Consultation Conclusions on the OTC derivatives regime for Hong Kong
Proposed margin requirements for non-centrally cleared OTC derivative transactions
The Hong Kong SAR Securities and Futures Commission ("SFC") released consultation conclusions on its proposals to impose margin requirements for non-centrally cleared over-the-counter ("OTC") derivatives in December 2019.
The exchange of margin is important to mitigate both counterparty credit risk as well as systemic risk. Taking into consideration the benefits of the regime as well as the operational costs and liquidity impacts on market participants, the SFC will adopt the proposals set out in the 2018 consultation with some amendments and clarifications. The new rules will be applicable to licensed corporations ("LC") which are contracting parties to non-centrally cleared OTC derivative transactions entered into with covered entities, consistent with the policy expectation expressed in the BCBS-IOSCO Margin Requirements.
To ensure a smooth and orderly implementation and, in view of the large number of covered entities which will be subject to the final phase of the initial margin ("IM") requirements (originally scheduled for 1 September 2020), the SFC will phase in the IM requirements as follows:
- From 1 September 2020 to 31 August 2021 the exchange of initial margin ("IM") by a licensed corporation is required in a one-year period where both the LC and the covered entity have an average aggregate notional amount ("AANA") of non-centrally cleared OTC derivatives exceeding HK$375 billion on a group basis.
- On a permanent basis starting from 1 September 2021 and for each subsequent 12-month period, the exchange of IM by a licensed corporation is required in a one-year period where both the LC and the covered entity have an AANA of non-centrally cleared OTC derivatives exceeding HK$60 billion on a group basis.
This means that the IM requirements will be phased in starting from 1 September 2020. There is no similar phase-in schedule for variation margin ("VM") requirements and they will become effective on the same date for LCs exceeding certain thresholds which is explained in the next section.
As it is only a few months away from the actual implementation, all LCs now should take the time to review and assess their current contracts and instruments, in order to identify and address any gaps against the relevant requirements. This may pose a challenge for LCs and stretch the limits of their resources.
Key Highlights of Consultation Conclusions
Instruments subject to the requirements
The minimum transfer amount (aggregate of IM and VM) is HK$ 3.75 million and the margin requirements apply to all non-centrally cleared OTC derivatives with several exceptions. Examples of exceptions are:
- Physically settled FX forwards and FX swaps;
- Excluded currency contracts;
- Physically settled commodity forwards; and
- On or before 3 January 2021, non-centrally cleared single-stock options, equity basket options and equity index options.
The IM amount for a given counterparty has to be recalculated at least every ten business days and the required amount of IM may be calculated by reference to either
- Standardised margin schedule (“standardised approach”); or
- Quantitative portfolio margin model (“model approach”).
A licensed person may use the standardised approach to calculate IM for one asset class while using the model approach for another asset class. The choice between these two approaches should be made consistently over time.
LCs are required to obtain approval in writing from the SFC before using an IM model, regardless of whether the LCs are using its counterparty’s IM model or whether the IM model has been approved by the Hong Kong Monetary Authority ("HKMA").
Regarding the VM requirements, the higher AANA threshold i.e. exceeding HK$60 billion for VM exchange will apply only to Physically Settled FX Derivatives. For all other in-scope instruments, the proposed AANA threshold of HK$15 billion for VM exchange will remain.
LCs may encounter difficulties during the transition period especially when the SFC’s margin requirements are different from the HKMA’s. Common challenges include:
- Monitoring of threshold
- Instruments subject to differing requirements
- IM calculation approach
Monitoring of threshold
LCs will need to act diligently when their exposures approach the threshold to ensure that the relevant arrangements are in place if the IM threshold is exceeded, and be aware of the volatility of the IM amount for their non-centrally cleared OTC derivative portfolios when monitoring the IM threshold. For example, LCs should plan ahead and allow sufficient time to have in place the relevant agreements and documentation with trade counterparties.
Instruments subject to differing requirements
Compliance costs and the operational burden on market participants will increase, as LCs will need to develop systems and infrastructure to accommodate the conflicting rules as well as source cash or other liquid assets as collateral to meet the VM requirements.
IM calculation approach
A key difference from the HKMA's approach is that the SFC requires LCs to obtain regulatory approval for an IM model prior to its use. LCs are expected to take into consideration how to manage risks not covered by the industry-wide IM modelling methodology. As well, LCs must ensure that the application of the industry-wide IM modelling methodology, including its calibration and ongoing maintenance, is appropriate for the specific composition and risk profile of the LC’s aggregate portfolio across its counterparties.
Given the demanding nature of the margin requirements, it will not be easy for many LCs to navigate. A number of factors such as lack of detailed guidance and inconsistencies of requirements between regulators have contributed to difficulties faced by firms.
While most LCs are likely already familiar with the VM rules, the concept of IM may be relatively new to many of them. Before the implementation of the margin requirements, LCs must properly assess the progress of implementation and bring in sufficient resources to achieve the full compliance target. Below summarise some key actions that LCs should take:
- Monitor the AANA of non-centrally cleared OTC derivatives;
- Understand differences in applicable rules and develop appropriate systems to incorporate the requirements for OTC derivatives; and
- Assess the appropriateness of the IM model for SFC approval.
The range of requirements and actions means it can be difficult to know where you may or may not be operating in line with the regulations. Deloitte can help you chart a path that is most suited to your organization specific needs. In order to meet the SFC's expectations, LCs should pay attention to how the new requirements are being implemented within their own organisation and maintain an open dialogue with supervisors.
Our expertise and experience with regulatory reform and technical knowledge in derivative markets allows us to support clients with a broad range of services that are tailored to their specific needs, including:
- Support in the calculation and monitoring of margin requirement needs;
- Strategic definition and operational efficiency of margin and collateral management process;
- Ongoing implementation support throughout the implementation phase; and
- Identification of gaps and definition of remedial actions.
Deloitte's approach takes all of the components required to deliver a client outreach project, and warps them up together as a single service. We can help you chart a path that is most suited your organisation's specific needs.