Edmond Lau, Executive Director (Monetary Management), Hong Kong Monetary Authority(Keynote Address at the 2011 ISDA Annual Conference: Shaping the Future of Derivatives, Hong Kong)
Good morning ladies and gentlemen. It is my great pleasure to be here today to discuss and share with you, the future we envision for OTC derivatives market in Hong Kong.
Before we look into the future, we must reflect on the past to understand why we are at the cross-roads that we are at today, and why reform is necessary. Whilst this should rightfully invoke thoughts about the 2008 collapse of Lehman Brothers it is crucial we remember that this event only triggered the financial tsunami and that the core of the problem required deeper analysis.
The scale of the crisis was amplified by two key characteristics of the OTC derivatives market: interconnectivity and opaqueness.
Firstly, on interconnectivity – whilst it is normal for firms to become connected to each other through their normal trades and dealings – the global nature of OTC derivatives intensified this interconnectivity to unseen levels. The increased ease of communication supported by technology advancements led entities to become more connected with each other either directly through their own engagement with a larger variety of market players, or indirectly through their counterparties’ engagement with others.
However, this increase in interconnectivity was not always obvious- which brings me to the second characteristic of OTC derivatives markets, opaqueness. Like we may not be aware that our mutual friends on such social networks as Facebook connect us to someone half-way across the globe, financial institutions similarly did not know the degree to which they were connected to other financial or non-financial entities. The bilateral nature of OTC derivative trades meant that only the counterparties to a transaction were privy to the details of the trade; their other affiliates and trade partners were completely unaware of the extent and nature of their dealings with others, including the risks they were taking and the degree to which they were leveraging.
Taken together, interconnectivity and opaqueness were a perfect recipe for disaster. Interconnectivity meant high contagion risks and the ability for a single failure to spread to the entire financial system. Opaqueness meant that many firms were simply unaware of these contagion risks and therefore failure to implement appropriate risk management practices. This was compounded by the fact that even regulators lacked the information required to properly assess the build-up of exposures in the market and devise preventive measures.
It was in this sort of opaque and interconnected context that Lehman Brothers failed.
It was against such background that regulators worldwide came to work together on the reform of this market. Given the highly globalized nature of the OTC derivatives market, any reform solution must be internationally co-ordinated. Such a movement emerged in 2009 when the G20 leaders agreed in Pittsburgh in September 2009 that:
“All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”
These proposals aim to : firstly, enhance transparency by requiring all OTC derivatives transactions be reported to trade repositories; and secondly, lower the degree of interconnectivity between market players to reduce contagion risks, by interjecting central counterparties between buyers and sellers. In circumstances where interconnectivity cannot be lowered through such means, these connections will at least be better protected by requiring higher capital standards.
Since jurisdictions around the world are now working together to develop the regulatory framework required to support the G20 commitment, Hong Kong has also been taking steps to introduce a regulatory regime in line with these global standards. Last week, the HKMA and the SFC issued a joint consultation paper which sets out preliminary proposals on how to regulate this market with a view to promoting the transparency and resilience of this market in Hong Kong.
Before I introduce the proposed regulatory regime, I would like to outline some of the key principles that have guided us during the development of our regime. This will provide you with a better understanding of our main intentions and considerations, and highlight the foundation on which our regime is built.
First and foremost, we are committed to designing a regime that successfully ensures financial stability and resilience without compromising the ability of market players to engage in derivatives activities. We believe OTC derivatives (including those that cannot be standardised) do have their place in the financial market and therefore they should only be regulated but not banned altogether.
Secondly, given the relatively smaller size of Hong Kong’s OTC derivatives market, we are mindful that we cannot be the leader in the reform process but at the same time, we cannot lag too far behind our global counterparts. This recognizes the cross-border nature of these transactions. If Hong Kong does not follow the rule of the game globally, international financial institutions would withdraw liquidity from Hong Kong to the detriment of our market.
The importance of aligning with international standards is akin to how one can achieve success in dragon boat racing (a popular sport which celebrates the Tuen Ng festival). Rowers can only reach their destination if they paddle in sync and towards the same direction – if even one rower deviates from this, the boat will flip or go in circles. In our context, international regulators, like rowers in a race, share a common destination: global financial stability and resilience of the derivatives market. If some rowers decide to paddle the other way, say by imposing less stringent requirements, thereby creating regulatory gaps that market participants can take advantage of – the entire boat will fail to reach its destination.
Together, these two principles lay the basic foundation for our new regulatory regime: dictating that it needs to be one that is aligned with international standards but takes into consideration local market factors and characteristics to ensure the achievement of financial stability.
Let me now turn to the proposed regulatory regime. We propose that Authorized Institutions (AIs), Licensed Corporations (LCs) and other non‑FI participants in this market should be brought under the same regulatory framework under the Securities and Futures Ordinance to ensure a level playing field among all participants. The primary legislation will establish the new mandatory obligations on central clearing, reporting, and where appropriate, trading on exchanges or electronic trading platforms as well as confer the necessary rule making powers on the regulators. The detailed requirements such as which types of persons and what types of transactions will be subject to the mandatory obligations will be specified in the rules by the regulators. Such an approach would give us the flexibility to monitor the developments elsewhere and needs of our own market before we decide to specify new product classes in the rules for the purpose of the clearing, reporting and trading requirements. The regime will be jointly administered by the HKMA and the SFC in that the HKMA, being the principal regulator for banks in Hong Kong, will be responsible for overseeing and regulating the OTC derivatives activities of AIs while the SFC will be responsible for overseeing and regulating the OTC derivatives activities of non-AIs.
To support the central clearing and reporting requirements, as announced in December 2010, the Hong Kong Exchanges and Clearing Limited will develop a new local CCP for OTC derivatives, and HKMA’s Central Moneymarkets Unit will also establish a new TR where trades of systemic relevance to Hong Kong must be reported. These two important pieces of infrastructure are expected to be launched in the third quarter of 2012.
When the clearing and reporting requirements are first introduced, tentatively in January 2013, they will only apply to certain products and market players. Product-wise, only certain types of interest rate swaps and non-deliverable forwards will initially be identified as clearing eligible transactions or reportable transactions that must be centrally cleared through a designated CCP and reported to the HKMA-TR respectively. They are the two most common types of derivatives transactions in Hong Kong after foreign exchange derivatives. FX derivatives like foreign exchange swaps and forwards are not included in the initial stage of implementation because they are usually shorter-dated and settled through the Continuous Linked Settlement system (CLS system), which pose lesser risk to the financial system. The scope of coverage will, however, be gradually extended to other OTC derivatives asset classes as appropriate.
Under our proposed regime, all AIs, LCs and those identified as Hong Kong persons will come under our purview, although the manner in which the requirements applicable to them will differ. In addition, financial intermediaries, other than AIs, who provide dealing, advising or clearing agent service in the OTC derivatives market will have to register for a licence with the SFC. They will become LCs in the process and thus subject to the regulation by the SFC as well as the mandatory reporting, clearing and trading requirements. We are also considering to subject large market players, whose positions may present systemic risk concerns, to some oversight requirements, even though they may not be carrying on any intermediary function. This is to enable us to monitor and contain the build-up of systemic risks in the market.
I would now like to take the opportunity here to explain two special features in the proposed mandatory clearing and reporting requirements that are particularly relevant to AIs: the applicability of the mandatory obligations to the locally incorporated AIs on a consolidated basis; and the reporting of Hong Kong connected transactions by foreign incorporated AIs.
For locally incorporated AIs, the HKMA has always been supervising these institutions on a consolidated basis. This reflects the role of the HKMA as the home regulator of these entities. It is thus important that we are in a position to monitor the risks of the institutions on a group basis regardless of the location where such risks might be assumed. Therefore if the HKMA has decided to specify certain subsidiaries of a local AI for inclusion into the relevant requirement, the AI has to ensure that the relevant transactions be reported to the HKMA-TR or cleared through a designated CCP. However, the clearing and reporting obligation will only rest with the AI rather than its subsidiaries.
Foreign AIs are not required to comply with the mandatory obligations on a consolidated basis because consolidated supervision is the responsibility of their home supervisor rather than the HKMA as the host supervisor for their Hong Kong offices. It follows that the mandatory reporting and clearing obligation would usually apply to the OTC derivatives activities of these institutions that are conducted through the Hong Kong branch. However, in cases where the transactions have a Hong Kong nexus (e.g. when the underlying assets of the derivatives contract are denominated in Hong Kong dollar), we would also expect the foreign AI to report such transactions to our Trade Repository even though such transactions may not involve the Hong Kong branch in any way. We believe this can be justified because the regulatory access to such Hong Kong connected transactions would be critical to the assessment of risks to our monetary and financial system.
To facilitate compliance, market players will be able to comply with the clearing and reporting requirements through both direct and indirect channels. For clearing, entities can either become a direct member of a designated CCP or clear the transaction indirectly through such a clearing member. As for reporting to the HKMA-TR, the TR will accept both direct reports to it or reports from agents, e.g. trade-matching platforms or a foreign TR, acting on behalf of the reporting entity.
Overseas persons will be exempted from both requirements under most situations. For reporting, they will be completely exempted. As for clearing, they will only be affected if they engage in a clearing eligible transaction with an AI, LC or Hong Kong person. However, trades conducted between two overseas counterparties that have been cleared in accordance with the laws of an acceptable overseas jurisdiction or exempted from clearing by those laws will be unaffected by Hong Kong’s obligations.
We have also proposed to provide the end-users in the OTC derivatives market with some relief in respect of the reporting requirement. Our current intention is that an end-user (i.e. other than an AI or LC) will not need to report a transaction if it is already a transaction reportable by an AI or LC. Since an end-user in the OTC derivatives market will usually deal with an AI or LC, this should provide relief to an end-user from the reporting obligation in most cases.
Apart from the requirements discussed above, there are still a number of important requirements that will need to be introduced at a later stage, but they can only be finalised upon further guidance from the relevant international bodies. For example, we are currently considering how to impose higher capital requirements on non-centrally cleared trades based on the guidelines and standards provided by the Basel Committee. We are also taking part in international discussion under the auspices of the Financial Stability Board on whether and how we should introduce margin requirements for non-centrally cleared trades.
Before I close, I would also like to mention two topical issues of concern on the radar screen of the international discussion on this subject. One area which has been the subject of contention is that of mutual recognition of CCPs. At this stage of regulatory reform, some jurisdictions have rather stringent requirement in terms of designating CCP for compliance purposes, to the extent that CCPs located outside the jurisdiction will not be accepted. As it is likely that global and regional CCPs will co‑exist with each other in the evolving landscape of the OTC derivatives market, it is critical that market participants can choose a CCP which meets certain internationally recognised standards, for them to comply with the regulatory requirement effectively. In this regard, we support any effort to develop an international framework for recognition of CCPs for OTC derivatives products. Such a framework would allow mutual recognition of CCPs provided that they meet the international standards in terms of risk management, governance, operations and other necessary criteria, which in turn would avoid financial disintermediation in the OTC derivatives market.
Another prevalent issue of concern relates to the international cooperation on regulatory access to data stored in TRs, in order to fulfil their regulatory mandates. The problem can be amplified when indemnification requirements are imposed on overseas regulators in exchange for data access in some jurisdictions. Given the cross-border nature of OTC derivatives activities, this would impede regulators’ ability to access data relating to the overseas transactions of the financial institutions under their supervision, thus defeating the purpose of mandatory reporting. Regulators worldwide are currently seeking agreement on the data sharing framework that governs the rules, format and level of data from TRs and CCPs through discussion at international forums such as the OTC Derivatives Regulators’ Forum (ODRF).
Through highlighting these examples, I hope to emphasize that the regulatory standards for regulation of OTC derivatives are still evolving. This underscores the importance of designing our regulatory regime with flexibility so that it is not cast in stone but is progressing in times with the needs of the market.
Ladies and gentlemen, I began this speech by looking into the past, but we must not linger there after learning its lessons. After all, we are here today to shape the future of the derivatives market, one which I am confident will be characterized by greater transparency, resilience and most importantly, stability in the future. But this will be a formidable task which requires strenuous and concerted efforts of all of us involved in this market.
Thank you very much.