Hong Kong Sanctions Create Fissures Between US & Chinese Financial Systems – A Quagmire for Foreign Banks in US

[Update: The President said he had signed the Hong Kong Autonomy Act into law.]

Will the fissures turn into a gorge?

The question is whether the fissures may coalesce into a deep gorge dividing the financial systems of the 2 largest economies of the world.

Quagmire for financial institutions

Less than 2 weeks ago, on 7/2/2020, the US Congress unanimously passed the Hong Kong Autonomy Act (HKAA), which was the Congress’ response to the HK National Security Law (HKNSL) that the Chinese government enacted a few days prior on 6/30/2020 (see my previous post). The legislation should become a law soon, likely by midnight today.[1]

The HKAA generally will ban financial institutions (FIs)[2] from engaging in certain transactions with those foreign FIs (primarily Chinese FIs, but can be any non-US FIs) that have done “significant” businesses with certain sanctioned persons who have “materially” contributed to the erosion of autonomy in HK. (For more info about the definitions of the terms under HKAA, please see here.) To comply with such sanctions, however, a FI may run afoul of Article 29 of the HKNSL, which makes it a crime for any person (anyone in the world) to “conspire” with a foreign country to impose such sanctions. (See, also, here.) Hence, a FI can be penalized in US if it does not comply with US sanctions[3], but face the quagmire of being prosecuted in HK/China if it so complies.[4]

Picking side, US or China, but not both – a Hobson’s choice

For FIs currently having exposures in both US & HK/China, this quagmire may force them to decide whether to conduct business in either US or HK/China, but not both. For example, consider a Taiwanese bank (or a German, British, French, Canadian, Japanese, S Korean, Indonesian, Brazilian or any foreign bank) that conducts banking in both US and HK/China. If its HK/China operations are identified as having conducted significant transactions with sanctioned persons under HKAA, its US operations may be prohibited from engaging in transactions with its HK/China operations, or even with the bank headquarter. But, by complying with the US prohibitions, the US operations of the Taiwanese bank may be found to have violated Article 29 of the HKNSL, and hence the bank’s HK/China operations may be prosecuted, because both the US operations and the HK/China operations belong to the same bank. Under such circumstances, the Taiwanese bank may have no choice but to pick where it wants to do business in, either US, or HK/China, but not both.[5] That may be a Hobson’s choice that is not a choice at all.

An outlier black swan

In a US election year, and amidst the fallout from the COVID-19 pandemic, tensions between US and China have escalated. Financial sanctions such as the HKAA & national security laws such as the HKNSL are but a part of the complicated web of conflicts and brinkmanship involved in this new cold war. However, the Hobson’s choice facing down global financial institutions and the potentially unfathomable impact on the global financial systems may tamper the practical effects of these laws and orders.

For example, after the HKAA becomes law, the President has up to 120 days to identify the foreign financial institutions to be subject to sanctions, and up to 1 year to implement the sanctions. That means in the short run, no sanctions under HKAA will likely be enforced before the US election. After the US election, the political tensions may ease, allowing fine-tuning of the laws & regulations and their implementations, which may reduce the risks involved.

On the other hand, the severe erosion of HK autonomy and civil liberties under the HKNSL are frighteningly real for the people of HK. The prospect of great disruptions to the current financial systems arising from the US-China tensions, even if a low-probability outlier at this point, can also be real. It can be a black swan testing humanity’s ingenuity!


[1] The legislation has been sent to the President, who is required to sign the legislation within 10 days (except Sundays) or return it to the Congress. (“If any Bill shall not be returned by the President within ten Days (Sundays excepted) after it shall have been presented to him, the Same shall be a Law”, US Constitution, Article I, Section 8, Clause 2). If the president takes no action by the 10-days deadline, the legislation automatically becomes a law. On the other hand, if the President returns it, the Congress should have the 2/3 votes required to override the veto, required under the same Section of the Constitution.

[2] “Financial Institution” under HKAA has the same definition as in FDIC (31 USC 5312(a)(2)), which includes a broad spectrum of institutions, including insured banks, commercial banks or trust companies, securities brokers & dealers, foreign bank branches or agencies, etc.

[3] Violations of HKAA can carry civil penalties of the greater of $250k or twice the amount of transaction. Criminal penalties include fines up to $1m, or imprisonment for up to 20 years for a natural person, in addition to the fine. (50 USC 1705)

[4] Penalties under HKSNA generally implicate imprisonment of various terms, up to 10 years, and/or fines.

[5] It’s not clear whether compliance of sanctions by US subsidiaries of the Taiwanese bank (not branches or agencies) may subject the HK/China operations or the parent bank to prosecutions under HKNSA. However, because the US subsidiaries may be subject to the prosecution, meaning its personnel may be at risk if they enter the “influence zone” of HK/China, it will be difficult for the Taiwanese bank to communicate with and maintain control of the US subsidiaries, even if its HK/China operations and headquarter are not implicated.

Hong Kong’s National Security Law – Implications in Business Risk Assessments

On June 30, 2020, the Chinese government enacted Hong Kong’s National Security Law (Chinese | English), which was not officially published until the same time when it became effective, at 11 pm local time, foreclosing any meaningful public input (at least from the HK public) to the new law. Within hours after the publication of the law, several commentators have made an effort to dissect and analyze the new law, such as the note by Professor Donald Clarke, and the videoconferencing sessions organized by Hong Kong Democracy Council. More analyses should become available as the international communities scrutinize and analyze the new law in greater scope and depth.

At a quick glance, the new law imposes several measures that severely restrict or eradicate the autonomy and civil rights previously vested in HK. Without going into great details, and not meant to be complete, I have summarized these measures below.

Note: The English translations used throughout this post are based on here.

Inevitably, the new law will have significant international ramifications, not limited to HK only, evidenced by the sanction legislation passed promptly by US Congress in response to the new law. Notably, the new law is applicable to ANY person on the earth, a/k/a extraterritorial application. (Article 38. See the table above.) That means, for example, a foreigner non-HK resident may be found to have violated the new law by posting on twitter the words, “Fight for Freedom! Stand with Hong Kong!” In such cases, the person may be prosecuted under the new law if he/she is present in HK or China. Or, in a worst-case scenario, if the person resides in a country having an extradition treaty with China, he/she may face the specter of having to defend an extradition request from China.

What is more, the law creates the Office for Safeguarding Nation Security (“OSNS”), which is an agency of the Chinese government, but stationed within HK. This agency has tremendous powers, including “collecting and analyzing intelligence and information concerning national security” (Article 49(3)) and “handling cases concerning offence endangering national security” (Article 49(4)). It can take over jurisdiction from local HK government (Article 55) and send the case to China for prosecution and sentencing according to Chinese laws (Articles 56 & 57). Moreover, any person, be it an institution, organization, or individual must “comply with measures taken by” OSNS (Article 57). And yet, despite the tremendous powers OSNS wields, it is not subject to HK jurisdiction or law enforcement (Article 60). According to Professor Clarke, OSNS is not subject to Chinese law either. No wonder Professor Clarke lamented that the OSNS was “untouchable” and “Gestapol-level stuff”!

Considering its vague and broad scope, the extraterritorial application, the creation of such an unaccountable yet powerful agency as OSNS, and other authoritarian aspects of the new law, the business risks for international communities doing business with HK and China have increased substantially. It is unclear at this point how the new law will be enforced. Also, potential economic gains from the China markets and trades will likely remain an important factor in business risk assessments, which is itself a complicated undertaking. If we have learned anything about global risk assessments from recent events, however, it is that underestimating the risks in the early stage may prove to be unforgiving!

Black Lives Matter!

All human lives matter!

Civil liberties matter!

Political rights matter!

Democracy matters!

Four score and seven years ago our fathers brought forth on this continent, a new nation, conceived in Liberty, and dedicated to the proposition that all men are created equal.

Abraham Lincoln

It is still a long way to go before the words “all men” uttered by President Lincoln more than 150 years ago can truly mean “all humans”!!!

Just Laws of a Nation

IN MEMORY OF THE TIANANMEN SQUARE MASSACRE, JUNE 4, 1989.

Just laws of a nation must limit the powers of the government against the people.

“The accumulation of all powers, legislative, executive, and judiciary, in the same hands, whether of one, a few, or many, and whether hereditary, selfappointed, or elective, may justly be pronounced the very definition of tyranny.”

James Madison

The road to just laws of a nation can be long and arduous. The fight for civil liberties and political rights for the people in UK & US started no later than 800 years ago, and is still ongoing.

“It is rather for us to be here dedicated to the great task remaining before us – […] that government of the people, by the people, for the people, shall not perish from the earth.”

Abraham Lincoln
YearSome UK & US Civil Liberty Laws
1215UK – Magna Carta
1628UK – Petition of Rights
1679UK – Habeas Corpus Act
1689UK – Bill of Rights
1776US – Declaration of Independence
1777US – Articles of Confederation
1787US – Constitution
1791US – Bill of Rights
1865US – 13th Amendment
1868US – 14th Amendment
1920US – 19th Amendment
1968US – Civil Rights Act

Global Risk Events Require Global Risk Assessments – Virus Pandemic & Climate Change

The current COVID-19 pandemic is a powerful reminder that our world is riddled with abundant uncertainties and risks.

In an uncertain world, without the help of hindsight (or a clairvoyant crystal ball), our policy decisions can at best be based on our assessments of the risks. That means probabilities, averages, variations, distributions, ranges, etc. By definition, risk assessments carry uncertainties themselves. So, we will never know for sure whether our decisions made according to the risk assessments are the right ones. But, that’s the best we can do!

For global risk events, such as virus outbreaks, climate changes, or even financial crises, which can have far-reaching global ramifications, risk assessments on a global scale are necessary for optimal policy decisions and responses. Assessments limited to local perspectives will not be enough. This can be clearly seen in the COVID-19 pandemic.

As of today (4/14/2020), US has reported over 600k infections nationwide, and more than 25k lives lost. We will never know for sure whether we could have responded to the virus outbreak better, or worse. It has become clear, however, that information and data about the virus from other regions, countries, states, and cities can greatly help to improve our own risk assessments and responses. Be it the virus genome codes, strain variations, mortality rates, spreading rates, spreading mechanisms, human-to-human transmission paths, incubation periods, asymptomatic transmission, known effective treatments, known effective policies, potential vaccines, supply chain managements, governmental coordination, economic preparations, …, etc. All these information and data have proven instrumental, if not critical, in assessing the risks associated with the virus. Because the virus spreads without regard to political boarders (nations, territories, states, provinces, prefectures, counties, cities, towns, …), collecting the information and data globally can help to maximize the data collected and minimize the time required.

This need for global risk assessments, i.e., assessing the risks by examining global data, not limited to local data, similarly applies to climate changes. The weather or temperature patterns in New York or Texas or California, for example, will most likely be insufficient to assess the risks associated with global climate changes. – I have made the mistake numerous times of concluding it was global warming / cooling because of an abnormally warm / cool day in New York. (To be critical, one photo of a skinny polar bear on a floating ice may not be conclusive either, by itself.)

Even with real-time access to extensive global data, it may still be difficult to assess the risks and determine the responses. Rather, different people can assess the risks differently, sometimes substantially, and reach different decisions. (Witness the spars between New York governor, New York City mayor, and US president on re-opening of the economies, even after months of global data exchanges and collections on the COVID-19 virus.) Additionally, in reality, it is unlikely decision-makers will have at their disposal a complete set of global risk data at any particular time.

Therefore, given the complexities of the earth’s weather systems, I do not expect a uniform policy response to climate change in the foreseeable future, unless imminent dangers due to climate changes becomes clear and present, such as the case for the COVID-19 virus.

The stakes associated with climate change, or other global risk events, however, can be high, and the potential losses of lives, properties, or welfare can be tremendous. Recognizing the potential shortfalls and uncertainties in the risk assessments of global risk events, we should strive to make sure our best scientists and professionals, trained to objectively study and analyze risk events, receive the fullest attention possible in the public discourse and debates of such global risk events, undisturbed by politics and other subjective factors. That way, even if there are uncertainties associated with the risk assessments, we can claim to have done our best.

It is my hope that the need for global open information sharing regarding global risk events will lead to greater opening of authoritarian regimes, particularly those who desire to further integrate themselves into the global economy. If the global economy slows, however, I am also wary of the possibility that these authoritarian regimes may instead resort to even harsher surveillance and oppression to retain domestic control and powers, and inflame populist nationalism in and conflicts with foreign players. Even in more open societies, surveillance and centralized control may also intensify, in the name of public security and safety. But, that’s another story!

LIBOR Replacement – Analyzing & Assessing Alternative Rates

NYDFS requirements

In December last year, the NYDFS (New York Department of Financial Services) required each of the regulated financial institutions supervised by NYDFS to submit a plan for addressing the LIBOR cessation and transition risks. Reflecting the urgency of the regulator’s concerns, the institutions were required to submit the plan within less than 2 months, by early February this year. (The deadline was later postponed by 45 days to late March.)

Specifically, NYDFS required the plan to include the following 5 items, without providing further details:

  1. Programs that would identify, measure, monitor and manage all financial and non-financial risks of transition;
  2. Processes for analyzing and assessing alternative rates, and the potential associated benefits and risks of such rates both for the institution and its customers and counterparties;
  3. Processes for communications with customers and counterparties;
  4. A process and plan for operational readiness, including related accounting, tax and reporting aspects of such transition; and
  5. The governance framework, including oversight by the board of directors, or the equivalent governing authority, of the regulated institutions.

Analyzing & assessing alternative rates – What is required?

Financial institutions subject to the requirements are likely scrambling to put together a LIBOR transition plan to meet the deadline. Toward this effort, the 2nd required item (“processes for analyzing & assessing alternative rates) seems to pose the lowest hurdle. After all, the ARRC (Alternative Reference Rates Committee), with the implicit approval & supports by the FRB, has chosen SOFR to replace LIBOR; more than $300b of cash instruments have been issued; the daily trading volumes of the SOFR futures contracts set a record, exceeding 80k contracts, recently; and LCH cleared more than $200b of SOFR swaps in January 2020. Moreover, Fannie Mae & Freddie Mac announced on 2/5 that they would no longer accept ARMs based on LIBOR by the end of 2020, and that they planned to begin accepting ARMs based on SOFR later in 2020.

Choosing SOFR, therefore, seems to be a path of the least resistance, particularly for budget-constrained institutions. In that case, the descriptions for item #2 should be simple and straightforward.

However, it is not clear at this point what additional information NYDFS will require for item #2 even if an institution simply decides to choose SOFR to replace LIBOR, as recommended by ARRP. Does the plan need to describe how the institution reached the decision to choose SOFR? Does the plan need to compare, analyze and assess the benefits & risks of other alternative rates? Does the institution need to discuss with its customers and counterparties and incorporate their positions and preferences into the analyses & assessments? Does the plan need to analyze and assess compliance with the 19 IOSCO principles?

Regardless of what the regulator(s) will specifically require in the LIBOR transition plan regarding alternative rates, and notwithstanding the fact that ARRC has recommended SOFR, it should be recognized that one size may not fit all. SOFR may not be the most appropriate replacement for LIBOR for some institutions, such as community and regional banks that depend substantially on unsecured funding. Furthermore, the regulator(s) may require an institution to develop and describe an independent and complete process & framework for analyzing and assessing alternative rates, even if the institution chooses SOFR to replace LIBOR. The spike in the repo market volatility in mid-September last year exemplified some of the shortcomings of SOFR, and demonstrated the need to be abreast of the pros & cons of other alternative rates.

Other alternative rates

If an institution desires or is required to analyze and assess alternative rates, what would be the right approach? In April last year, the Federal Reserve gave a broad-stroke clue that a bank should “conduct at least as much due diligence on the reference rates that they use as they conduct on the creditworthiness of the borrowers”.

To get started on this due diligence process, the table below lists information associated with some of the alternative rates. The information may be helpful to form the basis for developing a due diligence process to analyze and assess the alternative rates for replacing LIBOR, as required by NYDFS & FRB. Other currently available alternative rates not listed in the table include OIS, Effective Fed Funds, PRIME, Certificate of Deposit, Cost of Savings Index, etc.

Click image to view the full-sized table.

US-HK Policy Act – A New Battleground in US-China Trade Wars

As US-China trade wars escalate, residents in Hong Kong have waged fierce battles against a proposed extradition law, which poses the horrendous specter of any person physically present in Hong Kong being seized and extradited to China and subject to its “capricious legal system” on trumped-up charges, without meaningful legislative or judicial reviews. (See, eg, here.) The battles in Hong Kong, however, may turn out to be more than merely domestic politics, but rather far-reaching extensions of the US-China trade war battlegrounds.

To circumvent the rising tariffs imposed on Chinese goods, one strategy for Chinese manufacturers and exporters is to label the Chinese goods as made in another country/region that is not subject to the high tariffs. One such country/region is Hong Kong. (See, eg, here.) Under the US-HK Policy Act of 1992 (22 USC §5701 et seq), Hong Kong is treated by US as a region “autonomous” from China with regard to commerce, among others, even after UK returned HK to Chinese control in 1997. Specifically, the Act provides:

“The United States should continue to […] treat Hong Kong as a territory which is fully autonomous from the People’s Republic of China with respect to economic and trade matters.”

22 USC 5713(3)

Therefore, currently, goods designated as made in Hong Kong are not subject to the increased tariffs imposed on Chinese goods. If Chinese goods are first shipped to HK and then re-labeled (if necessary) and re-shipped to US, potentially these goods could evade the higher tariffs. – As long as the US laws continue to grant HK the special treatment as an autonomous region.

That special treatment, however, may be subject to change, and may be used as a weapon and an extended battleground in the trade wars. Specifically, the Act allows the President of US to suspend the special treatment, in consultation with the Congress, if the President determines that HK is “not sufficiently autonomous”. (22 USC 5722(a)) Additionally, the Congress may enact new laws affecting adversely or eliminating altogether the special treatment.

Judging from recent news headlines (eg, “U.S. warns extradition law changes may jeopardize Hong Kong’s special status”, Reuters, 6/10/2019; “McConnell: Protesters in Hong Kong Should be Heard”, Youtube Senate Majority Leader Mitch McConnell Channel, 6/11/2019; “Pelosi Vows to Review Hong Kong Trade Ties Over Extradition Bill”, Bloomberg, 6/12/2019), the battle of Hong Kong might have begun!

LIBOR Replacement – Determining Whether A Benchmark Is “Representative”

EU Benchmark Regulations “representative” requirement

In a speech on 7/12/2018, the head of the British financial regulator, FCA (Financial Conduct Authority), Andrew Bailey, declared that the regulator could prohibit LIBOR from continuing to be used for new businesses, if it determines that LIBOR no longer sufficiently “represents” the market. (EU Benchmark Regulations, Article 11(1)(a): “[T]he input data [of a benchmark] shall be sufficient to represent accurately and reliably the market or economic reality that the benchmark is intended to measure.”) Such a determination might not have been overly difficult, if LIBOR had remained a poll-based benchmark. As Mr. Bailey asserted in the same speech, “[LIBOR] relies on the so-called judgment of the panel banks. […] [T]o continue in the new regulated world of benchmarks, LIBOR has to be representative. I struggle to see the case for this judgment.”

LIBOR, however, has evolved.

Reformed LIBOR and permissible “waterfall” input data

ICE, the administrator of LIBOR, has reformed LIBOR to incorporate a “waterfall” of input data types, including transactions, transaction-derived data, and expert judgments. (See here.) Moreover, the EU Benchmark Regulations explicitly permit an interest rate benchmark to incorporate these hybrid types of input data. (See table below.)

Determining “representative”

Since the EUBMR explicitly permit an interest rate benchmark to incorporate such “hybrid” input data types, the Reformed LIBOR can satisfy the “representative” requirements even if it incorporates non-transactional data (e.g., judgments). The question then is: How does one determine whether the Reformed LIBOR is “representative”? According to what criteria? What are the parameters and factors to be used?

The EUBMR do not provide a clear answer to these questions. However, logically such a determination may depend on the following factors, among others:
• Total number of input data;
• Total number of transactional data;
• Total number of judgments;
• Percentage of transactional data;
• Percentage of judgments;
• Variations in the numbers & percentages;
• Etc.

Recognizing the shrinking unsecured interbank funding markets, the Reformed LIBOR broadens the sources of its transaction data to include certificates of deposit and commercial papers. Whether the expansion in data sources will be sufficient to satisfy the “representative” requirements, however, remains uncertain.

ICE Bank Yield Index

In a clear effort to further expand the sources of transactional data, ICE created the Bank Yield Index (BYI) to supplement LIBOR as a credit-sensitive interest rate benchmark. According to ICE, BYI is derived from two types of input data:

  1. Wholesale, primary market funding transactions executed by large, internationally active banks (e.g. inter-bank deposits, institutional certificates of deposit and commercial paper); and
  2. Secondary market transactions in wholesale, unsecured bonds issued by large, internationally active banking groups.

Below figure shows the average numbers and volumes of transactions underlying BYI. (See here.)

Will these expanded data satisfy the “representative” requirements? The answer remains blowing in the wind! The regulators will eventually need to step up to resolve the issue.

Libor Replacement – ICE Bank Yield Index & Benchmark Regulations

[Update 4/13/2019: Last Wed, Randal Quarles, Vice Chair for Supervision of the Federal Reserve and Chair of the Financial Stability Board (“FSB”), gave a speech at an FSB roundtable on reforming interest rate benchmarks. On the topic of choosing a replacement rate, Mr. Quarles did not foreclose the adoption of rates different from SOFR (or other risk-free rates). Instead, he established the principle that banks should “conduct at least as much due diligence on the reference rates that they use as they conduct on the creditworthiness of the borrowers”. Mr. Quarles concluded that SOFR satisfied the due diligence requirements. However, the other benchmark rates (e.g., ICE BYI) may also satisfy the requirements, and thus be a potential candidate to replace LIBOR.]

IBA, the administrator of the ICE Bank Yield Index (“BYI”) (see here & here), may have gained some ground in promoting BYI as a replacement for LIBOR. According to ARRC meeting minutes and agenda, IBA has been scheduled to make a presentation to ARRC on BYI at the ARRC April meeting. The presentation supposedly was requested by ICE in response to comments on BYI made at the February ARRC meeting. However, the fact that ARRC specifically discussed BYI in its meeting seemed significant. Moreover, there have been claims (although unconfirmed) that large banks “don’t like SOFR” (see here), but instead endorse BYI (see here).

This development increases the chances that multiple benchmarks (e.g., BYI, AMERIBOR, etc), in addition to SOFR, may co-exist post-LIBOR, as I discussed previously here & here. That is, even if LIBOR is eventually phased out, it is increasingly likely that BYI and potentially other benchmarks administered by private parties may partly replace LIBOR, for example, for the cash markets, while SOFR is used for the derivative markets.

For the regulators, however, the co-existence of private benchmarks with SOFR raises the question of whether these private benchmarks are qualified to replace LIBOR, free from the issues that plagued and doomed the latter. For example, the regulators desire a transaction-based benchmark to replace LIBOR. But, what are the minimum number or volume of transactions underlying a benchmark that can pass muster with the regulators? SOFR has a trading volume of nearly $1 trillion across thousands of transactions each day. BYI, on the other hand, may cover less than $10 billion of daily transactions across less than 200 daily transactions. Moreover, these numbers are the totals over various tenors from 5 to 500 days. The respective number for each tenor will be even less. (See Figures 3, 4, & 5 of the ICE Bank Yield Index Update, here.) Are these numbers sufficient for a benchmark designed to replace the flawed LIBOR? If not, what are the minimum thresholds?

As a result, it is likely that the US regulators will eventually need to establish a set of protocols and procedures to control and manage the quality of the private benchmarks, similar to the EU Benchmark Regulations. The Congress, however, will first have to enact legislations authorizing the regulators to establish the regulations. The legislative and regulatory processes may be time-consuming and the outcome uncertain, adding to the uncertainties already embedded in the LIBOR-replacement undertaking!