Hong Kong: China derivatives update - PRC banks may trade cross currency swaps with their

clients and reforms on CBRC Derivatives Rules

1. Overview

At the beginning of the Year of the Rabbit, more reforms to the regulatory framework were announced by the PRC regulators to expand the types of derivatives instruments available for bank customers, and to enhance the supervision of derivatives businesses by financial institutions that are regulated by the China Banking Regulatory Commission (CBRC). To accommodate the increasing demand of hedging tools for foreign currency exposures in the domestic market, the State Administration of Foreign Exchange (SAFE) issued the Notice on Designated Banks' RMB-FX Cross Currency Swaps Business with Their Clients in January 2011 (SAFE Notice) to allow designated banks to trade RMB-FX cross currency swaps with their clients starting from 1 March 2011. In the same month, the CBRC also issued the revised Provisional Administrative Rules Governing Derivative Activities of Banking Financial Institutions (New Derivatives Rules) to replace the Provisional Administrative Rules Governing Derivative Activities of Financial Institutions (Old Derivatives Rules) issued in 2004 and revised in 2007.

The New Derivatives Rules prescribe two types of derivatives licences to regulate the derivatives businesses of financial institutions. This is achieved by referring to whether the relevant derivatives transactions are for hedging purposes or not. CBRC also promulgates further enhancements to its regulations on risk management, design, sales and the distribution of derivatives products, product description, risk disclosure and after sales services applicable to derivatives businesses.

2. Bank customers may start trading RMB-FX cross currency swaps in China from March

Currently, designated banks in the PRC are allowed to provide RMB-FX forward and RMB-FX swap services to their clients. RMB-FX cross currency swaps are only permitted to be traded amongst qualified members through the China Foreign Exchange Trade System (CFETS), i.e. within the National Inter-bank FX Market.

To support the continuing increase of international trade and the acceleration of overseas investments by PRC investors, the SAFE Notice expands the trading of RMB-FX cross currency swaps beyond the National Inter-bank FX Market, with a view to offer more hedging tools for PRC corporates to hedge their currency and interest risks in their global trading activities.

Starting from 1 March 2011, designated banks that have been engaged in RMB-FX swap businesses for at least one year will be qualified to also provide RMB-FX cross currency swap services to their clients without the need for a separate SAFE approval. RMB-FX cross currency swap is defined in the SAFE Notice to mean an arrangement between a designated bank and its client for the exchange of interest payments and principal amounts in RMB and foreign currency respectively within the prescribed contract period at a pre-agreed exchange rate. Banks may determine the key terms of a RMB-FX cross currency swap, including the type of the currency pair and the tenors. The applicable interest rates under a RMB-FX cross currency swap must be agreed between the bank and its client within the parameters of deposit and lending rates set by the People's Bank of China.

Cross currency swaps have traditionally been used in the financial market as a tool to fund foreign currency investments, secure cheaper funding in foreign currency or hedge against exchange rate fluctuations. The latest SAFE Notice is another step amongst the many recent reforms of the PRC regulators on the path towards RMB internationalisation.

3. New Derivatives Rules

Compared to the Old Derivatives Rules, the New Derivatives Rules prescribe a more comprehensive regulatory regime for the conduct of derivatives businesses by banking financial institutions in the PRC. The New Derivatives Rules also demonstrate that CBRC is dedicated to monitoring the onshore derivatives activities closely, and to aligning the PRC regulatory regime more closely with the developments on derivatives products regulations undertaken by other international financial markets following the 2008 Lehman Brothers collapse.

  • Scope

Under the New Derivatives Rules, the term "derivatives" is defined to mean financial contracts that derive their value from the prices of one or a number of underlying assets or indices, such as forwards, futures, swaps, options and any combinations of hybrid financial instruments with these characteristics.

The scope of the New Derivatives Rules has been expanded to govern derivatives businesses to be conducted by commercial banks, policy banks, city credit cooperative unions, rural credit cooperative unions, financial asset management companies, trust companies, financial leasing companies, financial holding companies and any other banking financial institutions approved by CBRC. All derivatives transactions entered into between these banking financial institutions or between any such banking financial institution and its clients will be subject to the New Derivatives Rules. The term "clients" is defined to include both individual and non-financial institutional customers.

  • New CBRC licensing regime

"Hedging Derivatives Transactions" vs "Non-hedging Derivatives Transactions"

"The New Derivatives Rules divide derivatives transactions into the following two categories:

Category of derivatives transactions

Characteristics

Hedging transactions

  • Derivatives transactions that are initiated by a banking financial institution for hedging its credit risk, market risk and liquidity risk associated with its own assets and liabilities.
  • Such transactions must comply with the specific hedging accounting rules and be recorded under the relevant banking financial institution's own book.
Non-hedging transactions

  • It mainly includes the following three types:

1. derivatives transactions that are (i) initiated by the clients of a banking financial institution and provided by such banking financial institution to satisfy its clients' needs; or (ii) entered into by a banking financial institution with any third party to hedge its exposure under the transactions that such financial institution has entered into with its clients;

2. derivatives transactions entered into between a banking financial institution as a market maker and other market participants; and

3. proprietary trading by a banking financial institution.

  • Such transactions must be recorded under the relevant banking financial institution's trading book.
  • Such transactions must not exceed 3% of the core capital of the banking financial institution.

"Basic Licence" vs "General Licence"

Based on the two categories of derivatives transactions, CBRC will impose different conditions on (i) a "Basic Licence" for conducting hedging transactions; and (ii) a "General Licence" for conducting both hedging as well as non-hedging transactions. The following table summarises the key conditions applicable to the applicants for the two types of CBRC derivatives licences. The New Derivative Rules do not specify that existing CBRC derivatives licence holders need to apply for new licences. As at the date of this alert, CBRC has not provided written guidance on the implications of this new licensing regime on existing CBRC derivatives licence holders.

Type of licence

Permitted derivatives business

Requirements applicable to the relevant licence applicant

Basic Licence

Hedging type of derivatives transactions

The applicant must have:

i. sound policies and procedures for risk management and internal control of derivatives activities;

ii. two traders with a minimum of six months' professional training and two years' experience in derivative trading, one risk control officer; one risk analyst or researcher of risk modelling; and one personnel familiar with hedge accounting rules to be responsible for compliance related matters;

iii. proper premises and facilities for trading derivatives;

iv. legal and compliance departments; and

v. satisfied any other conditions imposed by CBRC.

General Licence

Hedging and non-hedging types of derivatives transactions

In addition to satisfying the requirements to apply for a Basic Licence, it must also have:

i. a sound processing system for derivatives transactions that automatically connects the front, middle and back offices, and a real-time risk management system;

ii. an officer in charge of derivatives trading with a minimum of five years' experience in derivatives trading, and such officer must have a clean record;

iii. a strict Chinese wall system in place to ensure proper segregation of market information, risk management and determination of profit and loss between the hedging and non-hedging types of derivatives transactions;

iv. a sound risk control system to monitor market risk, operational risk and credit risk; and

v. satisfied any other conditions imposed by CBRC.

In respect of innovative products/business and commodity and equity related derivatives, the New Derivatives Rules adopt a similar approach to the Old Derivatives Rules. Article 7 of the New Derivatives Rules states that any banking financial institution intending to engage in foreign exchange, commodity, energy and equity related derivatives transactions should obtain the derivatives licence from CBRC and comply with the requirements imposed by SAFE and any other relevant regulators. This does not seem to impose any additional licensing requirement other than the Basic Licence and General Licence.

Article 18 of the New Derivatives Rules further provides that banking financial institutions are required to submit a written consultation with CBRC before engaging in any transaction for innovative products and business.

However, Article 8 of the New Derivatives Rules stipulates that CBRC may impose different requirements on the business model and product categories applicable to a banking financial institution under its General Licence. Therefore, imposing additional requirements for different types of derivatives products is at CBRC's discretion.

  • Restrictions on complex derivatives products

On many occasions, CBRC has emphasised that derivatives products offered by banking financial institutions should be kept simple and "vanilla" in type, taking into account the lessons from the global financial crisis. This principle has been incorporated into the New Derivatives Rules that the banking financial institutions are prohibited from holding for their own accounts or selling to their clients (i) any "naked short selling derivatives product " that may cause unlimited losses; and (ii) any "re-derivatives product " that has another derivative product embedded as the underlying asset or is linked to another derivatives product. However, what constitutes these two types of complex derivatives products are still subject to further clarification from CBRC.

  • Product sales and after-sales services for clients

CBRC continues to focus on the suitability assessment, risk disclosure measures and ongoing compliance obligations that are imposed on banking financial institutions by incorporating most of the provisions from the Notice on Further Strengthening the Risk Management of Derivative Product Transactions between Banking Financial Institutions and Institutional Clients Circular No. 74) into the New Derivatives Rules.

The New Derivatives Rules impose an enhanced disclosure standard for product descriptions and risk disclosure statements to be written in a clear and concise manner, but not otherwise presented in the form of footnotes/end notes, on the side of the page or in small font size. In addition, as a further reform to improve the after-sales services for customers, Article 53 of the New Derivatives Rules imposes a requirement on financial institutions to make periodic disclosures of the valuation reports and other risk factors for their derivatives transactions, rather than a minimum of once a month disclosures as previously stated in the Circular No. 74.

Both the Circular No. 74 and the New Derivatives Measures should be read together. The provisions in the Circular No. 74 will continue to apply unless otherwise superseded by any contrary provisions under the New Derivatives Rules. Please click here for our previous alert on the Circular No. 74.

Hyperlinks to rules and notices referred to in this alert

Provisional Administrative Rules Governing Derivative Activities of Financial Institutions promulgated by CBRC on 4 February 2004 and revised on 3 July 2007.

Provisional Administrative Rules Governing Derivative Activities of Banking Financial Institutions promulgated by CBRC on 5 January 2011.

Notice on Further Strengthening the Risk Management of Derivative Product Transactions between Banking Financial Institutions and Institutional Clients promulgated by CBRC on 31 July 2009.

Notice on Designated Banks' RMB-FX Cross Currency Swaps Business with Their Clients promulgated by SAFE on 30 January 2011.

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