Banks face heavy workload under new derivatives rules

China's banking regulator has issued a new rule imposing new requirements on domestic banks, and domestic branches of foreign banks, which engage in derivatives transactions.

The Notice on Further Strengthening Risk Management for Derivatives Transactions between Banking Financial Institutions and Corporate Clients (关于进一步加强银行业金融机构与机构客户交易衍生产品风险管理的通知) was issued by the China Banking Regulatory Commission (CBRC) on July 31 2009 and is likely to have a significant effect on banks' activities.

“It will have a substantial impact on compliance procedures for onshore banks that are selling or entering into derivatives transactions with their onshore corporate clients,” said Minny Siu, partner of Mallesons Stephen Jaques' derivatives/structured products team in Hong Kong.

“[Those banks] will need to immediately review their compliance procedures … That itself will impose a high workload,” she added.

Banks have been documenting their procedures using international industry standard documents – such as National Association of Financial Market Institutional Investors (Nafmii) or International Swaps and Derivatives Association (Isda) – but, according to Siu, the Notice contemplates a further step to help onshore clients understand derivatives products.

The CBRC's issuance of the Notice is consistent with Chinese regulators' recent efforts to strengthen risk management in onshore banks and prohibit speculation in the onshore derivatives market. Kennies Fung, a Mallesons senior associate in Shanghai, said the Notice also expressly requires banks to make sure their corporate customers are entering into derivatives transactions for hedging purposes only.

Another part of the Notice is seen as particularly relevant to foreign banks: derivatives' sales activities must only be carried out by staff employed by the onshore bank. Onshore banks are now prohibited from jointly promoting derivatives products with salespeople employed by offshore entities, ending the kind of joint promotion that was previously popular among foreign banks. Those institutions also relied on back-to-back hedging with their offshore entities, but the Mallesons lawyers say the Notice conveys another message from the government: banks should develop their own valuation modelling system for their onshore derivatives products.

“Currently, not all foreign banks have a pricing system in place in China,” said Fung.

As well as putting in place internal compliance procedures, risk evaluation processes and pricing models that please the regulator, the new Notice also requires onshore banks to:

• recalculate the market value of the derivatives at least once a month 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; and
• make sure all staff are properly trained and all salespeople are properly authorised to promote the products.