40 Things You Should Know to Pass HKSI Paper 3 – Regulation of Derivatives

TOPIC 1 – REGULATORY FRAMEWORK

1. Definitions of Futures Contracts

• Under the Securities and Futures Ordinance, futures contracts are defined to include:
  • Contracts for differences (meeting either the futures contract or options on futures contract definitions)
  • Forward contracts (but only when they are traded on an exchange)
  • Futures contracts and option contracts (options on futures contracts and traded on an exchange)

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

2. Structure of Legislation and Regulation

• The SFO came into effect in April 2003 to meet challenges being faced and replaced 10 previous ordinances which had been drafted at various times to meet needs as they arose
• Reasons for overhauling Hong Kong’s financial legal framework included meeting changes due to:
  • Globalization
  • Technological innovations
  • Introduction of new products, services and trading methods
• SFO empowers SFC to publish rules, codes of conduct and guidelines, guidance notes and circulars
• Rules have status of subsidiary legislation and have the force of law. Breaches of rules can be a criminal offence
• Codes of conduct and guidelines set out practices and standards and do not have the force of law. Failure to follow may reflect on fitness and properness of persons licensed or registered and may result in fines or license suspension/revocation
• Guidance notes and circulars provide interpretations and SFC’s views on particular issues

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

3. Regulatory Objectives of the SFC

• As stated in the SFO, the objectives of the SFC, in relation to the securities and futures industry, are:
  • Maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness of the industry
  • Promote understanding by the public of financial services including the operation and functioning of the industry
  • Provide protection to the investing public
  • Minimize crime and misconduct in the industry
  • Reduce systemic risks in the industry
  • Assist the financial secretary in maintaining the financial stability of Hong Kong by taking appropriate steps in relation to the industry

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

TOPIC 2 – LICENSING AND REGISTRATION

4. Dealing in Futures Contracts

• The SFO definition is that a person deals in futures contracts if he:
  • makes or offers to make an agreement with another person to enter into, acquire or dispose of, a futures contract; and
  • induces or attempts to induce another person to enter into, acquire or dispose of a futures contract
• Excepted from the definition are:
  • Persons engaging in the above acts through a Type 2 licensed/registered person (no exception if for remuneration)
  • Persons entering into market contracts (contracts entered into by the clearing house with a clearing participant pursuant to a novation)
  • Persons acting as principal with a professional investor in dealing in futures contracts
  • Persons engaged in the above acts on markets referred to in the Commodity Exchanges (Prohibition) Ordinance
  • Type 9 licensees who engage in the above solely for the purposes of the type 9 activity

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

5. Advising on Futures Contracts

• Advising on futures contracts is defined in the SFO as:
  • The giving of advice
  • The issuing of analyses or reports to allow recipients to make decisions on the buying or selling of futures contracts
• Persons exempted from requiring a Type 5 license are:
  • Solicitors, counsel, professional accountants, trust companies and Type 9 licenses who give advice wholly incidental to their professions
  • Financial journalists and broadcasters who give investment advice or issue analyses/reports on investments through the public media
  • Corporations giving advice/issuing analyses and reports to wholly owned subsidiaries/holding companies/fellow wholly owned subsidiaries
  • Type 2 licensees giving advice wholly incidental to their dealing activities

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

6. Providing Automated Trading Services (ATS)

• ATS describes any automated system that provides, by means of electronic facilities, a trading mechanism for securities and futures contracts (including clearing services), other than the operations of recognized exchange company or clearing house
• The services provided include:
  • Trade confirmation and matching systems provided by brokers *
  • Full trading and settlement systems for non-local securities #
• ATS are covered in two Parts of the SFO:
  • #Part III – a person may be authorized to provide ATS similar to the services provided by a recognized exchange or clearing house
  • *Part V – a person may be licensed/registered to provide ATS as a regulated activity
• ATS, in relation to futures contracts (other than those provided by HKFE), which require a license/registration, are defined as those where:
  • Offers to sell or purchase futures contracts are regularly made in a way that results in a binding transaction; and/or
  • Persons are regularly introduced, or identified to other persons, to negotiate/conclude sales or purchases of futures contracts

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

7. Financial Resources Requirements

• A licensed corporation must meet the requirements before obtaining a license and continue to maintain sufficient capital at all times.
• The required level of paid-up share capital for a licensed corporation is:
• Dealing in futures contracts: HK$5 million
• Advising on futures (except if client assets not held): HK$5 million
• If a corporation is licensed for more than one activity, the capital requirement will be the highest amount for all such activities.
• Approved introducing agents and securities advisers not holding client assets do not have paid-up share capital requirements
• A licensed corporation must maintain at all times minimum Liquid Capital as follows:
• Dealing in futures contracts: HK$3 million
• Advising on futures contracts:
• where it does not hold client assets: HK$100,000
• where it holds client assets: HK$3 million

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

8. Responsible Officer

• A responsible officer is a licensed representative who:
  • Actively participates in or supervises a regulated activity;
  • Is nominated by the licensed corporation; and
  • Is approved by the SFC
• Although the SFO does not provide a definition of responsible officer, the SFC has stated:
  • Every executive director* of a licensed corporation is required to obtain the approval of the SFC as a responsible officer; and
  • Every licensed corporation must have, for each regulated activity for which it is licensed, at least two responsible officers approved by the SFC – at least one of them must be an executive director and at least one must be based in Hong Kong

*  A director who actively participates in, or is responsible for directly supervising, the business of a regulated activity for which the corporation is licensed (s113, SFO)

• For registered institutions: the Banking Ordinance requires at least two executive officers to be responsible for supervising regulated activities – at least one to be available at all times

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

9. Licensing of Representatives

• Individuals conducting regulated activities within licensed corporation need to be individually licensed with SFC as licensed representative
• Individuals may act for more than one licensed corporation, within the same group of companies
• The SFC may grant a temporary license to representatives of a licensed or a temporary licensed corporation, for not more than 3 months. This would enable someone based overseas to conduct a regulated activity in Hong Kong
• On application for a representative license, a person may be given a provisional license to cover the period before a decision is made on the licensing application
• If a licensed representative ceases to be employed by the licensed corporation, the corporation must notify the SFC within seven business days of cessation. If the license is not transferred to another licensed corporation within 180 days, the license is deemed to have been revoked

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

10. Substantial Shareholder

• Substantial shareholders have a special relevance in the licensing regime
• All substantial shareholders of licensed corporations must be approved by the SFC
• Under this legislation, a substantial shareholder is a person who, alone or together with his associates:
  • Has an interest of more than 10% of the nominal value of the issued share capital
  • Directly or indirectly has more than 10% of the voting power of the company at a general meeting
  • Is able to exercise 35% or more of the voting power of another company at a general meeting which in turn has more than 10% of the voting power of the company at a general meeting
• A substantial shareholder must keep the SFC informed of his contact details and notify the SFC of any changes within 14 days
• A person who becomes a substantial shareholder without obtaining permission from the SFC commits an offence and is liable to a fine and/or imprisonment
• Someone who becomes a substantial shareholder, without being aware, must apply for approval when he discovers the fact. Time limit for approval is “as soon as reasonably practicable” or within three business days from becoming aware)

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

TOPIC 3 – CLIENT SECURITIES AND MONEY

11. General Requirements

• Intermediaries are called upon to handle client assets, including money, in a fiduciary capacity. The SFC protects the assets of investors by making rules regarding:
  • The holding of and dealing with client assets and securities collateral
  • The holding of and dealing with client money
• No person may receive or hold client assets of an intermediary in Hong Kong, unless the person is:
  • The intermediary
  • An associated entity of the intermediary
  • An excluded person
    • Any AFI
    • Another intermediary holding securities collateral
    • Any company approved by the SFC

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

12. Securities and Futures (Client Securities) Rules

• The Client Securities Rules apply to client securities or securities collateral of an intermediary that are:
  • Listed on a recognized stock market (ie SEHK);
  • Interests in an SFC authorized CIS; and
  • Received or held in Hong Kong by an intermediary (or its associated entity) in the course of conducting a regulated activity
• The Client Securities Rules do not apply to securities held by an intermediary in an account in a client’s name, set up by that client with persons other than the intermediary or its associated entity:

[Rules only apply to Hong Kong stocks held in Hong Kong received by an intermediary or associated entity in the course of conducting regulated activities]

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

13. Requirement for Deposit or Registration of Securities

• The intermediary shall, as soon as reasonably practicable after receiving client securities/securities collateral, deal with them as follows
  • If a deposit is to be made, it must be with
    • An AFI
    • An approved custodian
    • Another intermediary licensed for dealing in securities
  • Any deposits
    • Must be in separate segregated accounts for each category, designated as trust or client accounts
    • Which are securities collateral, may be deposited in an account in the name of the intermediary/associated entity
  • If registered, it must be in the name of:
    • The client
    • The associated entity of the intermediary
    • For securities collateral only, the intermediary itself

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

14. Standing Authority

• A written notice authorizing the intermediary/associated entity to deal with client assets in specified ways
• Effective for a period not more than 12 months (no time limit for PIs)
• May be renewed on the written request of the client for a period not more than 12 months
• May be deemed to be renewed by the intermediary/associated entity giving written notice at least 14 days prior to expiry reminding client of impending expiry. Deemed to be renewed on date of expiry, unless client objects
• Intermediary/associated entity must provide written confirmation of deemed renewal to client within a week of expiry date

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

15. Relevance to Trading in Futures Contracts

• Generally, the Client Securities Rules allow the disposal of client securities or securities collateral in settlement of a clients’ liability to the intermediary, associated entity or a third person
• One situation where the Rules can be applied to dealing in futures contracts is the accepting of securities collateral from clients to cover derivative margin obligations
• HKFE Clearing Corporation Limited allows its participants to use cash and non-cash collateral to discharge their margin liabilities from dealing in futures contracts
• An intermediary licensed/registered for dealing in futures contracts may deposit the securities collateral with:
  • A recognised clearing house; or
  • Another intermediary licensed/registered for dealing in futures contracts as collateral for settlement obligations

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

16. Mode of Treatment of Client Money on Receipt

• The licensed corporation/associated entity holding client money should have one or more segregated accounts (designated as a trust or a client account) maintained with an AFI or another SFC-approved person (ie open a separate bank account)
• Within one business day of receiving client money, the licensed corporation/associated entity should pay the money:
  • Into a segregated account
  • To the client directly
  • In accordance with a written direction
  • In accordance with a standing authority

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

17. Payment of Money Out of Segregated Account

• Money should be held in the segregated account until payment has to be made
  • To the client
  • In accordance with a written direction
  • In accordance with a standing authority
  • To meet settlement or margin requirements
  • To meet amounts due from the client to the licensed corporation/associated entity
• Money held in a segregated account, which is discovered not to be client money, must be moved out of the account within one business day of discovery

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

TOPIC 4 – CONDUCT OF BUSINESS

18. Code of Conduct Principle 2 – Diligence

• A licensed/registered person should act with due skill, care and diligence, in the best interests of its clients and the integrity of the market. Some practical examples of this are:
  • Client orders should be executed promptly in accordance with clients’ instructions – prompt execution
  • Client orders should be executed on the best available terms – best execution
  • Orders executed for clients should be promptly and fairly allocated to those clients – prompt and fair allocation
  • Clients’ orders should not be withheld for convenience
  • Advice should be given to clients with due skill, care and diligence
  • Separate accounts should be kept for each client and for securities, futures, cash and margin accounts
  • Clients must be informed of derivative position and reporting limits
  • All orders should be time-stamped
• Telephone orders should be centrally recorded. Recordings should be kept for at least 6 months
• The use of mobile phones for taking client orders is discouraged, but not banned – time of order receipt and details should be recorded immediately
• The best interests of the clients should be considered when recommending the services of an affiliated person
• Collect promptly from clients any amount due as margin
• Not offer any gift other than a discount on fees or charges when promoting a specific investment product

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

19. Omnibus Accounts

• An omnibus account is an account opened with an exchange participant by a client who operates the account for a customer, or a number of customers, of the client and not the client itself
• Information that should be kept for all omnibus accounts:
  • Name of client and whether it is an HKFE Participant
  • Client’s address and account title
  • Whether transactions are HKFE or non-HKFE trades; and
  • Whether the client is a registered dealer authorized to operate an omnibus account

• A licensed/registered person which is an HKFE exchange participant must ensure that a client who is not an HKFE exchange participant, but operates an omnibus account should:
  • Comply with and enforce the HKFE margin and variation adjustment requirements
  • Deal with instructions so that there is no unlawful dealing in differences in market quotations and no betting
  • Ensure that the persons who give instructions to the client comply with the HKFE margin and variation adjustment requirements

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

20. Client Agreements

• Full names and addresses of client (verified by reliable proof) and licensed/registered person
• Undertakings by parties to notify material changes of information to each other
• Full description of services to be provided and charges to be paid by the client
• Full explanation of the margin procedures, the circumstances under which a client’s positions may be closed without the client’s consent and a statement that a report may need to be made to HKFE and the SFC, if margins are not paid on time
• A statement that the licensed person will provide the client, upon request, with product specifications and prospectuses
• An explanation that, if the client suffers loss because the intermediary defaults, the liability of the Compensation Fund will be limited and, accordingly, there can be no assurance that any or all of the loss will necessarily be recouped
• A statement that trades are subject to the rules of the HKFE including:

• • Client’s identity will be disclosed if a request is received from the HKFE
  • HKFE may limit positions or close out contracts if client’s trading affects the fair and orderly operation of the market
• A statement (prominently displayed in bold type) that the intermediary may take the opposite position to the client’s order provided that the opposing trade is executed competitively on or through the facilities of the HKFE
• Clarification that, with regard to any account that the intermediary maintains with the clearing house as principal, any assets lodged with the clearing house for such an account are not held in trust for the client
• From 9 June 2017, the Code of Conduct requires:
  • A clause stating that any financial product solicited for sale or recommended will be suitable for the client
  • No provision in the client agreement that is inconsistent with the Code of Conduct obligations
• Appropriate risk disclosure statements
• Client agreements should not remove, exclude or restrict the legal rights of a client or the legal obligations of the licensed/registered person

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

21. Risk Management Techniques

Credit risk

• Establish and maintain effective system to evaluate client and counterparty credit worthiness
• Set Appropriate credit limits for all clients
• Check
  • Client’s credit rating
  • Past payment record and defaults
  • Client’s capital base
  • Known events which might have an adverse impact
• Monitor exposure to clients, including pre-settlement and settlement
• Make appropriate haircuts to market value of securities pledged where credit extended for margin trading

Market risk

• Place restrictions on instruments which can be traded
• Establish controls to ensure restrictions complied with
• Place trading and position limits on proprietary trading
• Risk managers should control open positions
• Establish measures to check effect of adverse market conditions, such as
  • Value at Risk methodology for general market risk
  • Sensitivity checks
  • Stress testing

Liquidity risk

• Use liquidity measures
• Set concentration limits for products, markets and business counterparties
• Measure mismatches in timing of receipts and payables, receipt and delivery of products
• Monitor level of arrears and defaults
• Establish default procedures so liquidity managers have adequate time to take action

Operational risk

• Segregation of duties
• Keeping secure, reliable, proper and up-to-date records
• Analysis of records to highlight adverse trends and to detect errors
• Employment of skilled and experienced staff
• Effective business continuity and disaster recovery plan
• Adequate insurance

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

22. Market Misconduct – False Trading

• Occurs in relation to securities and futures contracts when:
  • A person intentionally or recklessly creates a false or misleading appearance of active trading or the market or the price
  • A person is involved in transactions, intentionally or recklessly, which create an artificial price or maintains a price at an artificial level
• A person is presumed to have engaged in false trading if he enters into wash trades or matched orders:
  • Wash trade: any transaction involving a sale and purchase of securities without a change in beneficial ownership
  • Matched order: an offer to sell (or buy) securities that is matched by an actual or proposed offer to buy (or sell) the same securities
• Defence can be that acts were not for the purpose of creating a false market

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

23. Orders Made by the Market Misconduct Tribunal

• Orders that may be made by MMT against those found to have committed market misconduct include:
  • disqualification for up to 5 years from holding office as director, liquidator, receiver or taking part in the management of a corporation;
  • prohibition on investing or trading in HK markets for up to 5 years (cold shoulder order);
  • prohibition of further market misconduct as specified in the order (cease and desist order);
  • payment of profits made or loss avoided, plus compound interest, to the Government;
  • payment of reasonable costs incurred by the Government and the SFC; and
  • disciplinary referral orders recommending that a professional body of which the person is a member should take disciplinary action against him

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

24. Unsolicited Calls

• Unsolicited calls include most possible forms of communication made by an intermediary with any person without his express invitation
• Persons exempt from the prohibition:
  • Existing clients
  • Licensed persons
  • Registered institutions
  • PIs
  • Solicitors/accountants acting in their professional capacity
  • Money lenders
• It is an offence to engage in the following acts during an unsolicited call:
  • Offering to make agreements to buy/sell financial products regulated by the SFC
  • Offering SMF
  • Offering to provide profits, income or other returns from dealing in such financial products
• The provisions are intended to protect the investing public from:
  • Recklessly giving personal details and money to a stranger
  • Believing a person giving financial advice without checking the person’s status or background
  • Buying stock without checking the background of the issuer
  • Opening an account without taking proper precautions

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

TOPIC 5 – RECORD KEEPING AND CONTRACTS LIMITS AND REPORTING

25. Keeping of Records Rules

• Keeping of Record Rules (KRR) require intermediaries to maintain comprehensive records relating to their business and client transactions
• Records must be in sufficient detail to ensure proper accounting for business operations and financial position, including a true and fair view of profit and loss and balance sheet, and client assets
• Generally, records should be kept for 7 years, although there are some specific requirements under SFO and other legislation
• Records must be written in Chinese or English or in any electronic form, readily convertible into writing
• An intermediary must keep sufficient accounting, trading and other records in accordance with generally accepted accounting practices in sufficient detail to:
  • Explain financial position and operations of business
  • Prepare financial statements
  • Show all client assets and movement in assets
  • Reconcile positions each month with external parties
  • Demonstrate system of controls to ensure compliance with SFC Rules
  • Enable audits to be performed
• Records must show particulars of:
  • All money received and disbursed
  • All income received
  • All expenses, commissions and interest incurred or paid
  • All orders or instructions received or initiated (with detail of transactions, the account and ability to trace transaction through systems)
  • All disposals of client securities or collateral
  • Assets and liabilities, including commitments and contingencies
  • All securities held belonging to intermediary
  • All securities held not belonging to intermediary
  • All bank accounts, including segregated accounts
  • All off-balance sheet transactions or positions
• Records of all contracts, standing authorities, written directions and evidence of PI status must be kept

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

26. Associated Entities (AEs)

• An AE of an intermediary must, in respect of client assets of the intermediary, keep copies of all contracts, order forms, confirmations, statements and receipts.
• An AE must also keep sufficient records in accordance with GAAP to:
  • account for all client assets that it receives or holds
  • enable all movements of client assets to be traced through its systems
  • enable monthly reconciliations with external parties
  • demonstrate compliance with the client money and securities Rules
  • demonstrate that it has systems of control in place to ensure compliance with the Rules
  • enable an audit to be conveniently and properly carried out
  • show separately and account for all receipts, payments, deliveries and other uses of client assets made by it; and
  • demonstrate that it has kept contracts with clients, agreements with PIs, and authority or specific directions from clients.

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

27. Books and Accounts

Code of Conduct requires intermediaries who are participants of HKFE to maintain proper books and records which correctly and clearly record:

• Financial position of each client’s trading account
• Time, date and complete particulars of instructions received and trades executed
• Particulars of all intermediary and client open positions
• Amount of margin deposited with clearing houses and individual agents
• Amount of variation adjustment and interest rate cash adjustment paid to clearing house and each executing agent
• Amount of margin deposited or required to be deposited for each client
• Amount of variation adjustment collected or required to be collected from each client
• All payments and assets received or held to satisfy margin requirements
• Particulars of all margin calls and demands for variation adjustments
• Any other particulars as required from time to time by HKFE

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

28. Client Ledgers

Code of Conduct requires intermediaries who are participants of HKFE to:

• Maintain separate ledger accounts for every client for HKFE, non-HKFE and all other trades
• Record details of all collateral received from clients and send statements to clients with details
• Segregate clients’ ledger accounts for HKFE, non-HKFE and other accounts so there is no offset between accounts

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

29. Daily Statements of Account

• A daily statement must be prepared:
  • By intermediaries providing securities margin finance and their associated entities when client assets are deposited or withdrawn
  • By intermediaries conducting margined transactions, such as futures contracts, both when the margined transaction is entered into, and when it is closed
• A daily statement must be issued to the client no later than the end of the second business day after the specified event and should include:
  • Intermediary company name and name of any associated entity that holds client assets
  • Client name, address and account number
  • Date when statement prepared
  • Information for that day, including:
    • Opening and closing balances with details of day’s movements
    • Quantity, market price and market value of each type of collateral provided by client that day
    • Details of all contracts closed during the day
    • Details of all income and all charges that day
    • All floating profits and losses at the end of the day
    • Net equity at the end of the day
    • A list of all open positions at the end of the day
    • Minimum margin requirement for all open positions
    • Amount of margin excess/shortfall at the end of day
    • Client’s position limit and trading limit
    • Expiry date of the margined transactions arrangement

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

30. Contracts Limits and Reportable Positions Rules (CLRP)

• The CLRP Rules seek to prevent/discourage the large build-up of derivative positions that could adversely affect the orderly functioning and stability of HK’s financial markets
• The CLRP Rules apply to futures contracts/stock option contracts listed in the CLRP Rules schedules and traded through the HKFE and the SEHK
• The CLRP Rules primarily operate by specifying:
  • reportable positions, being the aggregate number of open positions in futures or stock options contracts that have reached a certain level; and
  • prescribed limits, being limits on the aggregate number of futures or stock options contracts that are permitted to be held or controlled.
• The CLRP Rules apply to any person who holds a relevant position in futures or stock options contracts, whether or not such person is licensed by or registered with the SFC
• SFC has issued the Guidance Note on Position Limits and Large Open Position Reporting Requirements (“CLRP Guidelines”).
• The CLRP Rules have the force of law and breaching them is a criminal offence that can result in the imposition of a fine of up to HK$100,000 and/or imprisonment for up to 2 years
• On the other hand, the CLRP Guidelines do not have the force of law and primarily operate to inform market participants of the SFC’s policy intent in relation to the CLRP Rules.

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

31. Reportable Positions

• The person holding or controlling a reportable position must report the position to the HKFE or SEHK, according to the exchange on which the futures or stock options contract is traded
• The report must be made in writing within one business day of there being a reportable position, and each day thereafter for so long as the person continues to hold a reportable position, even if the position remains unchanged
• The reporting obligation will only cease once the position is reduced to below the reporting level
• The person holding or controlling a reportable position may also appoint an agent to make a report on its behalf, however, as the obligation to make the report is non-delegable such person bears the ultimate responsibility to satisfy the reporting obligation

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

TOPIC 6 – FUTURES TRADING AND SETTLEMENT

32. Hong Kong Futures Exchange Limited (HKFE) Participantship

• To trade on the Hong Kong Futures Exchange, a licensed corporation/registered institution must become an HKFE Participant
• All HKFE Participants must be licensed/registered for Type 2 regulated activity (dealing in futures contracts)
• An applicant for HKFE participantship must:
  • be a Hong Kong incorporated company
  • fulfil the FRR requirements
  • pay all required HKFE fees
  • acquire an HKFE trading right
• There are four categories of HKFE Participant:

• With the Trader category, the ownership of share and loan capital, as well as the management and control, must be effectively vested in one individual

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

33. HKFE Clearing Corporation Limited (HKCC) Participantship

• Every HKCC Participant must be a HKFE Participant
• Applicants for HKCC participantship must:
  • be HKFE participants
  • operate under the same name which it is registered under as an HKFE Participant
  • satisfy FRR requirements
  • agree to abide by HKCC Rules
• An HKFE Participant can register with the HKCC as either a General Clearing Participant or a Clearing Participant
• An HKFE Participant which is not a HKCC Participant must clear its futures trades through a General Clearing Participant

Rights to record, register and clear through HKCC

• HKCC Participants may have the following types of account:
  • House Account: records proprietary trades and positions margined on a net basis
  • Omnibus Client Account: records, on an omnibus basis, client trades and positions margined on a gross basis
  • Individual Client Account: records trades and positions for an individual client (margined on a net basis)
  • Client Offset Claim Account: records positions of individual clients of an offset nature.  Maintained on a gross basis but margined on a net basis
  • Market Maker Account: records and maintains positions from market making activities conducted by a HKCC Participant.  Margined on a net basis
• HKCC Participants use the Omnibus Client Account as the default account for their trades – positions are maintained on a gross long and short basis

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 34. Position Closing

• HKCC allows position closing between the following:

*HSCEI:  Hang Seng China Enterprises Index

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 35. Futures Trading Rules

• All futures trading shall be conducted on HKATS
• Chief Executive of HKFE can ban anyone from using HKATS
• All futures trading must be through the HKFE facilities during trading hours
• No HKFE Participant shall knowingly take the opposite side of a client order, unless the following requirements are met:
  • The client has given consent in writing
  • The trade has been bid, offered and reported as laid down in the Board of HKFE procedures
• An HKFE Participant must not bid/offer to confuse other HKFE Participants or fail to confirm a transaction
• HKFE Participants must not disclose information of buy/sell orders in hand and pending for execution to any party except HKEX staff
• Block trades not executed in the prescribed manner or within prescribed trading hours will not be considered valid trades
• An error trade can only be cancelled when:
  • The trade takes place on HKATS outwith the price parameters set by HKFE
  • The trade is notified to the HKFE within 10 minutes of the trade being made; and
  • The parties to the error trade consent to its cancellation

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

36. Block Trades

• Block trades are large buy/sell orders privately negotiated outwith the public auction market
• Block trades must satisfy the following criteria:
  • Must be in block trade contracts, as designated by HKFE
  • Must be at or above the minimum volume threshold. Minimum thresholds are:

• Participants cannot aggregate separate orders to meet minimum volume thresholds
• Block trades must be negotiated during trading hours
• Once a block trade has been negotiated, it must be immediately executed on HKATS via the block trade facility

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 37. Default

• HKCC has prepared contingency plans for an HKCC Participant defaulting on its obligations, including
  • Closing out, settling and/or selling any or all of the open contracts registered in that HKCC Participant’s name
  • Suspending HKCC participantship
  • Realising deposited non-cash collateral and applying proceeds to amounts due to HKCC
  • Executing a buy-in or borrowing the underlying asset for delivery to the HKCC Participant
• If the defaulting HKCC Participant’s obligation cannot be settled after the above actions, the HKCC Reserve Fund can be used to settle the outstanding amounts
• Under no circumstances will customer-segregated margin deposits held by HKCC for an HKCC Participant be used to cover either a house or customer default of another HKCC Participant

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 38. Margin Requirements

• HKCC determines the level of margin required from each HKCC Participant on its open positions using a risk-based algorithm
• HKCC has the right to increase the amount of margin to be paid by any HKCC Participant at any time

Client’s Minimum Margin

• HKFE sets the minimum margin required to be collected by each HKFE Participant
• No HKFE Participant may deal for a client until the client has posted the minimum margin
• For established clients, limited exceptions are allowed where:
  • A call for minimum margin must be issued by close of business for a new transaction
  • The minimum margin is due no later than the next business day; and
  • New positions are not established until overdue minimum margins are settled
• HKFE Participants may demand higher levels of margin from their clients to protect against potential losses

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

TOPIC 7 – OVER-THE-COUNTER (OTC) DERIVATIVES TRADING, REPORTING AND CLEARING

 39. Reporting and Record Keeping

Means and Timing of Reporting

• All transaction information must be reported to the HKMA via the Hong Kong Trade Repository (HKTR) electronic reporting system operated by the HKMA
• HKTR membership is required to make a report
• Reports must be made within two business days of a transaction (T+2)
• A licensed corporation that ceases to be exempt will have a grace period of three months from the date it ceased to be exempt, to submit the information

Information to Report

• Information to be reported includes:
  • Product class and type
  • Dates: transaction; effective and maturity
  • Particulars of counterparties
  • Clearing information
  • References assigned to the transaction
  • Transaction particulars (notional amount, currency rate, interest rate etc)
  • Subsequent events
• The primary reporting obligations rests with the licensed corporation, however if the transaction is conducted on behalf of a Group company, the Group company may make the report. In such a case, the licensed corporation needs written confirmation from the Group company to demonstrate compliance with the reporting requirement

Exemptions

• A licensed corporation is exempt from the reporting requirement if the notional amount of all outstanding OTC Derivative transactions does not exceed US$30 million in aggregate over all product classes collectively
• The exemption is lost permanently once the notional value exceeds US$30 million

Record Keeping Obligations

• Transaction records must be kept for at least five years after the maturity date
• Records must be sufficient to demonstrate compliance with reporting requirements
• Where a licensed corporation is exempt from reporting, records should still be kept to justify the exemption

[For Paper 3 practice questions, go to Examinator.online – Paper 3]

 40. Clearing and Record Keeping

The Clearing Obligation and Designated CCP

• Where an OTC derivative clearing obligation exists, the transaction must be cleared through a designated central counterparty (CCP) within one business day of the transaction
• Eligible CCPs are:
  • Recognised clearing houses under the SFO
  • Persons authorized by the SFC to provide automated trading services
• Transactions that cannot be cleared in time will be terminated
• As at 1 September 2016, there were four designated CCPs:
  • Chicago Mercantile Exchange
  • Japan Securities Clearing Corporation
  • Clearnet Limited
  • OTC Clearing Hong Kong Limited

Nature of Persons Who Are Counterparties

• For a transaction to be subject to the clearing obligation, either:
  • Both counterparties to the transaction must be prescribed persons; or
  • One counterparty is a prescribed person and the other is a financial services provider
• If one of the counterparties is a designated financial services provider, the clearing obligation falls on the prescribed person
• Prescribed persons include authorized financial institutions, licensed corporations and others who are listed in the OTCD Clearing Rules as being subject to the clearing obligation
• A financial services provider is a person actively engaged in OTC derivative transactions or OTC derivative products outside Hong Kong

[For Paper 3 practice questions, go to Examinator.online – Paper 3]