Derivatives legislation opens door for foreign firms

Introduction

On 4 February, the China Banking Regulatory Commission (the "CBRC") promulgated the Provisional Measures for the Administration of Derivatives Activities of Financial Institutions (the "Derivatives Measures"). The Derivatives Measures took effect from 1 March 2004. The Derivatives Measures are the first regulations specifically enabling financial institutions to engage in derivatives transactions in The People's Republic of China (the "PRC"). In promulgating the Derivatives Measures, the CBRC aims to provide financial institutions with a clear legal basis and regulatory certainty in respect of financial derivatives. This has been seen to be necessary in light of the continuing increase in demand for financial derivatives in the Chinese domestic market and has in part been possible because of the improved internal management and increased sophistication of Chinese domestic financial institutions in recent years.

Background

Before the Derivatives Measures were issued, only scattered provisions relevant to financial institutions and derivatives could be found in PRC regulations and notices. These provisions provided that financial institutions in China could engage in derivatives activities only for hedging purposes and only with the approval of relevant government authorities such as the State Administration of Foreign Exchange ("SAFE"). However, such provisions failed to provide clear guidance to financial institutions for conducting their financial derivatives activities. For instance, the terms "hedging purpose" and "speculative purpose" were not defined or otherwise elaborated on in the laws or regulations. It was therefore problematic for domestic financial institutions to obtain approval from the relevant government authorities to carry out derivatives trading. In addition, prior to the issue of the Derivatives Measures, the China Securities Regulatory Commission ("CSRC"), the People's Bank of China ("PBOC"), SAFE and other government authorities in China had promulgated various stringent notices, under which financial institutions were in fact banned from engaging in certain derivatives products such as foreign exchange futures (margin) trading. Therefore the derivatives activities of financial institutions in China has to date been very limited.

Definition of "Derivatives"

The term "derivatives" is defined in Article 3 of the Derivatives Measures to mean "financial contracts the value of which is determined by reference to the prices of one or a number of underlying assets or indices" and includes forwards, futures, swaps and options. The Derivatives Measures further provide that "derivatives" also include structured financial instruments with the characteristics of forwards, futures, swaps and options, and various combinations thereof. With such a non-exhaustive definition of "derivatives", the application of the Derivatives Measures is, therefore, very broad.

Financial Institutions Eligible to Conduct Derivatives Activities

Article 2 of the Derivatives Measures provides that the Derivatives Measures apply to financial institutions incorporated within the PRC, including banks, trust and investment companies, finance companies, financial leasing companies, auto financing companies and branches of foreign banks opened in the PRC. Thus, the Derivatives Measures provide that, subject to the approval of CBRC and compliance with the Derivatives Measures, almost all types of financial institutions established in China are eligible to conduct derivatives activities.

According to the nature of its derivatives activities and its role in the transaction, a financial institution may be regarded as an end-user or a dealer (or both) of derivatives under the Derivatives Measures. Article 4 of the Derivatives Measures provides that a financial institution will be regarded as an end-user in a derivatives transaction when it conducts derivatives transactions for the purpose of hedging the risks arising from its own assets or liabilities or for a profit-making purpose. A financial institution will be classified as a dealer of derivatives if it provides derivatives-related services to customers. The Derivatives Measures do not provide for different standards and separate approval requirements for end-users and dealers. In other words, financial institutions will be subject to the same requirements and approval procedures, irrespective of their categorization as end-users or dealers. In practice, the CBRC will give only one type of approval without specifying the role that the financial institution can take in conducting its derivatives activities. However, the CBRC has indicated that the categorization will be recorded for internal supervision and risk management purposes.

One of the remarkable regulatory improvements contained in the Derivatives Measures is that a financial institution duly approved under the Derivatives Measures may conduct derivatives activities not only for the purpose of hedging the risks arising from its own assets or liabilities, but also for a profit-making purpose. In 1995, the PBOC promulgated a Notice Regarding Prohibition of Financial Institutions from Carrying Out Extraterritorial Derivative Instruments Business (the "1995 PBOC Notice"), prohibiting all domestic financial institutions from conducting derivatives activities for speculatory purposes. Although the 1995 PBOC Notice is not explicitly repealed by the Derivatives Measures, CBRC officials have confirmed that all the past regulations inconsistent with the Derivatives Measures, including the 1995 PBOC Notice, can be regarded as superceded by the Derivatives Measures. Therefore financial institutions will now be able to conduct derivatives activities for a profit-making purpose.

Approval and Regulatory Authority

The Derivatives Measures provide that the authority to regulate and supervise the derivatives activities of financial institutions is vested in the CBRC. Article 5 of the Derivatives Measures provides that financial institutions wishing to carry out derivatives activities must obtain prior approval from the CBRC and shall be subject to the supervision and examination of the CBRC.

Under Article 6 of the Derivatives Measures, financial institutions seeking to engage in derivatives transactions in respect of foreign exchange, securities, commodity or exchange-based derivatives (which are outside the scope of the Derivatives Measures) must continue to comply with foreign exchange controls and other applicable regulations and rules. In line with the general regulatory principles of separation of banking, securities and insurance activities in the Chinese financial industry, the CSRC has the authority to regulate activities involving equity securities and commodity futures. Banking institutions are generally prohibited from engaging in securities and futures activities. Therefore, in addition to the CBRC's supervision, the CSRC, SAFE and even the PBOC, may require consultation in relation to the regulation of a broad based derivatives business.

Qualification Requirements for Financial Institutions

A financial institution seeking to obtain approval for conducting derivatives activities must satisfy the following criteria set out in Article 7 of the Derivatives Measures:

1. complete and sound policies and procedures for risk management and internal controls of derivatives activities must be in place;
2. a sound processing system for derivatives transactions automatically connecting the front office, middle office and back office, and a real-time risk management system must be in place;
3. the personnel in change of the derivatives activities must have more than five years experience of direct participation in derivatives activities and risk management, and must have a clean record;
4. the institution must employ at least two professional traders with more than two years of experience in conducting derivatives transactions, at least one person responsible for risk management and one person responsible for research and development of risk models or risk assessment in connection with its derivatives activities. All such persons must be employed full time, must not act concurrently in each others' positions and must have clean records;
5. the institution must maintain proper premises and facilities for conducting derivatives transactions;
6. in the case of a foreign bank branch applicant, the institution's home country regulatory authority must have in place a supervisory framework and have relevant supervisory competence;
7. any other conditions required by the CBRC.

In view of the reality that the risk control system of foreign banks may be formulated on a global or regional basis rather than on an individual branch basis, the Derivatives Measures provide that where a foreign bank branch applicant does not meet the aforesaid conditions 1 to 5, these requirements may be dispensed with provided that (a) such applicant obtains a letter of authorization from its head office (or regional head office) specifying the types and size of the derivatives transactions it is authorized to conduct, and (b) except as otherwise prescribed by its head office, such applicant's derivatives activities must be uniformly executed in a real-time manner through the systems run by the head office (or regional head office) and the related transaction settlement, exposure, exposure management and risk controls must be uniformly conducted at its head office (or regional head office) level.

Application and Approval Procedures

Articles 8 and 9 of the Derivatives Measures provide that a financial institution wishing to conduct derivatives activities must submit applications to the CBRC directly or through its local offices for CBRC approval. For foreign-funded financial institution applicants, the application must be submitted to the local banking regulatory office for preliminary approval. It will then be forwarded to the CBRC for final approval. Where a foreign-funded financial institution, being a locally incorporated legal entity, seeks to conduct derivatives activities in more than two of its Chinese branches, the application must be filed by the applicant's head office. In the case of a foreign bank, the application must be filed by the applicant's lead branch in China. In both cases, the application must be submitted to the local banking regulatory office for preliminary approval and to the CBRC for final approval.

Under Article 9, a financial institution is required to submit the following documents and information (in triplicate) to the CBRC or its local offices in connection with the application process:

1. an application letter, feasibility study and business plan or business expansion strategy plan;
2. the internal management policies and procedures of the applicant pertaining to derivatives activities. These should include, for example, policies and procedures relating to business guidelines, business operating processes, the parameters used for risk models and qualifications, the types of derivatives business, risk reporting policies and internal audits, derivatives activities research and development, rules of conduct for derivatives traders, a description of management personnel's responsibilities etc.;
3. the accounting rules and procedures pertaining to derivatives activities;
4. the names and biographical information of the management personnel in charge of derivatives activities and of the principal derivatives traders;
5. the policies and procedures for the quantification of risk exposure and the management of risk limits;
6. a safety test report on the premises, facilities and systems; and
7. such other documents as are deemed necessary by the CBRC.

A foreign bank branch that does not meet the aforesaid conditions 1 to 5 must provide (a) a letter of authorization from its head office (or regional head office) specifying the types and size of the derivatives transactions it is authorized to conduct, and (b) assurance letters produced by head office (or regional head office) stating that its derivatives activities shall be uniformly executed in a real-time manner through the systems run by the head office (or regional head office) and that the related transaction settlement, exposure, exposure management and risk controls shall be uniformly conducted at its head office (or regional head office) level.

Article 11 of the Derivatives Measures provides that the CBRC shall decide whether to approve or decline the application within 60 days after receipt of a complete set of application documents.

Risk Management and Internal Control Systems

Chapter III of the Derivatives Measures sets out the risk management structure and internal control systems that financial institutions approved to conduct derivatives activities are required to adopt to avoid or minimize aggregate risks associated with derivatives activities. Financial institutions are only permitted to engage in derivatives activities for profit-making purposes upon the implementation of such prudential risk management systems.

Under the Derivatives Measures, financial institutions are required to implement sound risk management policies and internal control and business processing systems that are consistent with the nature, scale and complexity of the relevant derivatives activities. Such policies and systems should address the following:

1. the appropriate level of senior management's supervision and the establishment of suitable trading restrictions;
2. the separation of risk management between an assessment of market risks and an assessment of counter-party credit risks;
3. the adoption of a risk management process that covers accurate risk measurements for risk-quantification, an adequate risk-reporting system and regular and continuous updates on risk limits and loss limits;
4. the adoption of adequate liquidity arrangements for assurance of performance of contractual obligations under abnormal market conditions;
5. the presence of sound mechanisms and policies to control operational risks and legal risks;
6. the presence of comprehensive and effective controls and procedures for risk monitoring and transaction settlement.

The Derivatives Measures specifically require financial institutions to conduct due diligence before entering into derivatives transactions by formulating relevant policies to ascertain the suitability of the counter-parties in the transaction. For instance, financial institutions are required under Article 24 to investigate the legal status and business qualifications of a counter-party before entering into a transaction with that counter-party. The Derivatives Measures further provide that financial institutions must make full disclosure of the risks associated with derivatives transactions in providing derivatives services to domestic companies and individuals and must obtain from such companies and individuals a letter of confirmation to acknowledge that they understand and have the ability to bear the risks of such transactions.

Conclusion

The Derivatives Measures clarify financial institutions' ability to conduct derivatives activities in China. The Derivatives Measures introduce a regulatory framework for derivatives activities in China and are indisputably one of the major developments made by the CBRC in assisting financial institutions to expand their business and enhance their competitiveness in China.

However, unresolved issues still remain in relation to the Derivatives Measures that will be required to be addressed in the future or solved in practice.

For example, there may be potential conflicts and inconsistencies between the treatment of derivatives and financial institutions by the CBRC and other regulatory authorities such as the PBOC and the CSRC. It is reported that the PBOC and the CSRC are now drafting legislation in connection with derivatives. As derivatives are broadly defined under the Derivatives Measures, clear guidelines will be required to assist financial institutions to satisfy the various compliance requirements of different regulators.

In addition, for foreign bank branches, it is not yet clear whether they must obtain a "new product" license from the CBRC after obtaining the approval from the CBRC to conduct derivatives activities. Pursuant to the Regulations for Administration of Foreign-funded Financial Institutions, foreign bank branches must obtain approval from their local banking regulatory office prior to launching any new financial or relatively high-risk products in China.

Other unresolved issues include a conclusion on the legal effect of a derivatives transaction breaching the Derivative Measures – in such circumstances, will the transaction be enforceable in China? The Derivative Measures fail to provide a direct answer.

For more information on this topic please contact Barry Cheng (telephone no. (852) 2846 1925), Harvey Lau (telephone no. (86 21) 5047 1631) or Andrew Baggio (telephone no. (852) 2846 1931).