In a move designed to protect onshore (domestic) Chinese banks and their customers from exposure to derivative products which are perceived as being high risk, the China Banking Regulatory Commission (CBRC) has unveiled stringent new rules to further regulate the issue and use of derivative products.
The Notice on Further Strengthening Risk Management for Derivatives Transactions between Banking Financial Institutions and Corporate Clients (Notice), issued on 31 July 2009, imposes restrictions on the ability of onshore banks to engage in derivatives transactions with onshore corporate clients together with significant ongoing administrative obligations on both the clients and banks.
The Notice has immediate effect and requires all onshore banks engaging in derivatives transactions to submit a report to CBRC by 31 October 2009 outlining its plans for compliance with the Notice.
The Notice applies to all "onshore banks" holding a derivatives license. These include Chinese domestic banks as well as the onshore branches of foreign banks and the locally incorporated subsidiaries of foreign banks.
The transactions which are affected are only those with "corporate clients", being all the clients of a bank other than individuals and financial institutions.
The Notice applies only to future derivative transactions between onshore banks and corporate clients. Existing derivative transactions are not affected unless they are restructured.
Prerequisites To Entering Derivatives Transactions
The Notice requires an onshore bank to comply with strict new rules whenever it enters into a derivative transaction with a corporate client. The key requirements are:
- The corporate client must have evidenced a "real need" to enter into a derivatives contract. There is little guidance in the Notice on how this need is to be demonstrated but it is stated that the main risk profile of the derivatives transaction must have a "reasonable degree of relevance" to the main risk profile of the underlying assets or liabilities. The Notice expressly restricts onshore banks from treating their corporate clients' RMB debts as the transactional need for entering into a derivative transaction linked to non-RMB market parameters.
- The derivative product which a bank offers to its corporate clients must be a basic product (i.e. simple and common) which has a risk profile that can be analysed and priced by the bank. The implication of this requirement is that if the bank does not have an appropriate evaluation and pricing system it will not be able to offer anything other than the most basic of products. While it remains to be clarified, it does seem that if an onshore bank has appropriate systems in place there is the possibility that it will be able to offer slightly more sophisticated products to its clients - but this will be the subject of specific discussions between the bank and CBRC.
- The bank must have undertaken a formal risk evaluation process in relation to each product offered to its clients and concluded that the proposed derivative transaction is suitable for each client having regard to that client's ability to assume the risks of the transaction.
Restrictions On Marketing Activities
The Notice prescribes the way in which an onshore bank can market and sell derivatives products. The key features are:
- All sale activities must be undertaken by staff employed by the onshore bank. The Notice prohibits onshore banks from jointly promoting derivatives products with sales persons employed by any offshore entities (i.e. any entity which is not registered or incorporated in the PRC) or engaging in such joint promotion by any disguised means
- So called "back to back" derivatives transactions in which an onshore bank acts, at the request of its domestic corporate client, as the intermediary between that client and an offshore bank are now no longer allowed
- The bank must not misrepresent the risks associated with the product it is offering. That means that the description of the product (including associated risks) has to be set out in an objective and fair manner. The bank must not mislead clients, exaggerate strong points, guarantee any return to the client, or force the client to purchase the derivative product as a condition for other businesses or products, and
- All offering materials, product introductions and risk disclosure must be written in a clean and easy to understand way.
Ongoing Compliance Obligations
In addition to the above requirements, there are significant ongoing compliance obligations. The onshore bank will be required to:
- Re-calculate the market value of the derivatives at least monthly and provide this valuation in writing to its customer
- Evaluate all legal documents in relation to the derivatives (such as the master agreement, contracts and others) at least half yearly
- Put in place internal compliance procedures, risk evaluation processes and pricing models that meet the requirements of CBRC, and
- Ensure that all internal staff are properly trained and all sales persons are duly authorised to promote the products.
The new rules set out in the Notice are expected to have a significant impact on the ability of onshore banks to undertake derivative and trading activities in the Chinese domestic market. Clearly the government's objective in protecting onshore banks and their customers from the risks associated with high risk derivative products will be furthered by these rules, but it is likely that onshore banks will have to devote considerable time, energy and resources to developing the necessary internal compliance procedures and evaluation processes to satisfy CBRC.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.