CR-G-14 Non-centrally Cleared OTC Derivatives Transactions – Margin
4. Risk mitigation standards
4.1 Trading relationship documentation
4.1.1 An AI should establish and implement policies and procedures to execute written trading relationship documentation with its counterparties prior to, or contemporaneously with, executing a non-centrally cleared derivative transaction. The policies should include the minimum standards and minimum retention period for the trading relationship documentation (see paragraph 4.1.3). The relevant policies and procedures should be approved by the Board or, if the Board decides to delegate such authority, a designated committee and should be subject to independent internal or external review periodically.
4.1.2 The retention period for the trading relationship documentation and any modification thereof should be for a minimum of 5 years after the termination, maturity or assignment of any non-centrally cleared derivative which is subject to such documentation.
4.1.3 Trading relationship documentation should:
• provide legal certainty for non-centrally cleared derivatives;
• include all material rights and obligations of counterparties concerning their trading relationship with regard to non-centrally cleared derivatives (see paragraph 4.1.4). Such rights and obligations of the counterparties may be incorporated by reference to other documents in which they are specified;
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• be executed in writing or through other equivalent non-rewritable, non-erasable electronic means (without prejudice to the second sentence of the preceding bullet);
• be consistent with any applicable law or regulation.
4.1.4 The material rights and obligations referred to in the second bullet of paragraph 4.1.3 should include but are not limited to those with respect to:
• payment obligations;
• netting of payments;
• events of default or other termination events;
• calculation and netting of obligations upon termination;
• transfer of rights and obligations;
• governing law;
• processes for valuation, portfolio reconciliation and dispute resolution, where applicable;
• matters contained in credit support arrangements, where applicable: VM and IM standards, types of assets that may be used for satisfying such margin standards and any asset valuation haircuts, investment and rehypothecation terms for assets posted to satisfy such margin standards, guarantees, and custodial arrangements for margin assets, including whether margin assets are to be segregated with a third party custodian.
4.1.5 In the case of one-off transactions, trading relationship documentation could take the form of a trade confirmation that includes all material rights and obligations of the counterparties to the non-centrally cleared OTC derivatives transaction. 50
50 Trading relationship documentation in the form of long-form confirmations in the case of one-off transactions executed within the timeframe set out in paragraph 4.2.3 is deemed to be
“contemporaneous” under paragraph 4.1.1.
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4.2 Trade confirmation
4.2.1 An AI should establish and implement policies and procedures designed to ensure the material terms of its non-centrally cleared derivatives transactions are confirmed as soon as practicable after the transactions are executed. Material terms confirmed should include terms necessary to promote legal certainty to the transaction, including incorporating by reference, the trading relationship documentation or any other documents that govern or otherwise form part of the trading relationship agreement. A list of possible material terms is set out in Appendix D. In the case of one-off transactions, a confirmation that includes all of the material rights and obligations of the counterparties to the transaction (see paragraph 4.1.4) and all of the material terms of the transaction would meet the requirements for trading relationship documentation and trade confirmation.
4.2.2 The relevant confirmation should be in writing via non-rewritable, non-erasable automated methods and executed electronically where it is reasonably practicable for the relevant counterparties to the transaction to do so. Otherwise confirmation should be given in writing via manual means (e.g. fax) or other non-rewritable, non-erasable electronic methods (e.g.
email).
4.2.3 Trade confirmation should be completed as soon as practicable, depending on the type of non-centrally cleared derivative entered into. 51 An AI should implement appropriate policies and procedures designed to ensure a confirmation is executed by the following timelines:
• For interest rate swaps, cross-currency swaps and credit default swaps52: by T+1 from and after 1 March 2017;
51 The trade confirmation provisions do not apply to an AI acting as OTC derivatives intermediary in cases where it acts as an agent without obligations to prepare or sign any trade confirmations.
52 An interest rate swap is defined as a non-centrally cleared derivative transaction under the terms and conditions of which: (a) the two counterparties to the transaction agree to exchange interest rate cash flows at specified intervals while the transaction is still outstanding; and (b) the payments are to be
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• For other product types: by T+2 from 1 September 2017 to 28 February 2018; and by T+1 from and after 1 March 2018.
An AI may use one-way confirmation instead of two-way confirmation, as long as (i) both parties to the transaction have agreed in advance on this process; (ii) one-way confirmation is not prohibited under the applicable laws and regulations which govern the non-centrally cleared derivative transaction that is to be confirmed; and (iii) the outcome of the confirmation is legally binding on both parties. In this case, an AI should provide an acknowledgement53 within the relevant timeframe set out above, and give a deadline for the counterparty to object.
4.2.4 For transactions concluded after 4:00 p.m. Hong Kong time, or with a counterparty located in a different time zone which does not allow for confirmation by the set deadline, the confirmation should take place as soon as practicable and, at the latest, one business day following the otherwise applicable deadline in paragraph 4.2.3.
4.2.5 Confirmation is required upon entering into a transaction, including as a result of novation. An AI should also consider adopting policies and procedures to confirm material changes to the legal terms of, or rights and obligations under, the transaction. Such changes may include termination prior to scheduled maturity date, assignment, novation, amendment or extinguishing of rights or obligations.
4.2.6 An AI should maintain records of transactions that remain unconfirmed after 5 business days from the execution date of the transactions. The records should be made available to the MA upon request.54
calculated by reference to (i) a notional amount that is denominated in a single currency; and (ii) agreed interest rates or interest rate indexes. A credit default swap is defined as a contract, which commits two counterparties to exchange a periodic fee for a payment contingent on a default event or any other agreed change in the credit quality of a reference asset for an agreed period of time.
53 An acknowledgement refers to a written or electronic record of all of the terms of an OTC derivative transaction, signed and sent by one counterparty to the other.
54 Before 1 September 2017, paragraph 4.2.6 only applies to interest rate swaps, cross-currency swaps and credit default swaps.
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4.3 Valuation with counterparties
4.3.1 An AI should agree with its counterparties on, and clearly document in writing, the process that will be relied upon for determining the value of non-centrally cleared derivatives in a predictable and objective manner at any time from the execution of the transaction to the termination, maturity, or expiration thereof, for the purpose of exchanging margin.
4.3.2 The valuation determinations should be based on economically similar transactions or other objective criteria.55 The valuation may be computed internally or provided by third parties.
4.3.3 The general process for valuation to be agreed on should at least cover the approach, the key parameters and or the data sources for such parameters.
4.3.4 All agreements on the valuation process should be documented in the trading relationship documentation or trade confirmation. A process for determining the valuation should be in place for the entire duration of non-centrally cleared derivatives transactions.
4.3.5 An AI should perform periodic review of the agreed-upon valuation process to take into account any changes in market conditions. Where changes are made as a result of the review, the relevant documentation must be updated to reflect such changes.
4.3.6 The inability to agree on the value of non-centrally cleared derivatives became especially acute during the 2007-2009 financial crisis when there was widespread failure of the market inputs needed to value many transactions. Therefore, valuation documentation should include an alternative process or approach by which an AI and its counterparty will determine the value of a non-centrally cleared derivative in the event of the unavailability, or other failure, of any inputs required to value the transaction. An AI and its counterparty may agree on changes or procedures for modifying or
55 No OTC derivative market participant should, however, be required to disclose to its counterparty confidential and/or proprietary information about, or used in, any model it may use to value an OTC derivative.
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amending the valuation process or approach at any time so long as the agreements remain consistent with applicable law.
4.3.7 An AI should also agree with its counterparties and document how disputes on valuation should be resolved should they arise (see Sub-section 4.6).
4.4 Portfolio reconciliation
4.4.1 An AI should establish and implement policies and procedures to ensure that the material terms and valuations of all outstanding transactions (both collateralised and uncollateralised) in a non-centrally cleared derivatives portfolio are reconciled with counterparties at regular intervals.
4.4.2 The process or method of portfolio reconciliation should be agreed upon by an AI and its counterparties. It should be designed to ensure an accurate record of the material terms and valuations of the non-centrally cleared derivatives in the portfolio, and to identify and resolve discrepancies in the material terms and valuations in a timely manner. In case of a discrepancy in valuation, a difference between the lower valuation and the higher valuation of more than 10 percent of the higher valuation needs to be reconciled. Portfolio reconciliation should encompass all transactions in the portfolio.56
4.4.3 An AI should have policies and procedures in place to agree on and undertake portfolio reconciliation:
• where the other counterparty is a financial or significant non-financial counterparty: (i) each business day when the AI and the counterparty have 500 or more outstanding non-centrally cleared derivatives with each other; or (ii) once per week
56 The valuation reconciliation threshold of 10% could be applied at the netting set level. Once the 10%
threshold is exceeded, all the transactions in the netting set portfolio need to be reconciled. Nevertheless, this does not preclude an AI from applying a reconciliation threshold at the transaction level which is agreed with its counterparty taking into account the risk profile of the portfolio.
As to the material terms of outstanding transactions in a non-centrally cleared derivatives portfolio, they should be reconciled at the transaction level.
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when the AI and the counterparty have between 51 and 499 outstanding non-centrally cleared derivatives with each other at any time during the week; or (iii) once per quarter when the AI and the counterparty have 50 or less outstanding non-centrally cleared derivatives with each other at any time during the quarter;
• subject to paragraph 2.2.3, for all other counterparties: (i) once per quarter when the AI and the counterparty have more than 100 outstanding non-centrally cleared derivatives with each other at any time during the quarter; or (ii) once per year when the AI and the counterparty have 100 or less outstanding non-centrally cleared derivatives with each other.
4.5 Portfolio compression
4.5.1 To reduce operational risk and counterparty credit risk exposure, an AI should establish and implement policies and procedures to regularly assess and, to the extent appropriate, engage in portfolio compression by replacing economically-equivalent transactions by decreasing the number of transactions and/or notional value of a portfolio of non-centrally cleared derivatives transactions.
4.5.2 Portfolio compression may be performed on a bilateral or multilateral basis.
4.6 Dispute resolution
4.6.1 An AI should agree with its counterparties on, and document, the mechanism or process for determining when discrepancies in material terms or valuations of non-centrally cleared derivatives should be considered disputes, as well as how such disputes should be resolved as soon as practicable, with a specific process for those disputes that remain unresolved within five business days. Such mechanism or process should provide for the escalation of material disputes to an appropriate level of senior management at the AI.
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4.6.2 To facilitate early identification of disputes relating to material terms by the MA, an AI should report to the MA any material disputes in excess of HKD 100 million (or its equivalent in any other currency) if not resolved within 15 business days.57
4.6.3 An AI and its counterparties should have in place agreed detailed procedures and processes in relation to the identification, recording, and monitoring of disputes relating to the recognition or valuation of derivatives contracts and to the exchange of margin between counterparties.58 Sufficient records should be kept to facilitate the reporting of material disputes, as discussed in paragraph 4.6.2.