China Issues First Regulations Governing Derivatives Activities by Financial Institutions

Background

Certain derivatives products, such as futures, forward foreign exchange contracts and options, began to be traded in China more than a decade ago. But generally speaking neither Chinese government officials nor bankers thoroughly understood the complexity of the products and the potential risks associated therewith. In the early 1990s, Chinese financial institutions, particularly banks and trust and investment companies, engaged in financial derivatives activities without strong internal controls and in the absence of government regulations. The result was rampant unsupervised risk-taking that contributed to the perilous condition of these institutions. The government responded with stringent rules on derivatives trading. In particular, the People's Bank of China (the PBOC), which exercised supervisory responsibility over financial institutions prior to the establishment of the CBRC, prohibited domestic financial institutions from engaging in financial derivatives transactions with foreign institutions except for necessary low-risk transactions conducted with the approval of the State Administration of Foreign Exchange (SAFE).¹

The establishment of the CBRC on April 28 2003 created a much more focused regulatory body that is determined to place China's commercial banks and various other financial institutions on a sounder and more effectively regulated foundation (insurance companies and securities institutions are subject to separate regulatory authorities).

The CBRC on October 13 2003 published a draft of the Procedures to solicit public comments and opinions. In subsequent months, the draft underwent multiple rounds of discussion and was improved in a number of ways. We summarize the main contents and principal differences between the draft and the final Procedures below.

Refinements During the Drafting Process

Defining Derivatives

The draft did not define derivatives directly but rather defined derivatives transactions that indirectly entailed a meaning of derivatives. By contrast, the Procedures define derivatives directly. Under the draft, "derivatives transactions" were defined as transactions in which the product price is determined by reference to one or more underlying financial assets or indices, including transactions relating to forwards, futures, swaps and options, and other transactions with the characteristics of derivatives. The Procedures improved upon this by directly defining "derivatives" as financial contracts that derive their value from the prices of one or more underlying assets or indices, which are basically classified as forwards, futures, swaps and options. Furthermore, under the Procedures, "derivatives" also include structured financial instruments with the characteristics of forwards, futures, swaps and options, and various combinations thereof. Thus, the scope of regulation has been made more comprehensive.

Application Process

With respect to market access, the discussion draft provided that financial institutions seeking to conduct derivatives trading must apply to the CBRC and satisfy the following qualifications:

(i) they must possess sound derivatives trade risk management and internal control systems;

(ii) they must possess a complete derivatives transactions processing system that automatically links front, middle and back offices, and a real-time risk management system;

(iii) they must employ a chief manager responsible for derivatives business who has directly participated in derivatives trading and risk management activities for not less than five years and has a clean record;

(iv) they must employ at least two persons who have (a) not less than two years' experience in derivatives trading, and (b) at least six months of specialized technical training in conducting derivatives trading;

(v) they must employ at least one person responsible for risk management and one person responsible for research and development of risk models or risk assessment;

(vi) they must possess proper trading premises and equipment; and

(vii) they must comply with other requirements as determined by the CBRC.

Article 7 of the Procedures adds the following additional provisions to the discussion draft to accommodate foreign bank branches that do not meet the above standards but may qualify by meeting the following standards:

(i) its home country or region has in place a legal framework for the regulation and supervision of derivatives activities and its home country supervisor has relevant supervisory competence;

(ii) it has provided a letter of authorization from its head office (or regional head office) specifying, among other items, the types and size of derivatives activities it is authorized to conduct; and

(iii) except as otherwise prescribed by its head office, its derivatives transactions shall be uniformly executed in a real time manner through the system run by its head office (or regional head office), and the related transactions settlement, exposure management and risk controls shall be uniformly conducted at its head office (or regional head office) level.

Key Provisions of the Procedures

Financial Institutions Eligible to Undertake Derivatives Transactions

Article 2 of the Procedures specifies that banks, trust and investment companies, finance companies, financial leasing companies, automobile finance companies, and foreign bank branches are the types of financial institutions eligible to engage in financial derivatives trading. A financial institution may qualify as a dealer or end user (or both) according to the nature of its derivative business and market position. A financial institution must specify the category or categories before launching its derivatives business.

An end user refers to a financial institution providing derivatives products or related trade services to a customer, including acting as a broker or a market maker. Among the financial institutions acting as derivatives dealers, those further providing derivatives quotes and derivatives services for their customers or other dealers are treated as derivatives market makers.

An end user refers to a financial institution that conducts derivatives hedging transactions for the purposes of hedging risk or that uses its own assets to conduct profit-oriented transactions.

Although financial institutions engaging in derivatives activities may be categorized as either dealers or end users or as both, the standards for market access do not differ between these two categories under the Procedures. In other words, financial institutions in either category must meet the same standards and follow the same approval procedures to be able to engage in derivatives activities.

The Supervisory Authority

The Procedures for the first time establish the CBRC as the supervisory authority responsible for regulation of derivatives transactions. Article 5 provides that the CBRC shall regulate and supervise the derivatives activities of financial institutions. A financial institution seeking to conduct derivatives activities must obtain prior approval from the CBRC, and will be subject to its oversight and examination. However, because derivatives are broadly defined under the Procedures, regulation also involves other government authorities (such as the PBOC, the China Securities Regulatory Commission (CSRC) and SAFE) with authority over such institutions as investment banks that may separately qualify to engage in derivatives activities, or aspects of such transactions, like foreign exchange.

Approval Procedures

Under Article 9, a financial institution applying to conduct derivatives activities is required to submit the following documents and information (in triplicate) to the CBRC or its local offices:

(i) an application letter, feasibility study and business plan or business expansion strategy;

(ii) internal management policies pertaining to derivatives activities (including business guidelines, business operating processes, parameters used for risk models and quantification, types of derivatives activities, risk reporting policies and internal audits, derivatives activities research and development, rules of conduct for derivatives traders, description of managerial personnel's responsibilities, etc.);

(iii) accounting rules and procedures pertaining to derivatives activities;

(iv) names and biographical information of the managerial personnel in charge of derivatives activities and of the principal derivatives traders;

(v) policies and procedures for the quantification of risk exposure and the management of risk limits;

(vi) safety test report on the premises, facilities and systems; and

(vii) other documents as deemed necessary by the CBRC.

For a foreign bank branch that does not meet the standards set forth for domestic financial institutions, its head office is required to provide (i) a letter of authorization authorizing the types and size of derivatives activities and (ii) assurance that the derivatives transactions conducted by the foreign bank branch will be executed in real time through systems run by the head office, or regional head office that shall also implement relevant internal controls.

The CBRC is required under Article 11 to decide whether to approve an application within 60 days after receipt of a complete set of application documents and the information set forth in the Procedures. If a branch or subsidiary of a domestic financial institution wishes to conduct derivatives activities, the institution's head office is required under Article 12 to review the branch or subsidiary's capability with respect to relevant risk management and to issue a letter of authorization to authorize the types and sizes of derivatives activities to be conducted and also assure the real-time execution of such activities through the head office's systems. The CBRC's corresponding local offices are responsible for processing applications from branches or subsidiaries.

Risk Management

Chapter III of the Procedures governs risk management. Financial institutions engaging in derivatives activities are required under Article 14 to have in place risk management and internal controls policies to avoid or minimize both operational and legal risks, and under Article 15 to have capable senior management with effective oversight and guidance capability. Article 16 requires that senior management establish risk exposure parameters and methods, and crucially requires that senior management in charge of derivatives activities be separated from their colleagues in charge of risk management. Whenever derivatives services are provided to a domestic corporation or individual, the financial institution under Article 19 is required to make full disclosure of risks to the customer, and to obtain a letter of confirmation from the customer confirming that it fully understands and is capable of accommodating the risks. When performing its risk control and management obligations, a financial institution is allowed under Article 18 par. 3 to rely to a certain extent on written documents provided by its counterparties in good faith, which limits the potential liability of such institution.

Remaining Issues

Potential Overlap of Regulatory Authorities

Under Article 3, the definition of derivatives includes forwards, futures, options and swaps; under Article 6 foreign exchange, securities and commodities transactions are also covered. The latter transactions fall outside the bounds of the CBRC's authority and require coordination with other government departments, including the PBOC, SAFE and the CSRC.

The PBOC in January 1997 proclaimed its authority over forward transactions involving foreign exchange issues by promulgating the Administration of Forward Transactions Concerning the Settlement and Sale of Foreign Exchange Tentative Provisions. Immediately after publication of the above measures, the PBOC authorized Bank of China (BoC) to become the first commercial bank to conduct forward foreign exchange transactions. BoC dominated this market until August 2002 when the other three large state-owned commercial banks (China Construction Bank, Industrial and Commercial Bank of China, and Agricultural Bank of China) were permitted to engage in the same business. The PBOC has the exclusive power to regulate derivatives transactions of foreign exchange and will continue to exercise authority in this regard. Additionally, securitization of individual housing loans has attracted a great deal of attention in recent years. The PBOC is understood to be preparing new measures to regulate the securitization of individual housing loans as mortgage-backed securities. In the interim, futures transactions, as a special form of forward transactions, are subject to supervision by the Futures Regulatory Division of the CSRC if they are publicly traded on designated exchanges. In addition, officials of the Futures Division of the CSRC have announced that state debt futures will begin trading in the near future. Moreover, SAFE has authority over foreign exchange issues with respect to financial derivatives activities under Article 27 par. 3.

Supervision and Examination of Financial Institutions

The CBRC has already assumed a heavy responsibility with respect to the supervision and examination of the relatively straightforward businesses of commercial banks and other financial institutions, many of which are still troubled institutions. It now faces the challenge of undertaking other comparable tasks for more sophisticated derivatives instruments. The CBRC's workload may be aggravated by time pressure. The CBRC itself referred to a six-month transition period at a press briefing held immediately after the publication of the Procedures. All financial institutions hoping to conduct derivatives activities are expected not only to submit applications but also to obtain final approval from the CBRC within six months after publication of the Procedures. The six-month transition period is relatively short in view of the complex approval standards set forth under the Procedures and the large number of applications that are likely to be submitted soon after the Procedures take effect. The CBRC may be tempted to delay approval of more complex instruments for fear that they will exceed its regulatory capacity. This would unfortunately have a disproportionate impact on foreign-invested financial institutions, including foreign bank branches, which already have extensive experience in conducting such transactions.

Endnote

1 People's Bank of China, Prohibition on the Casual Development of Offshore Derivatives Investments Trading Businesses by Financial Institutions Circular (March 29 1995).