Risk and reward in the China derivatives market

More excitingly for foreign banks in the renminbi exchange rate regime, the PBOC's Circular on Issues Relevant to Accelerating the Development of the Foreign Exchange Market (关于加快外汇市场有关问题的通知) increases market participants and market transaction models, diversifies trading instruments by allowing foreign and domestic banks with foreign exchange business licence to offer cross-currency swaps to customers. By 2005, infrastructure had been established for official entry of derivative instruments into the Chinese foreign exchange spot and forward markets.

Recent highlights in the derivatives markets
Since the PBOC loosened restrictions on renminbi forwards and cross-currency swaps in 2005, the inter-bank market is providing an increasingly smooth avenue to offset risks in currency-related transactions. Also, the growth of derivative transactions in China has been reinforced through the 2008 crisis. Chinese regulators have paid heed of effective measures in managing risks from derivative transactions based on interest rate, exchange rate and commodity prices. Meanwhile, Chinese enterprises have proven their thirst for new investment instruments and expressed willingness to utilise derivative products against risks from conducting cross-border transactions, particularly those of renminbi interest rate and exchange rate derivatives. As such, these enterprises adopt complex offshore derivative products underlying renminbi, such as constant maturity swaps (CMS), to lower their trading costs.

Concerned with potential risks affiliated with the complexity of the derivative products and sophistication of the counterparties, the Chinese regulators currently prefer relatively simple derivative products in the Chinese market, renminbi-based in particular; neither does the market expect complex derivative products linked to offshore indicators that draw in additional risks to the transactions. Hence in July 2009, the CBRC promulgated the Circular on Further Strengthening the Risk Management of Derivative Product Transactions between Banking Financial Institutions and Institutional Clients (关于进一步加强银行业金融机构与机构客户衍生品风险管理的通知).

Highlights of the Circular's requirements
The Circular incorporates broad categories of practices regarding know-your-customer (KYC) procedures, risk disclosure, marketing activities and materials, post-transaction evaluation and documentation for policy banks, state-owned commercial banks, joint-stock commercial banks and postal savings banks (Banks) in dealing with their non-financial institutional clients. While the Circular is primarily directed toward domestic Banks, local offices of the CBRC are required to forward the Circular to the Chinese branches or subsidiaries of foreign banks located within their jurisdictions.

KYC procedures
The Circular requires Banks engaged in the derivatives business to formulate and improve client assessment systems and to assess the propriety of the particular derivative transaction in light of the character of the client and the type of derivative product marketed in every transaction. This assessment takes the form of a two-pronged approach. The first prong requires Banks to assess the risk and complexity of the derivative product being transacted. The second requires Banks to evaluate the level of sophistication and expertise of the institutional client involved. Both assessments must be reviewed on a yearly basis. Banks should proceed with derivatives transactions only after determining that the institutional client's sophistication and expertise suits the level of risk and complexity of the derivative product involved.

In addition, Banks may only conduct derivatives transactions with institutional clients with a “legitimate need” for the derivative product sought. The derivative transaction must be “directly relevant” to the underlying assets/liabilities which constitute the legitimate need. The main risk profile of the derivative transaction must have “reasonable relevance” to the main risk profile of the underlying assets/liabilities. The Circular also stipulates that renminbi debts of an institutional client may not serve as the basis of “legitimate need” for derivative transactions linked to non-renminbi market indices.

Risk disclosure
The Circular requires Banks to provide institutional clients clear, concise, and easy to understand written materials regarding the derivative product and the underlying risks associated. Among other disclosures, compliance with risk disclosure obligations require Banks to provide an introduction of the product's structure and the basic terms and integral legal text of these products, instructions for the index, yield rate and other indicators linked to the products, disclosure of the main risks associated with the transaction, cash flow analysis, stress test, simulative analysis of worst case scenarios under certain assumptions and confidence, loss of cash flow and analysis of the rationality of such assumption.

Marketing activities and materials
The Circular places limits on puffing during the sales process, requiring that Banks describe the proceeds and risks of the derivative products being sold in an objective and fair manner, not mislead client's opinions of the market, or exaggerate the strengths or diminish the weaknesses of the product. Banks are prohibited from making guarantees regarding the profitability of the product being marketed. In addition, Banks shall fully respect an institutional clients' independent and autonomous decision-making process and shall not piggy-back a derivative product onto another financial product being marketed by the Bank or as a condition for conducting business with an institutional client.

The Circular restricts Banks from conducting joint marketing activities promoting derivative products with sales agents employed by non-PRC registered entities or engage in joint promotion activities through veiled means. Banks are also barred from accepting direct designation by any institutional client of a non-PRC registered entity as the counterparty to the Bank as an intermediary to a back-to-back derivative transaction (Intermediated Sales). According to public comments issued by the CBRC, Intermediated Sales were oftentimes driven by sales agents of foreign financial entities and many tended to be highly leveraged, overly complex and lacking transparency. It is believed that Intermediary Sales may play in role in preventing Banks from selecting the most appropriate counterparties for derivative product transactions and limits their ability to control risks effectively. A further rationale for prohibiting joint marketing arises from its capacity to create confusion among institutional clients with respect to the rights and obligations of Banks and foreign financial institutions. Although the Circular only applies to Banks, CBRC comments encouraged foreign financial institutions to enhance the management of their derivative product sales agents and prevent them from conducting veiled marketing activities through training, consultation, or seminars. The CBRC official, however, pointed out that the sharing of professional expertise in derivative products and other non-marketing activities of Banks and non-sales agents of foreign financial entities would still be allowed.

Post-transaction evaluation
After the completion of a derivatives transaction, the Circular requires Banks to provide clients with updated market information regarding the derivatives product transacted in written form using communication methods that are capable of being verified (such as mail, email or fax) on a monthly basis. In times of greater market volatility, Banks are required to increase the frequency in which market reports are provided to their clients.

The evaluation system should allow communications between internal management and clients on a regular basis, through which Banks seek to incorporate clients' feedback on sales compliance and disclosure. All means of communication shall be achieved by recordable methods as part of the post-transaction evaluation mechanism.

Documentation
The PBOC, in conjunction with Nafmii, drafted a set of standardised legal documents for the purpose of enabling counterparties to “take out of the brackets” to the greatest extent possible according to each specific transaction. Terms and financial figures vary with rounds of negotiations, yet standardised documents significantly reduce the negotiation period and form mutual trust on the basis of the neutrality of the original terms. General documents required for the Chinese derivatives market include:

• 2009 Nafmii Master Agreement
• Supplemental Agreement
• Effective Transaction Agreement
• Nafmii Pledge Performance Assurance Document
• Nafmii Title Transfer Performance Assurance Document
• Nafmii Definition Document

The 2009 Nafmii Master Agreement is adopted to avoid overlapping scope of application by the 2007 CFETS Master Agreement and the 2007 Nafmii Master Agreement. It sets uniform Chinese standards for the documentation of over-the-counter (OTC) financial derivatives products in China, and lays foundation of dialogue for Chinese financial institutions to engage themselves in not only onshore OTC derivatives transactions, but also cross-border derivatives transactions.

It is noted that the 2009 Nafmii Master Agreement generally is not required for non-renminbi derivatives transactions; however, two types of non-renminbi derivatives transactions must be documented under this Agreement: renminbi-FX related transactions that used to utilise the 2007 CFETS Master Agreement as their principal document and renminbi interest rate swap and forward rate transactions that previously adopted the old version of the Nafmii Master Agreement.

Looking forward
The CBRC set a deadline for Banks in the business of derivative product transactions to submit their implementation proposals in accordance with the Circular by October 31 2009. Foreign financial institutions are restricted from dealing directly with domestic counterparties in offshore derivative transactions, provided that such domestic counterparties are not licensed in the business of derivative transactions. They may, however, obtain access to the offshore derivative transactions with domestic banks, insurance companies, Safe, the Ministry of Finance, China's Social Security Fund, and those who hold derivative business licences issued by the relative Chinese authorities. Clarification has been called for in terms of categories, service scopes and structures of portfolios.

Calvin Ding, associate, Greenberg Traurig; and Wei Huang, attorney-at-law, China Banking Regulatory Commission