Golden Opportunity for Banks in China: New Rules Issued to Allow Commercial Banks to Trade Gold Futures

It is generally believed that the CBRC Circular will bring the following benefits to commercial banks in China:

• It will help to generate new business for them – especially for those which are qualified to act as broker-dealers.

• It will help them to hedge their risk positions accumulated from their current spot gold activities, given the wide fluctuation of the gold price in international markets (for example, spot gold traded by the Industrial and Commercial Bank of China in 2007 totalled 200 metric tons, while the total quantity of gold traded by Bank of China Limited totalled

300 metric tons in the same year). In addition, by participating in Chinese domestic futures on the Shanghai Futures Exchange, it will increase their flexibility in gold trading, bringing out more opportunities for arbitrage and hedging risks.

• It will help to improve their competitiveness.

• It will help generally to improve their risk management capabilities.

Conditions for Engaging Gold Futures Business

In order to be able to engage in the gold futures business, a commercial bank is required to meet the following conditions:

(i) its capital adequacy ratio is at least 8%;

(ii) it is qualified to engage in (financial) derivatives business. This requires a separate approval from the CBRC, in addition to the usual banking license;

(iii) it is qualified to trade in spot gold. This means that the commercial bank will need to be a member of the Shanghai Gold Exchange in order to trade spot gold at the exchange. At present there are 19 commercial banks in China (such as ICBC) who are already members of the Shanghai Gold Exchange;

(iv) it has a sound ability to manage market risk, and complies with the requirements set forth in the Circular of CBRC on Further Strengthening Market Risk Management of Commercial Banks;

(v) its board of directors (or senior management authorized by the board) has authorized the bank to engage in the gold futures business;

(vi) it has completed a feasibility study report, which shall cover matters such as market trends, business objectives, business needs, operating procedures, risk control measures, profit forecasts, etc.;

(vii) it has comprehensive internal business management measures for the gold futures business, which shall, at least, include an internal control system and risk control system;

(viii) it has a business processing system necessary for the conduct of the gold futures business, which shall, at a minimum, include a trading system, risk control system, settlement system, account and audit system, data backup system, emergency handling system, etc.;

(ix) it shall have no less than four people who have passed the qualifying exam recognized by the Chinese commodities futures industry. At least two of the same shall be traders and at least two shall be risk control managers. Such persons may not concurrently hold both positions, and shall not have bad professional records.

Applying for Membership on the Shanghai Futures Exchange

The CBRC Circular provides that a commercial bank intending to engage in the gold futures business shall first become a member of the futures exchange. However, before applying for membership with the futures exchange, the commercial bank shall communicate with the CBRC in respect of its satisfying the conditions for engaging in the gold futures business and the completion of a self-appraisal with a view to obtaining a No Objection Letter from the CBRC. It should be noted that apart from such a letter, the CBRC Circular does not require commercial banks to obtain the CBRC's prior approval in order to engage in the gold futures business.

It appears from the Administrative Measures of Shanghai Futures Exchange on Membership that it is not difficult at all for a commercial bank to become a member if it meets the following conditions:

(i) it is duly organized and validly exists as a legal person;

(ii) it agrees to observe the charter of the exchange and its rules;

(iii) it has a minimum capitalization of Rmb30 million (broker-dealer category), or Rmb10 million (non broker-dealer category);

(iv) it has a good reputation and solid operating history. It has not committed any severe violation of law, nor has been dismissed by the exchange;

(v) it has a sound business management structure, financial management system and good futures business management system;

(vi) it has professionals with proper futures licenses, permanent business premises and the requisite facilities;

(vii) it possesses a Commodities Futures Brokerage License issued by China Securities Regulatory Commission (CSRC).

To apply for a membership of the futures exchange (e.g. Shanghai Futures Exchange), a commercial bank shall submit the following documents to the Shanghai Futures Exchange:

(i) an application signed by its legal representative;

(ii) its business license;

(iii) its latest audited annual report;

(iv) evidence of premises for its business operation;

(v) evidence of trading facilities and information facilities;

(vi) such other documents as may be required by the exchange;

In addition, if the commercial bank intends to become a broker-dealer type member, it shall provide the following additional information:

(vii) a copy of its Commodities Futures Brokerage License issued by the CSRC;

(viii) its articles of association and internal rules on futures brokerage business; and

(ix) information on its corporate structure, resumés of its legal representative and people in charge of its futures business, as well as a list of its professionals which hold the appropriate futures license.

Self-Appraisal

The CBRC Circular has placed great emphasis on risk control for commercial banks intending to engage in the gold futures business. It requires that a commercial bank shall submit to the CBRC, within three days of applying to the gold futures membership exchange, documentary evidence that it has satisfied the conditions for engaging in the gold futures business, and two copies of a self-appraisal report on its risk control capabilities and internal control capabilities in respect of the gold futures business. In addition, commercial banks that have commenced a gold futures business must conduct a self-appraisal at least once a year on their risk control and internal control capabilities in respect of their gold futures business, and they shall submit such a self-appraisal report to the CBRC.

China Wall Requirement

The CBRC Circular requires commercial banks which engage in gold futures transactions to establish an internal “China Wall” to separate their trading business from their settlement and clearing (custodian) business so that the two groups will not be able to share sensitive market information. This is to prevent the trading departments of commercial banks from making undue profits from inside information gained by the banks from their acting as designated settlement bank and gold custodian.

Concerns of Commercial Banks

While actively preparing for the gold futures business, commercial banks have also raised some concerns in respect of gold futures trading:

(i) the level of margin deposit imposed by the Shanghai Futures Exchange is rather high, which could potentially increase their hedging costs;

(ii) the level of position held each settlement month is rather low, which may not fit well with the trading volume of some of the commercial banks;

(iii) there is only a limited range of products at the Shanghai Futures Exchange which can be used for settlement. At present, the total number of products available at the Shanghai Futures Exchange is only nine, while the Shanghai Gold Exchange has about 70 products for settlement. This could, potentially, result in a situation where gold purchased by commercial banks on the Shanghai Gold Exchange cannot meet the settlement requirements of the Shanghai Futures Exchange.

Obviously these issues are more of an operational nature, rather than a regulatory nature, and therefore will need to be addressed by the Shanghai Futures Exchange after commercial banks have been conducting gold futures trading for a while.

*About the Author

Liu Yi is a graduate of Beijing University Faculty of Law in Beijing, China. He was a partner of Junyi Law Office, a leading Chinese commercial law firm founded in 1995. In April 2007 he led the merger of Junyi Law firm with another Beijing-based Chinese law firm, forming Run Ming Law Office, where he is now an executive partner. He specializes in banking and finance, foreign direct investments, mergers and acquisitions. He is also an arbitrator at CIETAC.