify the proposed definition of “financial group” and “financial services” and will work with the Department of Justice (DoJ) to refine the drafting.
- Taking into account the increasing popularity of central clearing for OTC derivative transactions, the SFC considered it appropriate to expand the carve-out for corporate treasury activities to cover Type 12 RA. The SFC acknowledged that for administrative and operational reasons, group companies may have only one entity which is a client of a clearing service provider. In such a case, so long as the clearing and settlement services are provided by the corporate treasury desk of a non-financial group to its affiliates only, these activities will be carved out from the scope of Type 12 RA. This is in line with the policy intent, which is to exclude the corporate treasury activities of non-financial groups from the regulatory net.
Activities of providers of post-trade multilateral portfolio compression services
- Respondents generally supported the proposal to narrow the scope of Type 11 RA so that it does not capture the provision of post-trade multilateral portfolio compression services.
- The SFC has also taken into account the drafting suggestions in relation to the definition of “multilateral portfolio compression services” made by a number of respondents, in relation to introducing a market neutral element in the definition, and clarifying the meaning of “risk tolerance level”. Subject to the approval of the DoJ, the definition of “providing multilateral portfolio compression services” will be revised as set out in full in the Consultation Conclusions, and the definition of “multilateral portfolio compression cycle” will also be amended in the Securities and Futures (OTC Derivative Transactions – Clearing and Record Keeping Obligations and Designation of Central Counterparties) Rules as a consequential change.
Provision of compression services by CCPs and providers of client clearing services
- There was overwhelming support to narrow the scope of Type 11 RA so that it does not capture portfolio compression services (whether bilateral or multilateral) provided by a central counterparty (CCP) or a provider of client clearing services.
Activities of overseas clearing members and their agents
- Respondents generally supported the expansion of the exemption in Type 12 RA so that overseas clearing members of overseas CCPs are not captured, subject to certain prerequisites being met such as overseas clearing members being regulated in a comparable jurisdiction for providing client clearing services, and marketing their services through an authorized institution or a licensed corporation.
- To prevent the additional flexibility provided by the expansion of the carve-out from being abused, the definition of “acceptable participant” will be amended in order to make it clear that acceptable participants may include persons who have applied to become CCP members but only if their application has not been rejected or withdrawn.
- The scope of Type 11 RA will be narrowed to carve out dealing and advising activities carried out by overseas clearing members of overseas CCPs which are incidental to client clearing services.
Changes to the scope of Type 12 RA to exclude certain ancillary and fund manager services
- The Respondents were supportive of the proposal to refine the scope of Type 12 RA so that it does not capture certain fund managers or other activities which are only ancillary to the clearing and settlement process. In addition, there was also consensus in providing the SFC with future flexibility to prescribe (by subsidiary legislation) further classes of persons whose activities may be carved out from the scope of Type 12 RA.
- The SFC noted that the carve-out for fund managers is intended to cover client clearing services by a person licensed for Type 9 RA who carries out client clearing services solely for the purpose of providing a service of OTC derivative products management permitted under that licence. In other words, the carve-out covers the provision of client clearing services by licensed asset managers for the asset management activities they are licensed for and solely for the purpose of such asset management, regardless of whether the asset manager is managing authorized or unauthorized funds, or managed or discretionary accounts.
- The SFC will proceed with the proposal to refine the definition of Type 12 RA (see paragraph 67 of the Consultation Conclusions). Subject to the DoJ’s comments, further drafting changes will be made to clarify concepts such as “indirect client” (see paragraphs 56 to 66 of the Consultation Conclusions).
Request to expand carve-outs for fund managers
- The Respondents were supportive of the proposals to: (a) extend the existing carve-outs under Type 9 RA for managing an OTC derivative portfolio for wholly-owned group companies and by professionals where the services are wholly incidental to discharging their professional roles (i.e., solicitors, certified public accountants etc.) to cover all OTC derivative products; and (b) incorporate a carve-out under Type 3 RA to cover fund managers who deal in foreign exchange derivatives solely for the purpose of managing assets.
- In addition, the Respondents also supported the proposal to provide the SFC with future flexibility to prescribe (by subsidiary legislation) further classes of persons whose activities may be carved out from the scope of Type 9 RA.
Competence and CPT requirements under the OTC derivatives licensing regime
- There was broad support for the proposal to extend the existing requirements under the Guidelines on Competence to Types 11 and 12 RAs.
- The Respondents were also supportive of the proposal for the existing CPT requirements to cover new and expanded RAs. The SFC has also reiterated that it remains their intention to grandfather market participants who qualify for a deemed status under the transitional arrangements (as set out in section 55 of the SFAO). The details of the grandfathering arrangements will be announced at a later stage.
(iii) Timing and implementation
No specific implementation date has been provided, however, the SFC has confirmed that the OTC derivatives licensing regime will not be implemented earlier than the related revamp of the Securities and Futures (Financial Resources) Rules, or prior to amendments to any other relevant subsidiary legislation being completed.
 The proposed definition of “financial group” is a two-tiered concept which covers a group of companies primarily engaging in (a) a business in Hong Kong that constitutes one or more of the proposed types of “financial services”; or (b) a business that, if carried on in Hong Kong, would constitute one or more of the proposed types of “financial services”.
 The proposed definition of “financial services” should adequately cover all the common types of financial services including businesses in regulated activities, banking and insurance.