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Despite its status as a major financial centre, Hong Kong remains an emerging market for the trading and clearing of commodities and non-equity related derivatives. In this guide, we outline the regulatory framework now in place and changes to that regulatory framework which have been proposed and which may affect prospective operators of trading and clearing systems.
For operators of trading and clearing systems, Hong Kong remains an emerging market. Although Hong Kong is a major global stock market, its footprint in the world of trading and clearing of commodities and non-equity related derivatives is smaller. It presently has no exchange for the trading of commodities, whether on a cash or physically settled basis. Its futures trading facilities are presently dominated by trading in equity related futures contracts and options. Based on data sourced from the Hong Kong Monetary Authority ("HKMA"), in 2010, Hong Kong accounted for less than 6 per cent. of the global turnover in FX related derivatives and just over 1 per cent. of the global turnover in interest-rate related derivatives.
Nevertheless, as has happened with the stock markets, it is not unforeseeable that Hong Kong will develop over time into a commodities and derivatives center for the People’s Republic of China ("PRC"). There are signs that the market is already moving in this direction. In 2012, Hong Kong Exchanges and Clearing ("HKEx") acquired the London Metals Exchange and launched an RMB currency futures contract. It has announced intentions to introduce trading in soft commodities and agricultural products. It has extended its trading hours to enable its products to be traded more globally. It is now finalizing plans to launch, in conjunction with a consortium of banks, an OTC derivatives clearing house which will initially focus on RMB denominated OTC derivatives.
The Securities and Futures Ordinance ("SFO") regulates trading and clearing systems. It establishes a framework for recognition of exchanges and clearing houses and for authorization and licensing of automated trading services ("ATS").
Under the SFO, the Stock Exchange of Hong Kong ("SEHK") has a monopoly. No person other than the SEHK, its parent (HKEx) or a person controlled by HKEx may operate a stock market in Hong Kong. This monopoly dates back to the 1980s, when the existing stock exchanges in Hong Kong were consolidated into a single exchange to strengthen market regulation. For the purposes of the monopoly, a "stock market" is a "place where persons regularly meet together to negotiate sales and purchases of securities (including prices) or a place at which facilities are provided for bringing together sellers and purchasers of securities". In this regard, as expected "securities" includes stocks, bonds, options on the foregoing and interests in collective investment schemes but it also includes structured products which the SFC has authorized (or which, because they are offered to the public, ought to have been authorized) for sale to the public. "Structured products" include instruments under which some or all of the return or the method of settlement is determined by reference to one or more of changes in the price, value or level of any securities, commodity, index, property, interest rate, currency exchange rate or futures contracts. As a result, though it is doubtful that this was intended, any market for the trading of commodities derivatives or interest rate or currency derivatives could potentially constitute a stock market within the monopoly.
Unlike a stock market, HKEx and its subsidiary, in this case the Hong Kong Futures Exchange ("HKFE"), does not enjoy a monopoly on futures markets. However, no person may operate a futures market unless (i) recognized by the SFC as an exchange company, (ii) authorized, licensed or registered as an ATS, or (iii) the person is licensed or registered to deal in futures contracts and is permitted to engage in activities that constitute the operation of a futures market.
A "futures market" is a place at which facilities are provided for persons to negotiate or conclude sales and purchases of, or for bringing together on a regular basis sellers and purchasers of contracts (and options on such contracts), the effect of which is that:
However, to constitute a futures market, such contracts or options must be novated or guaranteed by a central counterparty under the rules or conventions of the market on which they are traded or the contractual obligations under the contracts or options are normally discharged before the contractual expiry date under the rules or conventions of the market on which they are traded. As a result, contracts or options traded over-the-counter ("OTC") fall outside futures market regulation.
At present, other than HKFE, there are no recognized exchange companies operating futures markets. The SFC itself has no known procedures for processing an application for recognition of a futures market. Equally, whilst the definition of a futures market contemplates physically delivered contracts, at present, there are no futures contracts involving physical delivery of anything other than money or stocks.
Regrettably, there is no clear distinction between structured products and futures contracts, the latter potentially falling within the definition of the former.
The Commodity Exchanges (Prohibition) Ordinance ("CEPO") prohibits any person from establishing or operating a commodity exchange to which that legislation applies. CEPO does not apply to any futures market which is regulated by or exempt from regulation as a futures market under the SFO.
The SFO does not presently prohibit any person from establishing or operating a clearing house. A person may apply however, to be recognized as a clearing house. The benefits of being recognized as a clearing house by itself are not obvious. Whilst at first glance, being a recognized clearing house invokes statutory insolvency protection, on closer examination, as set out below, such protection applies generally to "market contracts" as well as to "market collateral" and "market charges". These in turn require trading on a recognized exchange. Thus, recognition of a clearing house provides insolvency benefits only to the extent that the clearing house clears trades executed through an SFC recognized exchange company (i.e. at present, the SEHK and the HKFE).
No person may provide an ATS or offer to provide an ATS unless that person is authorized, licensed or registered to do so. In this context, authorization refers to the regulation of a pure trading or clearing platform which constitutes an ATS. Registration refers to the regulation of a bank which offers such a platform and licensing refers to the regulation of non-bank intermediaries (e.g. brokers) for the offering of such a platform.
An ATS is a service provided by means of electronic facilities whereby:
Facilities provided by a recognized exchange or clearing house are exempt from being an ATS.
It is not immediately obvious what constitutes an "established method" to form a binding transaction and the SFO provides no definition. It will include any method commonly used by a stock or futures market and thus, is likely to include, for example, an algorithm which based on predetermined criteria matches buy and sell orders. Electronic systems designed merely to route trades are unlikely to constitute ATS as they do not by themselves use any established method to form a binding transaction.
The Guidelines on ATS Regulation set out core standards of practice for the regulation of an ATS and the SFC uses them to provide a benchmark for authorization. These standards relate to:
The SFC in practice requires that an overseas exchange applying for ATS authorization (i) demonstrate a minimum track record and sufficient qualifications and experience for key personnel, (ii) provide copies of rules and documentation governing the use of the ATS, (iii) describe the services offered, the technology used to offer those services and the types of products to be traded or cleared, (iv) provide information about its corporate background, and (v) demonstrate compliance with ATS standards set out above.
In June, 2013, the Hong Kong Government introduced a bill to amend the SFO to regulate OTC derivatives trading. Broadly, these amendments are intended to reflect international developments in relation to the regulation of OTC derivatives trading.
Under the new OTC derivatives legislation, an "OTC derivative transaction" is a transaction in any OTC derivative product. In turn, an "OTC derivative product" is any structured product which falls outside the following categories:
A "structured product" is, subject to prescribed exemptions, either a regulated investment agreement or an instrument under which some or all of the return or amount due (or both the return and the amount due) or the method of settlement is determined by reference to one or more of:
A "regulated investment agreement" is an agreement the purpose or effect, or pretended purpose of effect, of which is to provide, whether conditionally or unconditionally, to any party to the agreement a profit, income or other returns calculated by reference to changes in the value of any property, but does not include an interest in a collective investment scheme.
The new OTC derivatives legislation will introduce a number of requirements that will require additional infrastructure, including trade reporting. Under these requirements, authorized financial institutions (i.e. banks regulated by the HKMA), approved money brokers, licensed corporations and persons otherwise prescribed must report prescribed OTC derivative transactions in accordance with reporting rules.
No draft of the rules for trade reporting has yet been published.
It is presently contemplated that the HKTR will accept trade reporting information from agents (e.g. overseas trade repositories), thereby allowing market participants to report trades more conveniently.
Authorized financial institutions, approved money brokers, licensed corporations and persons otherwise prescribed will be required under the new OTC derivatives legislation to clear prescribed OTC derivative transactions with a designated central clearing counterparty ("CCP") in accordance with clearing rules. Clearing houses both inside and outside of Hong Kong will be eligible for designation provided that they are recognized by the SFC as a clearing house or authorized by the SFC as an ATS. A person may be designated as a CCP for OTC derivatives transactions generally or for specific classes of OTC derivatives transactions.
No draft of the rules for trade clearing has yet been published. However, the regulators have indicated that designation criteria will broadly coincide with international standards, including those set by the International Organization of Securities Commissions ("IOSCO") and the Committee on Payment and Settlement Systems ("CPSS"). They have also indicated that they are not inclined to grant temporary designations to overseas clearing houses as a transitional measure and that they are open to the idea of local designated CCPs accepting overseas members from acceptable jurisdictions. As would be expected, it is understood that market participants will be able to clear indirectly through clearing participants of designated CCPs.
Authorized financial institutions, approved money brokers, licensed corporations and persons otherwise prescribed will eventually be required by the new OTC derivatives legislation to execute prescribed OTC derivative transactions only on a designated platform in accordance with trading rules. However, it is understood that regulators will assess how to introduce this requirement at a later stage and accordingly, will not at the outset require market players to trade through designated trading platforms.
No draft of the rules for trading on a designated trading platform has yet been published. That said, the proposed legislation provides that whilst an operator of a trading facility inside or outside of Hong Kong may be designated as a trading platform, such operator must be recognized by the SFC as an exchange or authorized by the SFC as an ATS. Operators of trading platforms may be designated to handle trades for OTC derivatives generally or for specific classes of OTC derivatives transactions.
It is not clear how the legislation will mechanically work as securities (which include structured products offered or sold to the public) traded on exchange will not normally qualify as OTC derivative products.
The present ATS regulation only covers securities or futures. To the extent that OTC derivatives may be neither securities nor futures, the new legislation will extend ATS regulation to include OTC derivatives. This will provide an explicit regulated basis upon which an operator of a trading or clearing facility could provide trading or clearing services in OTC derivatives but will also effectively prohibit the operator of such a facility from offering trading or clearing services in OTC derivatives in the absence of an authorization.
The new legislation in effect subjects to regulation any activity in relation to OTC derivatives which otherwise would be subject to regulation if it were in relation to securities or futures contracts. In particular, it provides that, ATS regulation will include offering a service provided by means of electronic facilities whereby:
Whilst not directly a matter relating to trading and clearing systems, the new OTC derivatives legislation will introduce new categories for licensing of persons dealing in or advising on OTC derivatives (Type 11 regulated activity) and of persons providing clearing agency services for OTC derivative transactions (Type 12 regulated activity). As a result, operators of trading and clearing systems will need to ensure that in admitting participants in Hong Kong, those participants may need licenses different from those required under present legislation.
Clearing systems themselves are exempt from the new licensing requirement under Type 12 as the new legislation specifically carves out from the definition of that regulated activity any act carried out by a CCP, whether located in Hong Kong or elsewhere, for the purpose of performing the person’s functions as a CCP.
The new legislation also introduces reporting requirements for any person who reaches a specific threshold in a specified class of OTC derivatives and who is not otherwise regulated by the HKMA as an authorized institution or an approved money broker or by the SFC as a licensed corporation. Once the person reports, they are treated as a systemically important participant ("SIP") and entered on a public register as such.
An SIP will be subject to regulatory oversight.
An SIP may be disciplined by the SFC in much the same way as a broker-dealer or asset manager if they fail to comply with a direction from the SFC.
It is not clear whether persons authorized by the SFC for the provision of ATS may be treated as SIPs but on the present language, it appears that this is possible. Treating an ATS authorized by the SFC as an SIP would enable the SFC to exercise the power to direct the ATS to take specified action and to obtain information on a statutory basis (at present, in practice, the SFC may only obtain information on the basis that the ATS operator complies with its conditions of authorization).
At present, all trading and clearing systems, other than those provided by HKEX and its subsidiaries, are regulated as ATS. In this regard, there are broadly 4 categories of ATS authorization which have historically been granted, namely trade execution facilities for overseas stock exchanges and futures exchanges, trade execution facilities for proprietary pools of liquidity for securities, trade execution facilities for a local futures market and clearing facilities for a local futures market.
The SFC has authorized the electronic trading facilities of a number of overseas exchanges as ATS (e.g. Chicago Mercantile Exchange). The authorizations are generally subject to a number of common conditions including, for example, that the ATS:
The SFC has authorized the trading facilities of a limited number of proprietary liquidity pool operators (e.g. Bloomberg Tradebook and Reuters Trading for Fixed Income System). The authorizations are generally subject again to a number of common conditions, different from those for overseas exchanges, including that:
The SFC has authorized only 1 trade execution facility for a local futures market, namely the Hong Kong Mercantile Exchange ("HKMEx"), to provide an ATS which constituted a futures market. Whilst the HKMEx authorization was withdrawn as a result of financial irregularities at HKMEx, the conditions imposed upon HKMEx are instructive as to what a future local exchange operator may encounter. These conditions include requirements that the operator:
The SFC has authorized only 1 pure clearing facility for a local exchange for the specific purpose of clearing trades for HKMEx. The authorization was subject to a number of conditions including that the operator:
At present, there are no authorizations for overseas clearing houses to offer clearing services in Hong Kong as ATS and it is understood that the SFC will not yet entertain applications from such clearing houses to be authorized to provide clearing services for the forthcoming OTC derivatives regime which, as set out above, will require clearing through designated CCPs.
However, HKEx is in the process of establishing OTC Clearing Hong Kong Limited ("OTC Clear"), a clearing house for OTC derivatives and, contrary seemingly to its position on overseas clearing houses, it is understood that the SFC is processing its application as a recognized clearing house. Once the new legislation governing OTC derivatives is enacted, OTC Clear is likely to be a designated CCP and accordingly, market participants would be able to clear trades in OTC derivatives through OTC Clear in satisfaction of mandatory requirements to clear through designated CCPs.
It is understood that OTC Clear will initially seek to clear deliverable and non-deliverable RMB-denominated OTC derivatives and that it will commence clearing operations for participants on a voluntary basis well ahead of the new mandatory clearing requirements under the new OTC derivatives regime. It is further understood that OTC Clear and the HKTR will be electronically linked to allow eligible transactions reported to the HKTR to be passed to OTC Clear for clearing.
Unlike the current clearing houses wholly-owned by HKEx, OTC Clear will be held by HKEx as the sole voting shareholder and by 12 financial institutions as non-voting shareholders. These shareholders comprise global and local financial institutions, including Agricultural Bank of China, Bank of China, Bank of Communications, The Bank of East Asia Limited, CCB International Securities, Citibank, Deutsche Bank, The Hongkong and Shanghai Banking Corporation Limited, Industrial and Commercial Bank of China, J.P. Morgan, and Standard Chartered Bank. As is the case with other recognized clearing houses, OTC Clear will have its own guarantee fund.
The SFO establishes a comprehensive regime to protect clearing operations from laws relating to insolvency and other laws which could produce results different from those expected under clearing rules. This regime in effect protects market contracts. Under the present SFO, a "market contract" is a contract subject to the rules of a recognized clearing house entered into by the clearing house with a clearing participant pursuant to a novation which is both (i) in accordance with those rules, and (ii) for the purposes of the clearing and settlement of transactions in securities or futures contracts effected on a recognized stock market or a recognized futures market or subject to the rules of a recognized exchange company.
Significantly, the present definition of a "market contract" does not extend generally to OTC derivative transactions as such transactions are generally not subject to the rules of a recognized clearing house and do not relate to trades in securities or futures contracts effected on a recognized exchange.
On the basis that HKEx may commence clearing of OTC derivatives before the new legislation is introduced, the Hong Kong Government issued the Securities and Futures (Futures Contracts) Notice 2012. This notice deems structured products which are neither securities nor contracts or options made under the rules of a futures market as futures contracts, thus placing them within the definition of a market contract for the limited purpose of engaging the statutory insolvency protection regime. It is not clear whether this notice is effective to engage the statutory insolvency protection regime.
In any event, under the new OTC derivatives legislation, the definition of a market contract will be extended on a clearer basis to include an OTC derivatives transaction cleared through a recognized clearing house or a designated CCP that is an ATS specified by the SFC.
It appears that not all designated CCPs will benefit from the statutory insolvency protection regime as apart from designation, the SFC must specify that a designated CCP is to benefit from such protection. It is not clear why certain designated CCPs would not be entitled to such protection.
Significantly, the new OTC derivatives legislation does not extend the definition of a market contract to contracts which are traded on an overseas exchange and cleared through an overseas clearing house that has been authorized as an ATS by the SFC. This is because under the SFO, a market contract which is not an OTC derivatives transaction must be subject to the rules of a recognized clearing house and the trade must have been effected on a recognized stock or futures market. At present, as noted above, only entities controlled by HKEx are recognized as clearing houses, stock markets and futures markets and there is no precedent in place for recognizing entities unrelated to HKEx. Thus, an overseas clearing house which offers membership to Hong Kong clearing firms would likely not enjoy statutory insolvency protection in Hong Kong and would need to rely upon common law principles to achieve insolvency protection.
Founded in 2004, TIMOTHY LOH LLP is an internationally recognized Hong Kong law firm focused on mergers & acquisitions, litigation and general financial markets and financial services matters. The firm is a leader in banking, financial regulation, corporate finance, capital markets and investment funds as measured by its rankings and those of its lawyers in leading independent editorial publications. The firm routinely acts for Fortune Global 500 companies. For more information, visit www.timothyloh.com.
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