HKMA Issues Consultation Paper On OTC Derivatives – IBs & MAMs In Spotlight

Subsequent to responses from major industry organizations and financial institutions, the Hong Kong Monetary Authority has issued a consultation paper

Two of Hong Kong’s major regulatory authorities published a joint set of conclusions on Friday, based on a supplemental consultation relating to the proposed scope of activities to be regulated under the new over-the-counter (OTC) derivatives regime, and regulatory oversight of systemically important participants.

The consultation paper summarizes comments received from organizations and companies which are considered to be a reference point within the industry, and the responses of the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Ordinance (SFC) to these comments. It also notes that further work is necessary and is being conducted to implement the new OTC derivatives regime.

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The responses from industry participants, on which the consultation paper has been based, were submitted by fifteen organizations, including FIX Protocol Ltd, JP Morgan, DBS Bank, Clifford Chance and the Hong Kong Association of Banks, during August 2012.

According to the consultation paper, the respondents supported the proposals in general.

They recognized the need to extend Hong Kong’s licensing regime so that it also covers intermediaries that conduct OTC derivatives activities. They also agreed that the HKMA and the SFC should have effective regulatory powers in respect of systemically important participants, given the potential risk they may pose to the financial stability of our markets.

OTC Derivatives Products with Futures Contract Underlying

The consultation paper asserts that it is difficult to make a general statement on whether OTC derivatives products with a futures contract as the underlying asset, fall within the definition of futures contracts or not.

Much is dependent on the structure of the particular OTC derivatives product concerned. The HKMA’s policy intention is that if the particular OTC derivatives product falls within the definition of futures contracts under the SFO, and the person is licensed for Type 2 RA (RA stands for Regulated Activity), which is the license for dealing in futures contracts, it will not be necessary for the person to apply for Type 11 RA to continue the activities.

What Constitutes a Portfolio?

The consultation paper details that one particular respondent stated that a “portfolio” of OTC derivatives products should be more clearly defined, and the percentage level of OTC derivatives products within a portfolio should exceed a prescribed level before the expanded Type 9 RA licensing requirement is triggered for the person managing the portfolio.

There is no analogous triggering mechanism for any other RAs, therefore, the HKMA does not propose setting a percentage threshold for the level of OTC derivatives products within a portfolio being managed, before the expanded Type 9 RA is triggered for licensing purposes.

Some respondents also wanted to ensure that the drafting of the expanded Type 9 RA should make it clear that a portfolio can include securities, futures and OTC derivatives. In this regard, a person who is licensed to carry on OTC derivatives products management should also be licensed to carry on securities and futures contracts management if his portfolio includes securities and futures contracts, as well as OTC derivatives products.

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IB And Sub-IB Relationships

In the Asia-Pacific region, it is common practice for FX companies to rely on introducing brokers (IBs), who in turn operate via a series of sub-IBs or representatives in order to direct business to the FX company in return for revenue share which is split between the IB and sub-IBs. In addition, portfolio managers often serve as IBs and rely on sub-portfolio managers for referral of business.

As regulatory structures have become increasingly comprehensive, they now often include the requirement that each IB is registered and overseen by the appropriate regulatory authority.

A few market participants who responded to the HKMA, expressed concerns about potential duplicative licensing requirements when an investment manager of a fund delegates investment management responsibility to a sub-investment manager, and the sub-investment manager uses OTC derivatives transactions in managing the portfolio.


They sought clarification on whether both the investment manager and its sub-investment manager would need to comply with the expanded Type 9 RA licensing requirement. They also suggested that where the sub-investment manager is already appropriately qualified or regulated (in Hong Kong or overseas), the investment manager should be able to rely on the expertise of its delegate to meet the eligibility criteria under expanded Type 9 RA. The expansion of Type 9 RA covers the management of portfolios of OTC derivatives transactions, whereas. previously it had only covered the management of portfolios of futures contracts or securities.

On this basis, the HKMA’s policy intention is to regulate persons who carry out activities in OTC derivatives products management, unless they fall within certain proposed carve-outs. Whether, an investment manager who delegates his investment management responsibility for a portfolio of OTC derivatives products to a sub-manager is required to be licensed for the expanded Type 9 RA ,depends on whether the investment manager itself has any remaining function to be carried out in Hong Kong, which falls under the scope of the expanded Type 9 RA.

Further, if an investment manager is required to be licensed under the expanded Type 9 RA, it must be able to meet the eligibility criteria in its own right, and should not rely on the qualification of its delegate.

The same would apply to the sub-manager. If the sub-manager carries out any investment management responsibility for a portfolio of OTC derivatives products in Hong Kong (for example, pursuant to the functions delegated to him by the investment manager), then it will need to be licensed under the expanded Type 9 RA and meet the eligibility criteria in its own right.

Other matters worthy of consideration are that some respondents raised a concern on the need for clarity, that any OTC derivatives transactions entered into or cleared through an applicant for the new Type 11 or 12 RA prior to the date of an application being rejected should remain valid and legally binding.

The OTC derivatives licensing regime is intended to regulate derivatives market intermediaries. It is not intended to invalidate transactions or affect contracting parties’ rights or obligations under bilateral trades, solely by reason that the intermediary’s application for a license is subsequently rejected.

The HKMA intends to allow a transitional period of six months, during which the SFC and HKMA will not take action against any person for carrying on the new RAs or the new component of the expanded RAs. In other words, a person will not be regarded as having contravened any prohibition under section 114 of the SFO in respect of the new RAs, or the new component of the expanded RAs, even though, that person may not have made a Full Application to the SFC/ HKMA to carry on the new RAs or expanded RAs, or, where that person has made such an application, the licence/registration has not been granted.

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