Earlier this month the China Banking Regulatory Commission (CBRC) announced the promulgation of the much anticipated "Interim rules on Derivative Business of Financial Institutions," the first major regulations governing derivatives business in China. The rules set out, for the first time in China, the definition of derivatives, the approval requirements for financial institutions and the fundamental risk management and internal control framework to be observed by financial institutions when entering derivative transactions. The rules represent the most significant progress China has made to-date in the regulation of the use of derivatives by financial institutions.
Prior to the promulgation of the rules, there were no major laws or regulations in China that specifically dealt with derivatives other than commodity futures. The relevant regulatory authorities, such as CBRC, the People's Bank of China (PBOC), the State Administration of Foreign Exchange (SAFE) and the China Securities Regulatory Commission (CSRC), have given little guidance on derivatives and their precise regulatory treatment. As a result, financial institutions in China have had to rely on the provisions scattered around various ad hoc foreign exchange regulations. These regulations allow them to conduct financial derivative transactions for their clients, or on their own account, for hedging purposes but not for speculation. Accordingly, in practice, market participants frequently encounter ambiguities and uncertainties in this area of Chinese law. In this regard, the rules now purport to give the much needed regulatory certainty for financial institutions in China to conduct derivative transactions.
The rules define a derivative to be "a type of financial contract the value of which is determined by reference to one or more underlying assets or indices," including forwards, futures, swaps and options. This general and non-exhaustive definition is based on the approach adopted by the Basle Committee in relation to its Guidelines "Risk Management Guidelines For Derivatives" (July 1994).
The rules further clarify that derivatives also include structured financial products that have one or more characteristics of forwards, futures, swaps and options. Accordingly, embedded derivatives, which are commonly transacted by Chinese financial institutions, such as interest rate-linked, currency linked or credit-linked notes and deposits, would appear to be derivatives under the rules.
Under the rules, any financial institution wishing to conduct derivative transactions in respect of foreign exchange, equity, commodity or exchange-traded products shall comply with foreign exchange rules and other relevant regulations issued in China. This implies that a financial institution with an approval from the CBRC would still not be able to enter any renminbi/foreign currency, equity, commodity or exchange-traded derivative transactions even if the products fall within the definition of a derivative. In order to engage in these transactions, the joint efforts of CBRC and related regulators would be required, unless structural changes were made to the current financial regulatory regime in China.
Approval Requirements
The rules cover almost all financial institutions--commercial banks, policy banks, trusts and investment companies, financial leasing companies, auto financing companies and branches of foreign banks in China. These financial institutions must obtain approval from CBRC before conducting derivative business, both in the case in which the financial institution provides derivative services to its clients and when the institution is an end-user of derivatives. The rules prohibit non-financial institutions from providing derivative services to their clients.
The rules set out the two types of derivative business in which a financial institution can engage under the rules. First, a financial institution may be classified as an "end-user" of derivatives when it conducts derivative transactions for the purposes of hedging the risks arising from its own assets or liabilities or for making profit. Second, a financial institution may act as a "dealer" of derivatives when it provides derivative trading services to clients (including other financial institutions).
Profit-Making Permitted
Prior to the promulgation of the rules, under the "Notice Regarding the Prohibition of Derivative Transactions Conducted by Financial Institutions Outside China at Their Own Discretion" issued by PBOC on March, 29 1995, Chinese financial institutions could only enter into derivative transactions for hedging purposes and not for speculation. In the bankruptcy proceedings of Guangdong International Trust & Investment Corporation (GITIC), the Guangdong Higher People's Court ruled that the derivative transactions that GITIC entered into were void because they had not been entered into for hedging purposes.
It now seems clear under the rules that a financial institution may conduct derivative transactions for the purposes of hedging the risks arising from its own assets or liabilities, or for making profit. The paramount objective of the rules is to improve risk management and internal control systems of financial institutions, so that they may use derivatives to hedge risks arising from their business or to enhance their profitability and competitiveness. This new framework addresses some of the uncertainties under the PBOC notice and will certainly be greatly welcomed by market participants.
Risk Management & Internal Control Systems
The rules focus on overall risk management structures and the principles adopted in the Basle capital adequacy guidelines. By adopting this "prudential risk management" approach, the rules move away from the requirement of a hedging motive for individual derivative transactions and toward addressing the aggregate effect of those transactions on the risk profile for a financial institution.
The rules focus on the importance of sound risk management policies for the effective monitoring of derivative exposures, and specifically refer to the following aspects:
* implementation of risk management, internal control and
business processing systems that are commensurate with the
nature, scale and complexity of the derivative business;
* appropriate supervision by senior management and the
establishment of suitable trading restrictions;
* maintaining a risk management approach that assesses market
risk and counterparty credit risk separately;
* adopting an adequate risk management process that integrates
prudent loss limits, accurate measurement procedures for
quantifying risks, information systems for reporting risks,
continuous risk monitoring and frequent management updates;
* the requirement to make adequate liquidity provisions in
anticipation of any extraordinary market conditions;
* comprehensive internal controls and audit procedures to
ensure that the risk monitoring systems are effective;
* clear procedures for the documentation and settlement of
transactions.
Due Diligence, Client Suitability & Risk Disclosure
The rules require financial institutions to conduct due diligence before entering into derivatives. A financial institution is required to formulate relevant policies to ascertain whether its counterparties understand the terms of the contract and its obligations under the contract. Financial institutions also need to assess the credit risks of their counterparties and to ascertain whether derivative transactions entered into are consistent with their counterparties' business objectives. To this end, a financial institution may reasonably rely in good faith on formal written information or representations provided by its counterparties.
In relation to the provision of derivative services to domestic corporate and individuals in China, a financial institution is required to fully disclose the risks inherent in derivative transactions, including (1) the contents of derivative contracts and a summary of the risks involved and (2) significant factors that may cause potential losses arising from the derivative. The financial institution shall obtain written confirmation from clients to acknowledge that they have understood and have the ability to bear the risks in the derivative. The rules also require a financial institution to investigate the legal status and the qualification of its counterparties before entering transactions.
Application Procedure For Derivative Approval
Chapter II of the rules sets out in detail the application procedure and qualification requirements for financial institutions applying for approval to conduct derivative business. The relevant qualification requirements include the following:
* a sound risk management system and internal control system;
* a sound derivative transaction processing system automatically
connecting the front office, middle office and back office, and
a real-time risk management system;
* the person in charge of the derivative business has more than
five years experience of participating directly in derivative
activities and risk management activities;
* at least two dealers with more than two years of experience in
conducting derivative transactions, at least one employee
responsible for risk management, and one risk model
researcher or one risk analyst (any such positions must not be
concurrently held by the same person);
* proper premises and facilities for conducting transactions;
* in the case of a foreign bank branch applying to conduct
derivative business, its home country regulatory authority has
the supervisory framework in place and is competent to
supervise derivative business;
* other requirements stipulated by CBRC.
Many foreign banks carry out risk control on a global or regional, rather than on an individual branch, basis. To reflect this, the rules provide that the relevant requirements will be dispensed with so long as (1) any derivative transactions conducted by the foreign bank through its branch in China will be booked back-to-back with its regional headquarters and (2) the regional headquarters will be responsible for managing the exposures relating to these transactions.
Conclusions
Some of the basic restrictions on the ability of financial institutions to enter derivative transactions have been removed and the rules have clarified several ambiguities and uncertainties.
This week's Learning Curve was written by Chin-Chong Liew, partner, Jing Gu and Quentin Pak, associates, in the international capital markets group at Allen & Overy in Hong Kong.
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| Chin-Chong Liew |
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| Jing Gu |
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| Quentin Pak |
