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Introduction

The Hong Kong Monetary Authority (HKMA) and the Hong Kong Securities and Futures Commission (SFC) have issued a joint consultation paper on their proposals to regulate the over-the-counter (OTC) derivatives market in Hong Kong.  The consultation paper is a response to global efforts to enhance regulation of the OTC derivatives markets after the global financial crisis in late 2008.

The proposals affect:

• locally-incorporated banks
• overseas banks with a Hong Kong branch
• brokers
• investment managers
• persons wishing to provide central clearing services for OTC derivatives
• and other “large players whose positions may pose systemic risk”.

Overview of the proposals: regulatory framework

The HKMA is the government authority in Hong Kong responsible for maintaining monetary and banking stability.

The Securities and Futures Commission (SFC) is an independent non-governmental statutory body outside the civil service, responsible for regulating the securities and futures markets in Hong Kong.

The regulators propose to introduce a mandatory reporting obligation in Hong Kong whereby certain specified OTC derivative transactions must be reported to the Hong Kong Monetary Authority Trade Repository (HKMA-TR).

The regulators propose that these obligations should initially apply only to certain types of interest rate swaps (IRS) and non-deliverable forwards (NDF).  The obligation will be extended subsequently, and in phases, to cover other interest rate derivatives and foreign exchange derivatives, as well as other asset classes, such as equity derivatives.

“OTC derivatives transactions” will be defined broadly.  Securities, futures, structured products authorised for public offering and certain retail banking products will be excluded.

The regulators propose that this obligation should apply only to Authorised Institutions (AI), Licensed Corporations (LC) and others who are Hong Kong persons (persons other than AIs and LCs).

The reporting obligation is as follows:

• LCs and locally-incorporated AIs should be required to report all reportable transactions that they are either counterparty to, or that they have originated or executed
• Overseas-incorporated AIs should be required to report reportable transactions:(i) that they have become counterparty to, originated or executed, through their Hong Kong branch, or
  (ii) that have a Hong Kong nexus6 and that the overseas-incorporated AI is a counterparty to, and
• Others who are Hong Kong persons should be required to report reportable transactions that they are a counterparty to, but only if such persons have exceeded a specified reporting threshold.

Important dates

• 1^st January 2013: proposed start date of the new regulatory regime.

Post implementation, the regulators also propose:

• a 3 month grace period for firms to comply with reporting requirements
• a 6 month grace period for firms to report positions entered into previously and still outstanding

A grace period to comply with mandatory clearing requirements, being the later of (i) 3 months from the date you first enter into the relevant type of OTC derivative, and (ii) 6 months from the start date of the new regulatory regime.

Benefits of the Lombard Risk solution: REFORM

Lombard Risk has been working closely with several large global banks to analyse the impact of OTC Derivative Transactional reporting on their businesses.  As a result we have developed a Swap data reporting solution to enable firms to meet the regulatory requirements relating to global swap markets using the Lombard Risk REFORM software.

It is a technology and software solution that meets both real-time and event-driven reporting to the regulators, keeping firms that use the solution compliant and giving added benefits for internal management information and reporting.

Its key features are:

• Being independent of any specific trading or banking system, it allows it to gather all the necessary data from many different source systems
• Reporting to one or more (‘any’) Swap Data Engine
• Having optional functionality to enable Swap trades that have been executed on an SEF to be automatically loaded into a ‘trade system of record’
• Utilising event-driven business process management, based on event-specific and configurable rules to execute pre-defined processes as events occur
• Having a single system responsible for the formulation of Dodd-Frank reporting ensures a clean separation of functionality and means that only the Lombard Risk Swap data reporting solution will need to change when regulations do
• Allowing exceptions to be managed and resolved and reporting provided on error rate, throughput and latency
• Using a standard set of technologies that are widely used in the industry

Lombard Risk solution: REFORM

Lombard Risk REFORM is designed for real-time regulatory reporting, will interface seamlessly with an organisation’s banking (or other) systems and does not have dependencies on any specific system(s).  This is achieved using standardised APIs that enable the solution to be configured to interface with ‘any’ system. 

In this Dodd-Frank Swap data reporting application it:

• Listens for new trades in specified asset classes as they are booked – interacting with the firm’s front/middle office system(s), of which there may be many
• Generates and reports the required information to the SDR
• Receives Unique Swap Identifiers back from the SDR
• Listens for CHANGE EVENTS impacting the applicable Swap deals as they occur – interacting with the firm’s back office system(s)
• Generates and sends the appropriate information for changes to the SDR, cross-referenced with the USI
• Handles large volumes of Swaps impacted by these regulations
• Generates audit trails on all activities
• Provides the firm with its own SDR which will offer enhanced management information

 

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Introduction

On 18^th April 2012 regulators finalised rules further defining “Swap Dealer”, “Major Swap Participant” and “Eligible Contract Participant” – giving long awaited guidance on which swap market entities will be subject to the provisions of Title VII of the Dodd-Frank Act.

The salient point of the finalised guidance is the increased threshold of up to $8 billion in swap transactions that firms must trade in a 12 month-period to be designated a “Swap Dealer”.  This figure is a significant increase from the original proposed rules of December 2010 when the threshold was $100 million.

The regulators have also added a more explicit exemption for swaps pertaining to the hedging of market risks, such as reducing exposure to interest-rate fluctuations.  These trades will not count towards the threshold invoking “Swap Dealer” designation.

What it means for firms

Firms defined as swap dealers will ultimately be subject to the highest level of capital and collateral requirements in the market.  

The $8 billion threshold will fall to $3 billion within 5 years unless initial reported data persuades regulators otherwise. This will further designate more firms as “swap dealer” though it is much higher than the initial proposed level of $100 million.

Despite this, Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler said that he was “confident the rule would impose new requirements on the dominant players in the swap market”.  The CFTC did not provide details on how many firms would be subject to the heightened oversight.

The rule will take effect 60 days after it is published in the Federal Register.   

With a clearer picture on their market participant designation and the requirements beholden on them as a result, firms must prepare now for the implementation of the provisions of Title VII of the Dodd-Frank Act.

Definition of “Swap Dealer”

A swap dealer has been defined as any person who:

• Holds itself out as a dealer in swaps
• Makes a market in swaps
• Regularly enters into swaps with counterparties as an ordinary course of business for its own account, or
• Engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.

Interpretive guidance on the definition of swap dealer

The Adopting Release provides interpretive guidance on the “holding out” and “commonly known” criteria, market making, the not part of “a regular business” exception, and the overall interpretive approach to the definition. The guidance clarifies the following:

• The determination of whether a person is a swap dealer should consider all relevant facts and circumstances, and focus on the activities of a person that are usual and normal in the person’s course of business and identifiable as a swap dealing business; making a market in swaps is appropriately described as routinely standing ready to enter into swaps at the request or demand of a counterparty
• A person making a one-way market in swaps may be a market maker, and exchange executed swaps are relevant in the determination
• Examples of activities that are part of “a regular business,” and therefore indicative of swap dealing, are entering into swaps to satisfy the business or risk management needs of the counterparty, maintaining a separate profit and loss statement for swap activity, or allocating staff and resources to dealer-type activities; and
• The SEC’s dealer-trader distinction may be applied.

De Minimis exemption from the definition of swap dealer

The Dodd-Frank Act provides an exemption for a person who “engages in a de minimis quantity of swap dealing in connection with transactions with or on behalf of its customers.”

The rule requires that, in order for a person to be exempt from the definition on the basis of de minimis activity:

• The aggregate gross notional amount of the swaps that the person enters into over the prior 12 months in connection with dealing activities must not exceed $3 billion.
• Also, the aggregate gross notional amount of such swaps with “special entities” (as defined under CEA Section 4s(h)(2)(C) to include certain governmental and other entities) over the prior 12 months must not exceed $25 million.

The rule also provides for a phase-in of the de minimis threshold to facilitate orderly implementation of swap dealer requirements. During the phase-in period, the de minimis threshold would effectively be $8 billion (while the $25 million threshold for swaps with special entities would apply unchanged). Two and one-half years after data starts to be reported to swap data repositories, the Commission’s staff will prepare a study of the swap markets, including data and information that becomes available about the de minimis threshold. Nine months after this study, the Commission may end the phase-in period, or propose new rules to change the de minimis threshold (either up or down). If the Commission does not take action to end the phase-in period, it will terminate automatically five years after data starts to be reported to swap data repositories.

The regulators also defined the term “Major Swap Participant” (see below) which will affect firms holding large positions in certain categories of asset classes.   One of the guidelines on what constitutes a “substantial position” would be daily uncollateralised exposure of $1 billion in any major asset class excluding rate swaps where the de minimis level is $3 billion.

Definition of “Major Swap Participant” (MSP)

There are three parts to the Dodd-Frank Act definition and a person that satisfies any one of them is classified as a Major Swap Participant:

1. A person that maintains a “substantial position” in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan.
2. A person whose outstanding swaps create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.”
3. Any “financial entity” that is “highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency” and that maintains a “substantial position” in any of the major swap categories.

The statutory definition excludes swap dealers and certain financing affiliates.

Definition of “Substantial Position”

The final rules define “substantial position” using objective numerical criteria, which promote the predictable application and enforcement of the requirements governing MSPs. The tests adopted by the Commission account for both current uncollateralized exposure and potential future exposure. A position that satisfies either test would be a “substantial position.” The definition of substantial position excludes positions hedging commercial risk and employee benefit plan positions.

The tests apply to a person’s swap positions in each of four major swap categories: rate swaps (any swap based on reference rates such as interest rates or currency exchange rates), credit swaps (any swap based on instruments of indebtedness or related indices), equity swaps (any swap based on equities or equity indices) and other commodity swaps (any swap not included in the first three categories, including any swap based on physical commodities).

First test of substantial position

The first substantial position test:

•  Measures a person’s current uncollateralized exposure by marking the swap positions to market using industry standard practices
•  Allows the deduction of the value of collateral that is posted with respect to the swap positions; and
• Calculates exposure on a net basis, according to the terms of any master netting agreement that applies.

The thresholds adopted for the first test are the daily average current uncollateralized exposure of $1 billion in the applicable major category of swaps, except that the threshold for the rate swap category would be $3 billion.

Second test of substantial position

The second test adopted by the Commission for substantial position accounts for both current uncollateralized exposure (as discussed above) and the potential future exposure associated with a person’s swap positions. The second substantial position test determines potential future exposure by:

• Multiplying the total notional principal amount of the person’s swap positions by specified risk factor percentages (ranging from .% to 15%) based on the type of swap and the duration of the position
• Discounting the amount of positions subject to master netting agreements by a factor ranging between zero and 60%, depending on the effects of the agreement, and
• If the swaps are cleared or subject to daily mark-to-market margining, further discounting the amount of the positions by 80%.

The thresholds adopted for the second test are $2 billion in daily average current uncollateralized exposure plus potential future exposure in the applicable major swap category, except that the threshold for the rate swap category would be $6 billion.

Regulatory deadlines

Specific asset classes are impacted: Credit, Rates, Equities, FX and Commodities, with compliance dates ranging from 16th July – October 2012. It is anticipated that ALL asset classes will be covered by 12th January 2013.

From 16th July 2012 firms executing Swaps in the above asset classes, that meet any of the below three criteria, must submit details of the Swap, ‘real-time’, to a Swap Data Repository (SDR) and, for the duration of the Swap, notify the SDR of any amendments to it in order to meet the Dodd-Frank Act Swap data reporting regulations which are:

The regulations in Title VII impact firms executing Swaps where:

1. The counterparty is a US person OR
2. The Swap was executed in the US, even if it was not executed with a US person OR
3. The Swap was cleared through a registered clearing agency with a principal place of business in the US. Again, even if neither party was a US person.

Both regimes require Swap data to be reported throughout the lifecycle of the trade providing reporting for:

1. Real-time public dissemination – for price and volume transparency and
2. Confidential regulatory use – to help conduct market oversight, enforce position limits and track systemic risk

This includes: on-trade creation; daily, throughout the lifetime of the trade; when any significant trade event occurs (e.g. amendments, fixing, option exercise, termination, etc.); the natural end-of-life of the trade (e.g. trade maturity or option expiry without exercise).

All information is required to be reported ’as soon as technologically practicable‘ and requires sending Swap data to SDRs.

The information to be reported is not restricted to the primary economic data of the trade, but also includes MtM valuation and other data derived from SSIs and CASs.

How Lombard Risk can help

The Lombard Risk Dodd-Frank Act Title VII reporting solution has the following features – to:

• Listen for new trades in specified asset classes as they are booked – interacting with the firm’s front/middle office system(s), of which there may be many
• Generate and report the required information to the SDR
• Receive Unique Swap Identifiers (USI) back from the SDR
• Listen for CHANGE EVENTS impacting the applicable Swap deals as they occur – interacting with the firm’s back office and other appropriate system(s)
• Generate and send the appropriate information for changes to the SDR, cross-referenced with the USI
• Handle the large volumes of Swaps that are impacted by these regulations
• Generate full audit trails on all activities
• Provide the firm with its own SDR – which will enable enhanced management and business information
• Meet the regulators’ demands as defined in the Title VII of the Dodd-Frank Act: WALL STREET TRANSPARENCY AND ACCOUNTABILITY – Regulation of Over-the-Counter Swaps Markets

Join the next Dodd-Frank Act webinar: more details on line >>>

Online data sheet for Dodd-Frank Act solution >>>

For more information on any of these topics email info@LombardRisk.com

Source: Commodity Futures Trading Commission website, Final Rules Regarding Further Defining “Swap Dealer”, “Major Swap Participant” and “Eligible Contract Participant”

MIS reporting suite: With more complex business models, and evermore invasive regulators, the need to know that your systems and controls are in place, and are in action, has never been greater.

LISA stress testing and scenario analysis

Business insight into Basel III

In the field of financial regulation, the Basel Committee on Banking Supervision has played an international standard-setting role for many years. As the name implies, Basel III has seen two major previous episodes:

The first, agreed in 1988, was mainly concerned with credit risk. Basel II, agreed in 2004 (but implemented later, or in some cases not at all), added big changes to market risk, to cater for the much more complex trading environment of the early 21st century, and also added a capital charge for operational risk.

A mere three years later, as overextended institutions started to fail, it was clear that the missing risk was liquidity, and indeed also specific stress testing of the firm’s survivability from a liquidity and balance sheet perspective.

So we now have Basel III, agreed in 2010 and due for implementation in 2013, which incorporates liquidity in to the business model and a range of other issues including:

• A somewhat less generous definition of capital
• Higher capital charges especially for derivatives, and
• An absolute cap on leveraging assets.

Read the full paper >>

REFORM for Dodd-Frank Act application

The latest regulations relating to collateral management are moving to a central clearing house and those pertaining to liquidity.  Helen Nicol (nee Bramley), Director COLLINE (Lombard Risk’s collateral management solution) has her views.

Regulations relating to collateral management

Lombard Risk’s COLLINE provides firms with a comprehensive collateral management solution:

• Multi-agreement, multi-region and cross-product collateral management
• CCP Clearing, ISDA Dispute Resolution Protocol and electronic messaging initiatives are supported
• Flexible, configurable workflow to enable users to design screens with bespoke views
• Rule-driven collateral optimisation functionality
• Bespoke exposure calculation capability
• “What if” scenarios to forecast liquidity impact of credit rating changes
• Extensive reporting capability
• Customer and counterparty self-service

 

Risk management techniques that are based on stressing a portfolio under multiple conditions and scenarios have never been more critical than they are
today, in this post financial crisis environment.

Financial organisations are challenged with increased regulatory pressure to improve market risk analysis in order to better anticipate forward looking events that impact markets, and enhance the information available to make more informed capital allocation, pricing strategy and exposure level risk management decisions.

FirmRisk Value at Risk (VaR) is a versatile and comprehensive reporting module of OBERON, an integrated trade processing, valuation and risk management solution. Lombard Risk offers FirmRisk VaR, as a stand-alone installation or as part of an enterprise solution, to help you measure, monitor, and manage your market risk on a portfolio level to respond to a wide array of industry issues.  The solution has the ability to identify the trades that contribute to a high VaR to facilitate the industry need for more advanced risk information.

Financial Institutions are more involved in credit derivatives than ever before making the management of credit risk ever more challenging. Escalating credit volumes and the breadth of new instruments traded have driven operational costs and risks significantly. Lombard Risk offers a complete global solution capable of handling a broad range of products to reduce costs, manage risk, and control a wide range of arbitrage opportunities.

For financial institutions operating in today’s volatile markets, exposure to risk is a constantly evolving threat. Tradable instrument diversity and global regulatory compliance requirements are constantly in a state of flux. Organisations need access to a fast and accurate trading, valuation and risk management system to process trades more efficiently, manage ongoing risk exposure more effectively and have the ability to react quickly to sudden market shifts.

Governments and regulators have increased the scope of money laundering
and fraud prevention laws, raising the bar for financial compliance. This
reality is presenting a new challenge to Compliance Departments to update
policies, procedures, controls and information systems. Financial institutions
must adhere to global sanction programmes, monitor all transactions for
potentially suspicious activity, as well as carry out proactive customer due
diligence.