Administration of Trading of Derivatives by Financial Institutions Tentative Procedures

(Promulgated by the China Banking Regulatory Commission on February 4 2004 and effective as of March 1 2004.)

PART ONE: GENERAL PROVISIONS

Article 1:      These Procedures are formulated in accordance with thePRC Banking Regulation Law, the PRC Commercial Banking Law and other relevant laws and administrative regulations in order to regulate the administration of trading of derivatives by financial institutions and effectively control risk in derivatives trading by financial institutions.

Article 2:      For the purposes of the Procedures, the term ¡°financial institutions¡± shall refer to legal persons of banks, trust and investment companies, finance companies, lease-financing companies and auto finance companies legally established within the People¡¯s Republic of China, as well as branches of foreign banks established within China (hereafter, Foreign Bank Branches).

Article 3:      For the purposes of the Procedures, the term ¡°derivatives¡± means a type of financial contract, the price of which shall be decided by one or more underlying assets or indices. The basic types of contract shall include forwards, futures, swaps and options. Derivatives shall also include structured financial instruments containing one or more characteristics of forwards, futures, swaps or options.

Article 4:      Trading of derivatives by financial institutions as referred to in the Procedures shall be of two types:

(1)   Trading of derivatives by financial institutions in order to hedge against their own asset and liability risk, or to make a profit. A financial institution engaged in this type of business shall be regarded as the end-user of the derivative.

(2)   The provision of derivatives trading services by a financial institution to a client (including a financial institution). A financial institution engaged in this type of business shall be regarded as a derivatives dealer. A dealer that can provide price quotes for derivatives and trading services to other dealers or clients shall be regarded as a derivatives market maker.

Article 5:      The China Banking Regulatory Commission shall be the regulatory authority for derivatives trading by financial institutions. Financial institutions starting derivatives trading shall be examined and approved by the China Banking Regulatory Commission and shall be subject to supervision and inspection by the China Banking Regulatory Commission.

Non-financial institutions shall not provide derivatives trading services to clients.

Article 6:      Financial institutions engaged in derivatives trading related to foreign exchange, stocks or commodities, or in derivatives trading on the exchange, shall abide by state foreign exchange administration and other relevant provisions.

PART TWO: ADMINISTRATION OF MARKET ENTRY

Article 7:      Financial institutions applying to engage in derivatives trading must fulfil the following criteria:

(1)   they shall have sound derivatives trading risk management systems and internal control systems;

(2)   they shall have proper automated business management systems linking the front office, middle office and back office for derivatives transactions and real-time risk management systems;

(3)   personnel in charge of derivatives trading shall have five or more years¡¯ direct experience in derivatives trading and risk management, and have a good record;

(4)   they shall have at least two traders with two or more years¡¯ experience in derivatives or related trading who have received six months or more relevant specialist training in derivatives trading skills; at least one relevant risk management personnel; and at least one risk model researcher or risk analyst. The above personnel shall be dedicated to their posts only and shall not concurrently hold each other¡¯s post. They shall also have a good record;

(5)   they shall have suitable trading premises and equipment;

(6)   the parent countries of foreign bank branches applying to engage in derivatives trading shall have a legal framework for regulating derivatives trading and their regulatory authorities shall have the relevant regulatory capacity; and

(7)   other criteria as stipulated by the China Banking Regulatory Commission.

Foreign bank branches that do not fulfil the criteria listed in (1) to (5) above shall fulfil those listed in (6) and (7) and the following criteria:

(1)   they shall have formal authority from their headquarters (or regional headquarters) for the types and quantity, etc. of derivatives in which they are trading; and

(2)   except where the headquarters clearly stipulates otherwise, all derivatives transactions of the branch shall centrally be carried out in real-time transactions through the system of the authorizing headquarters (or regional headquarters), and the headquarters (or regional headquarters) shall centrally carry out squaring, exposure management and risk controls.

Article 8:      Policy banks, Chinese-invested commercial banks (not including urban commercial banks, rural commercial banks and rural cooperative banks), trust and investment companies, finance companies, lease-financing companies and auto finance companies wishing to engage in derivatives trading shall have their legal persons centrally apply with the China Banking Regulatory Commission and have the China Banking Regulatory Committee examine and approve the application.

Urban commercial banks, rural commercial banks and rural cooperative banks wishing to engage in derivatives trading shall have their legal persons centrally submit the application material to the banking regulatory bureau at the locality. Once the application material has been examined and agreed, it shall be submitted to the China Banking Regulatory Committee for examination and approval.

Foreign-invested financial institutions wishing to engage in derivatives trading shall submit the application material, signed by an authorized signatory, to the banking regulatory bureau at the locality. Once the application material has been examined and agreed, it shall be submitted to the China Banking Regulatory Commission for examination and approval. Foreign-invested financial institutions intending to have two or more of their branches within China engage in derivatives trading may have their foreign-invested legal person headquarters or the principal reporting branch of the foreign bank centrally submit the application material to the banking regulatory bureau at the locality. Once the application material has been examined and agreed, it shall be submitted to the China Banking Regulatory Commission for examination and approval.

Article 9:      Financial institutions applying to engage in derivatives trading shall submit the following documents and information (in triplicate) to the China Banking Regulatory Commission or its agencies:

(1)   application, feasibility study report and business proposal or business development plan regarding trading of derivatives;

(2)   internal management and ruling systems for derivatives trading;

(3)   accounting system for derivatives trading;

(4)   names and r¨¦sum¨¦s of senior personnel and principal traders;

(5)   authorized management system to quantify or limit risk exposure;

(6)   security assessment reports on place of trading, equipment and systems; and

(7)   other documents and information as required by the China Banking Regulatory Commission.

Foreign bank branches that do not fulfil the criteria listed in (1) to (5) of the first paragraph of Article 7 shall also submit the following documents to the banking regulatory bureau of the place where the branch is located:

(1)   formal written authorization from their headquarters (or regional headquarters) for the type and amount, etc. of derivatives to be traded by the branch; and

(2)   except where their headquarters clearly stipulates otherwise, a letter of undertaking issued by their headquarters (or regional headquarters) ensuring that all derivatives transactions of the branch be carried out in real time through the transaction system of the authorizing headquarters (or regional headquarters) and that the headquarters (or regional headquarters) be responsible for carrying out squaring, exposure management and risk controls.

Article 10:    The internal management and ruling systems of financial institutions engaging in derivatives trading shall at the least include the following:

(1)   guiding principles and business operations procedures (business operations procedures shall embody the principle for separation of the front, middle and back offices) for derivatives trading, and contingency plans for unexpected events;

(2)   risk model indicators and risk quantitative management indicators for derivatives trading;

(3)   types of derivatives traded and their risk control systems;

(4)   risk reporting system and internal audit system;

(5)   systems for managing the research and development of derivatives trading and for subsequent evaluating;

(6)   regulations governing traders;

(7)   a post responsibility system for those in charge of trading, and an accountability system and an incentive and restraining mechanism for all levels of managing personnel and traders;

(8)   a training plan for front, middle and back office managing personnel and workers; and

(9)   other contents as stipulated by the China Banking Regulatory Commission.

Article 11:    The China Banking Regulatory Commission shall render an official reply within 60 days of the date of receipt of a complete set of application material in accordance with these Procedures by a financial institution.

Article 12:    Financial institution legal persons in China that authorize their branches to engage in derivatives trading shall exercise rigorous verification of the risk management capability of the branches, and shall issue formal written authorization regarding the types and amounts of derivatives to be traded. Such branches shall, when engaging in derivatives trading, have their head office¡¯s (or headquarters¡¯) system centrally carry out real-time transactions and have their head office (or headquarters) centrally carry out squaring, exposure management and risk control.

The abovementioned branches shall, within 30 days of receipt of the authorization from their head office (or headquarters) or from the day of changes to their authorization, report to the banking regulatory bureau of the place where they are located on the strength of their head office¡¯s (or headquarters¡¯) authorization.

PART THREE: RISK MANAGEMENT

Article 13:    Financial institutions shall determine whether they are able to engage in derivatives trading and the types and scale of derivatives to be traded in view of their business objectives, capital strength, management capability and the risk characteristics of the derivatives.

Article 14:    Financial institutions shall establish the risk management systems, internal control systems and business management systems commensurate with the nature, scale and complexity of their derivatives transactions in accordance with the classification of derivatives trading specified in Article 4 hereof.

Article 15:    The senior management personnel of financial institutions shall understand the risks inherent in derivatives transactions engaged in. They shall verify, approve and assess the overall policy framework defining the principles, procedures, organization and limits to authority with respect to the conduct of derivatives trading and the risk management therof. They shall be able to obtain information regarding derivatives trading risks at any time through an independent risk management department and a sound checking and reporting system, and shall on this basis exercise the appropriate supervision and leadership.

Article 16:    The senior management personnel of financial institutions must decide the indicators and methods that are commensurate with the business of the institution to measure risk exposure in derivatives transactions. They must formulate and regularly review and update risk exposure limits, stop loss limits and contingency plans based on their institution¡¯s overall strength, own assets, profitability, business strategy and estimate of market risks, and formulate procedures to control and handle limits. Senior management personnel in charge of derivatives trading of a financial institution shall be appropriately separated from senior management personnel in charge of risk controls of the institution.

Article 17:    Financial institutions shall formulate clear standards for recognizing the qualifications of personnel such as traders and analysts. They shall provide training to traders and other relevant personnel according to the complexity of derivatives transactions and risk management to ensure that these personnel are equipped with the necessary skills and qualifications.

Article 18:    Financial institutions shall formulate relevant policies to assess the appropriateness of their counterparties. These shall include assessment of whether that counterparty fully understands the clauses of the contract and their obligations under that contract, identifying whether the derivatives transaction fulfils the counterparty¡¯s own aim in the derivatives transactions, and assessment of the counterparty¡¯s credit risk, etc.

For high-risk types of derivatives, the financial institution shall issue special provisions regarding their counterparty¡¯s qualifications and criteria.

When fulfilling the requirements of this article, a financial institution may, on the principle of good faith, rationally rely on the formal written documentation provided by the counterparty.

Article 19:    When trading derivatives for a domestic institution or individual, financial institutions shall fully explain the risks inherent in the derivatives transaction to that institution or individual and shall obtain a letter of acknowledgement from the institution or individual that they understand and can bear the risk.

The information to be disclosed by the financial institution to the institution or individual shall at the minimum include:

(1)   the content of the derivatives contract and summary of the inherent risk; and

(2)   major factors affecting potential losses in the derivatives.

Article 20:    Financial institutions shall appropriately and rationally use all types of measures to alleviate credit risk, such as security, in order to reduce their counterparty¡¯s credit risk. They shall select the appropriate methods and models to assess credit risk and adopt the relevant risk control measures.

Article 21:    Financial institutions shall use the appropriate risk assessment methods and models to assess the market risk of derivatives transactions and shall manage market risk according to market prices, adjusting the levels of the scale, type and risk exposure of their transactions.

Article 22:    Financial institutions shall make fully fluid arrangements according to the type and scale of derivatives transactions in order to ensure that they are able to fulfil their contractual obligations if there are unusual trading circumstances on the market.

Article 23:    Financial institutions shall set up sound mechanisms and systems to control operational risk, and shall rigorously control operational risk.

Article 24:    Financial institutions shall set up sound mechanisms and systems to control legal risk and shall rigorously check the legal status and qualifications to trade of their counterparties. When signing a derivatives transaction contract with its counterparty, a financial institution shall make reference to internationally recognized legal documents. They shall take full account of factors such as the practicality of legal measures taken to seek recourse or to preserve property after a breach of contract and adopt effective measures to prevent legal risk when drafting, negotiating and signing transaction contracts.

Article 25:    Financial institutions shall submit their accounts, statistics and other reports relating to derivatives trading to the China Banking Regulatory Commission in accordance with provisions of the Commission.

Financial institutions shall disclose their risk, losses, changes in profits and unusual circumstances in derivatives trading in accordance with the China Banking Regulatory Commission¡¯s provisions on information disclosure.

Article 26:    The China Banking Regulatory Commission shall have the power to examine at any time the material regarding and reports relevant to financial institutions¡¯ derivatives trading. It shall conduct regular examinations of whether the risk management systems, internal control systems and business management systems of financial institutions are commensurate with the derivatives transactions carried out by those institutions.

Article 27:    If financial institutions engaged in derivatives trading discover major business risks or losses, they shall take the initiative in reporting these in a timely fashion to the China Banking Regulatory Commission and shall submit the necessary measures in response.

If there are major changes to the derivatives transactions by, or operational or risk management system of, financial institutions, those institutions shall take the initiative in reporting the precise circumstances to the China Banking Regulatory Commission.

If any of the above circumstances involves foreign exchange administration or external payments, the report shall also be copied to the State Administration of Foreign Exchange.

Article 28:    Financial institutions shall properly preserve such material as all records of their derivatives transactions together with documents, accounts, original receipts and telephone recordings related to the transactions. Telephone recordings shall be kept for at least six months and other material shall be kept for three years after expiration of the transaction contract for verification, unless the accounting system has special requirements.

PART FOUR: LIABILITY

Article 29:   If derivatives traders in financial institutions carry out operations in violation of these Procedures or the relevant provisions of their institutions, causing major economic losses to their institution or its clients, the directly responsible senior management personnel, other senior personnel directly responsible for the operations and directly responsible persons shall receive disciplinary penalties, from recording of a demerit to dismissal from the financial institution. If a crime is constituted, the case shall be handed over to judicial authorities to pursue criminal liability in accordance with the law.

Article 30:    Financial organizations conducting derivatives trading without authorization shall be penalized by the China Banking Regulatory Commission in accordance with the Penalties for Illegal Financial Acts Procedures.

Non-financial organizations that provide derivatives trading services to clients in violation of these Procedures shall be shut down by the China Banking Regulatory Commission and their illegal income shall be confiscated. If a crime is constituted, the case shall be handed over to judicial authorities to pursue criminal liability in accordance with the law.

Article 31:    Financial institutions that fail to submit the relevant reports and information, or to disclose information on their trading of derivatives in accordance with these Procedures or with the requirements of the China Banking Regulatory Commission shall be penalized, depending upon the nature of the financial institution, by the China Banking Regulatory Commission in accordance with relevant laws and regulations such as the PRC Banking Regulation Law, the PRC Commercial Banking Law and the PRC Administration of Foreign-invested Financial Institutions Regulations.

Financial institutions that provide information on derivatives trading that is false or that conceals important facts shall be penalized by the China Banking Regulatory Commission in accordance with the Penalties for Illegal Financial Acts Procedures.

Article 32:    If the China Banking Regulatory Commission discovers that a financial institution fails to effectively implement its risk management system and internal control system necessary for trading of derivatives, it may suspend or revoke that institution¡¯s qualification to engage in derivatives trading.

PART FIVE: SUPPLEMENTARY PROVISIONS

Article 33:    The China Banking Regulatory Commission shall be responsible for interpreting these Procedures.

Article 34:    These Procedures shall be effective as of March 1 2004. If there is a conflict between these Procedures and provisions relevant to trading of derivatives by financial institutions promulgated before these Procedures, the Procedures shall prevail.