The Securities and Futures Commission (SFC) has issued its consultation conclusions on the proposed margin requirements for non-centrally cleared OTC derivative transactions set out in its consultation paper issued on 19 June 2018 (the Consultation Paper) following submissions from industry associations, market participants and other stakeholders.

By way of recap, the Consultation Paper contains proposals to introduce margin exchange requirements (i.e. post and collect initial margin (IM) and variation margin (VM)) for any non-centrally cleared OTC derivative transaction entered into by a licensed corporation with a covered entity (e.g. authorized institutions and licensed corporations) if the average aggregate notional amount (AANA) of the covered entity’s outstanding non-centrally cleared OTC derivatives exceed specified thresholds. The SFC’s proposals set out in the Consultation Paper are based on the margin requirements framework developed by the Working Group on Margining Requirements, with input from members of the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO).  For further details on the Consultation Paper, please click here.

Margin requirements imposed on non-centrally cleared OTC derivatives are intended to reduce systemic risks by ensuring that collateral is available to offset losses caused by the default of a derivatives counterparty.  Subjecting non-centrally cleared OTC derivatives to higher transaction costs will also incentivise parties to use central clearing (enabling greater transparency and regulatory oversight) which is one of the primary objectives of these proposals.

Key changes to the proposals set out in the Consultation Paper

In short, the proposals in the Consultation Paper will be adopted, with certain amendments as follows:

• Physically settled FX derivatives: the scope of the VM exchange requirement for physically settled FX forwards, FX swaps and FX transactions embedded in cross-currency swaps associated with the exchange of principal has been narrowed. The proposals have been revised such that a licensed person is only required to exchange VM with an authorized institution, licensed corporation or an entity with a similar business outside Hong Kong if that counterparty’s AANA of non-centrally cleared OTC derivatives exceed HK$60 billion. For all other in-scope instruments, the proposed AANA threshold of HK$15 billion for VM exchange will remain unchanged.
• FX haircuts (treatment of onshore renminbi and offshore renminbi): the Consultation Paper specified that where eligible collateral posted (as either IM or VM) is denominated in a currency other than the designated currency contained in the trading relationship document (e.g. master agreement or credit support agreement), an additive haircut of 8% will be applied to the market value of any IM collateral (cash and non-cash) and non-cash VM collateral (the FX haircut).  Whilst no distinction was made in the Consultation Paper for onshore renminbi (CNY) and offshore renminbi (CNH), the consultation conclusions indicate that they will be treated as different currencies and an FX haircut of 1.5% will be applied to the market value of the eligible collateral.

Other points to note from the consultation conclusions

The SFC has also clarified certain points in the consultation conclusions which are worth noting:

• Use of bank deposits for cash IM posted: Some respondents sought clarification on whether the SFC prohibited the use of bank deposits for cash IM posted to segregated accounts with custody banks (as it would fall foul of the rules on re-hypothecation, re-pledging and reuse of IM contained in paragraph 26 of Part II of Schedule 10 to the Code of Conduct for Persons Licensed by or Registered with the SFC (the Re-hypothecation Rules)). The SFC has confirmed that the Re-hypothecation Rules do not apply to third-party custody banks. In other words, cash IM may be posted to an account with a third-party custodian bank in the name of the licensed corporation and any posted cash IM may be placed on deposit with the custodian.
• Prior approval required for use of IM models: The SFC has clarified that where substituted compliance[1] is available and a licensed corporation opts to comply with the requirements applicable to its counterparty, the licensed corporation is still required to obtain approval in writing from the SFC before using an IM model (irrespective of whether the IM model has been approved by the counterparty’s regulator). Licensed corporations are encouraged to contact the SFC as soon as practicable if they would like to adopt a model for calculating IM.
• Legal opinion for netting related exemptions: Under the proposals set out in the Consultation Paper, a licensed corporation would not need to exchange (i) IM and VM in circumstances where there is reasonable doubt as to the enforceability of the netting agreement upon default or insolvency of the counterparty or (ii) IM in circumstances where arrangements for the protection of posted collateral are questionable or not legally enforceable upon default or insolvency of the counterparty. A licensed corporation must obtain an external legal opinion in writing to confirm the netting laws in order to rely on this exemption. Certain respondents queried whether legal opinions obtained from a licensed corporation’s independent internal department were sufficient.  The SFC has clarified that only external independent legal opinions may be used given the complexity of the issues involved.  In addition, the SFC will also amend the Code of Conduct for Persons Licensed by or Registered with the SFC to expressly provide that a jurisdictional opinion, obtained from an external independent legal counsel by an industry association of which the licensed person (or any member of the licensed person’s group of companies) is a member, is also acceptable.
• Exemption for intragroup transactions: Under the proposals set out in the Consultation Paper, intragroup transactions are exempt from the margin requirements i.e. they do not apply to non-centrally cleared OTC derivative transactions entered into between a licensed corporation and a covered entity which is in the same consolidated group as the licensed corporation (i.e. an affiliate) provided that, amongst other things, the licensed corporation and the affiliate are accounted for on a full basis in the consolidated financial statements of the holding company of the group of which they belong. The SFC has clarified that “accounted for on a full basis” is to be construed in accordance with the relevant accounting standards set out in the requirements, meaning that the licensed corporation and its affiliate do not need to be 100% owned and controlled by the holding company so long as the entities are consolidated for accounting purposes in the consolidated financial statements (in accordance with the relevant accounting standards).  

When will the margin requirements be implemented?

In line with the revised implementation schedule announced by BCBS and IOSCO[2], the IM requirements will be phased in as follows:

1. From 1 September 2020 to 31 August 2021: the exchange of IM by a licensed corporation is required in a one-year period where both the licensed corporation and the covered entity have an AANA of non-centrally cleared OTC derivatives exceeding HK$375 billion[3] on a group basis.
2. From 1 September 2021 onwards: for each subsequent 12-month period from 1 September 2021, the exchange of IM by a licensed corporation is required in a one-year period where both the licensed corporation and the covered entity have an AANA of non-centrally cleared OTC derivatives exceeding HK$60 billion on a group basis.

The VM requirements will become effective on 1 September 2020.

A copy of the SFC’s consultation conclusions can be found here.

[1] Where the SFC or the Hong Kong Monetary Authority has issued a comparability determination or the respective foreign jurisdiction has been deemed comparable in accordance with the rules.

[2] See https://www.bis.org/bcbs/publ/d475.htm

[3] The SFC has clarified that it will follow the approach set out in the statement published by the BCBS and IOSCO on 5 March 2019 that no specific requirements on documentation, custodial and operational arrangements will be imposed if the bilateral IM margin amount does not exceed the IM threshold of HK$375 million. The SFC however expects licensed corporations to have  relevant arrangements in place should their exposures exceed the IM threshold at any time.