OTC regulation in Asia: where are we now?

Author: Ashley Lee | Published: 30 Oct 2012
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Regulators across the Asia-Pacific are preparing to implement rules for central clearing of over-the-counter (OTC) derivatives transactions by January 1 2013. But many jurisdictions are stumbling on legal issues.

Following the 2008 financial crisis, G-20 leaders committed to reform OTC derivatives transactions based on standards from the International Organisation of Securities Commissions (Iosco).

Although it is almost November, most Asian jurisdictions lack the legislation necessary to implement CCP clearing. Moreover, the political environment and concerns about conflicting regulations have stalled the process.

“Trades can only be cleared once, and most jurisdictions will likely have an element of extraterritoriality to make sure that trades that could affect their systemic stability are appropriately regulated,” said senior associate Urszula McCormack of King & Wood Mallesons. “So we need a way to resolve overlapping clearing obligations.”

Local legislation

Many key jurisdictions such as the US and Korea have experienced regulatory uncertainty due in part to presidential elections.

The Hong Kong Monetary Authority (HKMA) and Securities and Futures Commission (SFC) published their conclusions following the joint consultation process in July. They also issued a supplemental consultation paper introducing newly regulated activities as well as regulatory oversight of systematically important players (SIPs).

Counsel are still waiting for the introduction of the OTC Reforms Bill, as well as a new round of consultation on reporting and clearing thresholds and mechanics. Another consultation in response to CPSS-Iosco principles of financial markets infrastructure is also expected.

Singapore is in a similar situation as the proposed amendments to the Securities and Futures Act for the regulation of OTC derivatives were tabled on 15 October 2012.

Stamford Law’s Wong Kee Fong said that the amendments include mandating central clearing and reporting of OTC derivatives, extending the current regulatory regime for market operations, clearing facilities and market intermediaries for OTC derivatives and introducing a new regulatory regime for trade repositories.

In Australia the Corporations Legislation Amendment (Derivative Transactions Bill) 2012 has been introduced into Parliament. Its third reading was agreed to on October 29.

A Seoul-based lawyer explained that for the Korea exchange (KRX) to set up its platform to clear OTC derivatives transactions it is necessary to amend Korea’s Financial Investments Services and Capital Markets Act.

“The amendment was scheduled to be passed by the National Assembly earlier this year but was delayed become of the end of term,” he commented. “The new term has now begun but the amendment is still pending because, among other things, Korea is going through a presidential election.”

Moreover there are concerns about whether KRX’s implementation of the CCP will meet Iosco’s standards. Korea’s bankruptcy law does not provide a solution for what happens if the CCP - in this case the KRX - becomes insolvent, which is not in compliance with CPSS-Iosco standards.

But, according to the lawyer, Korea will move very rapidly in terms of implementing the regulations once they are passed by the National Assembly. The Korean government is required to implement mandatory clearing by the end of 2012, he said, but the law’s delay means that we have little time to prepare. This is because of the limited amount of time available between the passing of the law and its enforcement.

“If it’s passed in November, we’ll only have one month to prepare,” he added.

Mitigating extraterritorial risk

Most issues however arise from extraterritorial regulations. As well as the CFTC’s frequently-criticised rules on extraterritoriality under Dodd-Frank and similar regulations from the EU, each jurisdiction’s regulations have extraterritorial components.

Domestic regulators have noted that each trade can only be cleared once and have limited their regulations’ reach accordingly. However most have stringent reporting requirements.

One report posted by the Australian Prudential Regulation Authority (Apra), Australian Securities and Investments Commission (Asic) and the Reserve Bank of Australia (Rba) has outlined the regulators’ goals.

Although they recommend that a mandatory clearing obligation for A$-denominated interest rate derivatives is not necessary at this time, regulators may revisit this issue if central clearing in this derivative class is not evident soon.

But the three regulators also said that having as many OTC derivative transactions as possible reported to trade repositories will enhance the efficiency of the Australian market. They recommended that the government consider a broad-based mandatory trade reporting obligation if the Derivative Transactions Bill is passed.

Hong Kong also has broad reporting requirements. McCormack said that a distinctive aspect of the Hong Kong OTC derivatives reporting rules is that they extend to local entities and branches that originate or execute a trade that has a Hong Kong nexus, even if the trade is booked elsewhere.

“This offshore booking model is popular here in Hong Kong and the regulators are keen to ensure that they have as much transparency as possible over what goes on here,” she added.

Kingsley Ong
Considering the definition of Hong Kong nexus, partner Kingsley Ong of Eversheds said that it has been fine-tuned since its introduction. It covers derivatives in which underlying asset, currency or rate is denominated in or related to RMB and HKD. In the case of credit and equity derivatives, it is where an underlying portfolio of referenced entities contain both HK-listed and other entities, and the HK-listed entities exceed a certain percentage of the portfolio.

He commented, “So there is some extraterritorial effect, although narrower compared to original proposals.”

Ong added that the HKMA and SFC have been careful to avoid conflict of law issues. Complying with Hong Kong reporting obligations may result in a breach of client confidentiality rules in other jurisdictions, so the HKMA and SFC have proposed an exemption in reporting obligations when the reportable transactions are booked outside of Hong Kong. If reporting of such transactions will result in the infringement of the laws in the jurisdiction in which the transaction is booked and reasonable efforts to avoid non-compliance have been unsuccessful, then Hong Kong reporting obligations won't apply.

Hong Kong regulators have also proposed to exempt global institutions and central banks from reporting requirements to avoid affecting their market stabilising powers.

Singapore counsel agreed that the Monetary Authority of Singapore (MAS) has been cognisant of extraterritorial requirements for OTC derivative clearing as it looks to be a clearing hub for the region.

Although it is presumed that most Singapore statutes don’t have extraterritorial effect unless stated clearly, Wong said that the Securities and Futures Act has an extra-territorial provision under section 339 which extends the law’s jurisdiction to cross-border activities wholly outside Singapore that could have a substantial and foreseeable effect in Singapore.

However Singapore will not require the trading of OTC derivative contracts to be on exchanges or electronic trading platforms. This differs from proposals in the US and Europe.

Korean regulations are equally simple: the lawyer said that although there may be issues between Korean regulations and foreign regulations such as the Dodd-Frank act, it may not be a big issue.

“Under the KRX draft regulations, mandatory clearing will only affect Korean won interest rate swaps in the initial stage of implementation, so most of these products will likely be local products and shouldn’t be affected by regulations under foreign law,” he said.

See also

‘Are you a US person?’ http://www.iflr.com/Article/3110292/Search/Results/Are-you-a-US-person.html

‘CFTC reveals cross-border swaps agenda’ CFTC reveals cross-border swaps agenda http://www.iflr.com/Article/3107627/Search/Results/CFTC-reveals-cross-border-swaps-compliance-agenda.html

‘Why Dodd-Frank extraterritoriality is fundamentally flawed’

http://www.iflr.com/Article/3084114/Search/Results/Why-Dodd-Frank-extraterritoriality-is-fundamentally-flawed.html

‘Q&A: Afma’s David Lynch’ http://www.iflr.com/Article/3096313/Search/Results/Q-A-AFMAs-David-Lynch.html