Anyone with the slightest interest in Chinese financial markets could not have missed the announcement of the Provisional Rules Governing Derivatives Business of Financial Institutions on 4 February 2004. The rules require every financial institution to obtain a specific derivative approval from the China Banking Regulatory Commission (CBRC) to carry out derivative business in China. By granting a derivative approval to a financial institution with prudential risk management and internal control systems and also by removing the "hedging only" requirement for conducting derivative transactions, the rules marked a significant shift in regulatory policy in China from a quantitative limitation on derivative activities to that of a qualitative assessment.
The licensing regime is now fully in place following a transitional period, which was extended to Dec. 31, 2004. According to the Web site of the CBRC as at May 24, a total of 53 domestic banks and foreign banks with Chinese onshore branches have now been granted derivative approvals. Interestingly, slightly less than three quarters among them are foreign banks with a little over one quarter comprising domestic Chinese banks. The slightly lower-than-expected number of approved Chinese domestic banks to date shows domestic financial institutions are still striving to meet the risk-management criteria required by the CBRC. However, it is believed many domestic Chinese financial institutions will--over time--meet the mark and be granted the derivative approval. To this end, the CBRC also issued interim rules on the evaluation of internal control of commercial banks and guidance on market risk management of commercial banks in Dec., aimed at improving the risk management capability of domestic banks.
With the rules, players and referee all in place for the Chinese derivatives game, more and more international market participants are gaining a foothold in the domestic playing field. As a result, the rules, including other relevant regulations on foreign exchange, futures, commodities and equity, are now under the microscope and subject to close scrutiny. Amongst the issues examined, the following are probably the most frequently discussed.
Definition Of Derivatives
The rules define derivative products as financial contracts with values dependant on one or more underlying assets or indices including forwards, futures, swaps and options. Structured products with one or more derivative features are also included in the definition. While it appears clear an embedded derivative, such as a credit linked note or a synthetic CDO, falls within the definition, questions have been raised as to whether any instrument with similar economics or the value of which depends on an underlying obligation, such as a cash CDO or asset-backed security, are included in the definition and subject to the application of the rules.
Hedging Requirement
The rules allow financial institutions with derivative approvals to engage into derivative business for both hedging and profit-making purposes--a fundamental change from the previous regime under which financial institutions were only permitted to enter into derivative transactions for hedging purposes.
Despite the general scope of the rules, it is understood some domestic policy banks have obtained derivative approvals to conduct only hedging transactions. In addition, the hedging only requirement remains applicable for Chinese corporates which are not financial institutions.
A careful reading of the rules also reveals financial institutions without a derivative approval may not enter into derivative transactions even for hedging purposes. The slightly unusual result is that while any Chinese corporate may enter into derivative transactions for hedging purposes, a financial institution (presumably with a better risk management capability) may not unless it has a derivative approval. This seems a curious step back from the previous regime and it is questionable whether this was intended by the CBRC.
Derivatives Linked To Commodities, Equities And The Renminbi
Due to the segmented regulation of different sectors of the financial industry by different regulators in China, many questions remain unanswered in relation to OTC derivative products linked to commodities, equities and the renminbi. It is generally believed derivative products linked to commodities and equities could potentially fall within the jurisdiction of the China Securities Regulatory Commission (CSRC), while derivatives linked to the renminbi would be fall under the People's Bank of China (PBOC).
A recent example highlighting this unsatisfactory position is the collapse of China Aviation Oil in Singapore. The incident raised some fundamental questions about the legal regime for OTC commodity products, such as who is the regulator for OTC commodity derivatives in China and are OTC commodity derivatives lawful in China.
Commercial banks in China are not permitted to hold equity shares. In the case of equity derivatives, the question remains whether a purely cash-settled equity derivative transaction would be permitted since no physical shares are involved. If the mischief is that equity is too volatile and could be risky for a bank, would a broad-based equity index-linked derivative or a principal-protected embedded derivative be permitted? The answer, under the rules for financial institutions with a derivative approval to undertake equity derivatives, would appear to be no.
With the PBOC's issue of the Regulations On The Administration Of Forward Bond Transactions On The Interbank Bond Market on May 16, forward bond transactions in renminbi will be officially introduced to institutional investors via the interbank bond market in June. This is a welcome development and will add to the very short list of renminbi derivative products, the growth of which has been curbed by the PCOC's interest rate and foreign exchange regulations.
Other Financial Institutions
Many other financial institutions in China which could potentially play a significant role in the derivative market are not covered by the rules. These include securities companies, which are regulated by CSRC, and insurance companies, which are regulated by the China Insurance Regulatory Commission (CIRC). Although not free from doubt, the general perception is that these entities may not enter into derivative transactions despite the absence of an explicit prohibition under PRC law. For example, the Interim Measures On The Administration Of Offshore Utilization Of Foreign Currency Funds For Insurance Companies announced on Aug. 9 last year permit insurance companies to invest in overseas bonds and deposits in foreign currencies which meet certain rating and investment criteria. However, it is questionable whether an insurance company would be entitled to invest in embedded derivatives in the form of the bonds or deposits even though they meet with the relevant rating and investment criteria and are prevalent among insurance companies internationally.
Enforceability Of Closeout Netting And Collateral
Many market participants have been concerned by uncertainty in insolvency setoff under PRC insolvency law. It appears to be partially addressed in the latest draft bankruptcy law presented to the legislature for the third reading in April 2005. However, many issues remain to be resolved. It is understood the International Swaps And Derivatives Association has been actively lobbying the Chinese legislature for further legislative support for the enforceability of close-out netting.
Similarly, as security law in China has not been fully developed, taking collateral from a Chinese counterparty by way of either a charge or a title transfer arrangement requires detailed analysis and balance of risk considerations resulting from various uncertainties both under Chinese law and in relation to Chinese regulatory and judicial practice.
Conclusion
The rules undoubtedly marked a major milestone in the development of the domestic financial market and set the pace for modern risk management based derivatives market in China. There remains, however, a number of major legal and regulatory obstacles which need to be tackled and clarified further before derivatives can flourish in China.
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| Chin-Chong Liew |
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| Jane Jiang |
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| Benjamin Liu |
This week's Learning Curve was written by Chin-Chong Liew, partner, Jane Jiang, associate, and Benjamin Liu, associate, at Allen & Overyin Hong Kong.
