On November 17, 2023, the China Securities Regulatory Commission (“CSRC”) released the Measures for the Supervision and Administration of Derivative Trading (Second Consultation Draft) (the “Second Draft”, and its final version is referred here as the “Measures”) and the corresponding drafting statement (the “Drafting Statement”), wherein CSRC reiterated and clarified the guiding principles and considerations when formulating these Measures.
Pursuant to the Drafting Statement, these Measures were formulated to implement the relevant requirements of the Futures and Derivatives Law of the People’s Republic of China (“FDL”) and to establish a unified regulatory framework of the OTC derivative market. They reflect a strengthening of the supervision of the OTC derivative market and prevent and resolve financial risks. When drafting these Measures, the CSRC considered the regulatory approaches of “regulation by function” and “integrated regulation”. “Regulation by function” means that the same rules shall apply to all activities of the same type, and that any breach of those rules would lead to legal liabilities. “Integrated regulation” reflects the regulatory need to strengthen the integrated supervision of the physical market (i.e., the stock market) and the derivative market, as well as the integrated supervision of the exchange-traded derivative market (i.e., futures market) and the OTC derivative market, to eliminate regulatory differences and prevent regulatory arbitrage.
The Drafting Statement highlights that the CSRC has set out an independent chapter called “prohibited trading activities” (Articles 15 to 22) to prohibit any activity that is either illegal or intends to circumvent regulation by entering into a derivative transaction. It also highlights that a real-name account regime shall be established for derivative trading, derivative operation institutions shall open real-name accounts for trading institutions according to unified requirements provided by derivative trade repositories, and trading institutions shall be prohibited from lending their trading account to or borrowing the trading account of others. The real-name account regime may facilitate cross-market supervision and monitoring and help to increase the transparency of derivative market.
These Measures only apply to derivative trading and related activities within the jurisdiction of the CSRC and shall exclude interbank derivative markets and OTC derivative markets organized by banking and insurance financial institutions. In addition, considering the particularity of exchange-traded credit derivatives, the CSRC may formulate special provisions for credit derivatives, leaving space for future rulemaking.
We set out below the major changes proposed by the CSRC to certain key provisions by reference to our written comments that have been submitted to the CSRC for the First Draft and share with our clients our interpretations and observations.
| Consolidated Positions of Derivative Trading and Futures Trading | ||
| First Draft v.s. Second Draft | JunHe’s Submission on First Draft | |
| 1. Art. 9 v.s. Current Art. 13 | 1. …We understand that it is uncommon in other jurisdictions to apply position limits to OTC derivative trading…. 2. …Clarification is needed as to the purpose behind aggregating positions of futures with OTC derivative contracts as they are currently regulated separately. | |
| Our Interpretations and Observations | ||
| We are pleased to see that the Second Draft adopts relevant suggestions and removes the previous Article 9 of implementing position limits and large position reporting regimes on derivative trading. However, the Second Draft retains the requirements of aggregating positions of derivative and futures trading when implementing the position limits and large position reporting regimes for futures trading. According to the Drafting Statement, the CSRC points out that this is to improve the position limits and large position reporting regimes that have already been adopted for the futures market and prevent any evasion of regulations applicable to the futures market through derivative transactions. In our view, this means that futures exchanges may look through derivative trading and apply the “consolidated positions” to determine whether relevant trading institutions have complied with the position limits and large position reporting regimes for the futures market. | ||
| Trading Information Reporting Mechanism | ||
| First Draft v.s. Second Draft | JunHe’s Submission on First Draft | |
| 2. Art. 12.3 v.s. Current Art. 11.3Derivative operation institutions shall record the | …It is unclear how derivative operation institutions should report the relevant trading information, including the reporting procedures and reporting templates. To ensure the operability of Article 12.3, more implementation details are expected to be formulated by the relevant exchanges. We suggest the relevant exchanges consider consulting the public and allowing sufficient time for market participants to ensure their readiness for reporting obligations. | |
| Our Interpretations and Observations | ||
| The Second Draft slightly adjusts the requirement of derivative operation institutions for recording and reporting information on the derivative contracts relating to hedging transactions, namely, it amends the general recording scope of “data and information” to only “information” and removes “trading strategy” from the recording scope. This reflects the CSRC’s response to market participants’ comments that the“trading strategy” may vary trade-by-trade, which is not capturable data, and derivative operation institutions are not aware of the trading strategy of their clients on a trade-by-trade basis.Notably, it still requires further clarification or detailed implementation rules on how offshore derivative operation institutions may discharge their trading information recording obligations. We will closely monitor any practice or regulatory developments as to when relevant exchanges would require derivative operation institutions to report relevant information. | ||
| Consolidated Positions of Derivative Trading and Physical Trading of Underlying Assets | ||
| First Draft v.s. Second Draft | JunHe’s Submission on First Draft | |
| 3. Art. 14 v.s. Current Art. 14For the performance of information disclosure obligations or in the acquisition activities or other activities, a derivative contract held by a derivative operation institution or a trading institution with the stocks of a listed company or a company whose stocks are traded on any other national securities trading venue approved by the State Council (the “underlying stocks”) that have voting rights as the underlying assets shall be calculated in aggregate with the underlying stocks directly or indirectly held by the derivative operation institution or trading institution in accordance with the provisions of the securities trading venue. | 1.We understand that Article 14 sets forth the requirement for aggregating physical stock positions with stock positions held indirectly through OTC derivative transactions for the purpose of information disclosure and listed-company acquisition activities. In practice, certain counterparties of derivative trading may not have the voting rights and investment decision-making power over the underlying assets. We would suggest the CSRC explicitly specify such circumstances when “consolidated positions” are not required.2.As provided under Article 14, “consolidated positions” shall apply to information disclosure and listed company acquisition activities. We suggest the CSRC clarify that the calculation of “5% shareholders” for the purpose of short-swing profit restrictions and the application of Article 21.1 of this First Draft shall not include derivative positions. | |
| Our Interpretations and Observations | ||
| The CSRC clarifies in the Second Draft that only where the derivative contract is linked to listed shares with voting rights, such derivative trading positions shall be calculated in aggregate with the physical trading positions of such underlying listed shares.We have advocated to exclude derivative transactions where no voting rights and investment decision-making powers are passed on when aggregating derivative trading positions with physical trading positions of the same listed shares. The Second Draft provides only limited exemptions of aggregation, i.e., only listed shares without voting rights can be disaggregated. We suggest that the CSRC consider other exempted circumstances, such as, where a trading institution does not have the relevant voting rights and investment decision-making power over the underlying listed shares under the derivative transaction entered into with the derivative operation institution.Besides, the CSRC does not adopt the comment that “consolidated positions” should not apply to the calculation of “5% shareholders” under the short-swing profit rules as well as the relevant provisions of the Measures. We expect that the CSRC may take a strict view and apply the “consolidated positions” to the calculation of “5% shareholders” under the short-swing profit rules as well as the relevant provisions of the Measures. | ||
| Prohibited Derivative Trading Activities | ||
| First Draft v.s. Second Draft | JunHe’s Submission on First Draft | |
| 4. Chapter 3 v.s. Current Chapter 3 | We note that Chapter 3 has codified the existing self-regulatory rules and normative documents on prohibited OTC derivative trading activities (such as OTC options and swaps). We understand these existing self-regulatory rules and normative documents reflect the “enhanced regulation” and impose high requirements on domestic securities companies (and other operation institutions) to prudently carry out derivative business, which is adaptive to the current market development stage. However, since the Measures, as administrative regulations, have a higher legal effect, the relevant provisions should be more stable. We suggest the Measures be distinguished from time-sensitive self-disciplinary rules or regulatory policies, and only provide for illegal acts that are contained in the current laws and administrative regulations, such as illegal acts related to information disclosure, short-swing profit rules, fraud, insider trading, and market manipulation, rather than acts that breach self-disciplinary rules or normative documents. | |
| Our Interpretations and Observations | ||
| The CSRC does not adopt the comment that the circumstances prohibited under these Measures should be limited to illegal acts that are explicitly specified in the current laws and administrative regulations. This indicates the CSRC’s intention to strengthen derivative market regulation. It is reasonably certain that these prohibited derivative trading activities under the current Chapter 3 will be retained in the final version of the Measures. | ||
| The Prohibition of Evading Shares Selling Restrictions and Enhancing Derivative Operation Institutions’ Obligations | ||
| First Draft v.s. Second Draft | JunHe’s Submission on First Draft | |
| 5. Art. 19 v.s. Current Art. 19It shall be prohibited to circumvent the shareholding reduction rules and restricted shares rules through derivative trading.Art. 21 v.s. Current Art. 21A derivative operation institution shall be prohibited from engaging in derivative trading with shareholders of a listed company who holds 5% or more shares of such listed company, the de facto controller, directors, supervisors, and senior management personnel of such listed company, or with the shareholders who hold lock-up shares or restrictive shares if the underlying assets of the derivative trading are stocks of such listed company.When the above paragraph applies, the shares held by a shareholder of the listed company and its persons acting in concert shall be calculated in aggregate.A derivative operating institution shall | Article 21 expands the prohibited target clients under the current self-disciplinary rules1 to include any shareholders who hold lock-up shares or restrictive shares and widely prohibits derivative operation institutions from entering derivative transactions with them. We believe this restriction may have a negative impact on the legitimate trading activities of market participants. Additionally, it may be more appropriate to put Articles 19 and 21 under self-disciplinary rules or normative documents, to clearly define the boundary of illegal acts and violations. | |
| Our Interpretations and Observations | ||
| Though we highlighted to the CSRC that the stringent restrictions under the previous Articles 19 and 21 may have a negative impact on the legitimate trading activities of market participants, the previous Articles 19, 21 and 20 have been retained in the Second Draft as follows: (1) It shall be prohibited to circumvent the shares selling restrictions of lock-up shares and restrictive shares through derivative trading (current Article 19). (2) (i) A derivative operation institution shall be prohibited from engaging in derivative trading with shareholders of a listed company who hold 5% or more shares of the listed company, the de facto controller, directors, supervisors, and senior management personnel of the listed company, or with shareholders who hold lock-up shares or restrictive shares if the underlying assets of the derivative trading are stocks of the listed company. (ii) When the above (i) applies, the shares held by a shareholder of the listed company and its persons acting in concert shall be calculated in aggregate. (iii) A derivative operating institution shall verify the real identity and the trading purpose of a trading institution and shall not conduct the transactions as provided in paragraph (i) with any persons specified in the preceding paragraphs (i) and (ii), or with the relevant products, legal persons and partnership enterprises controlled or established by them (current Article 21). (3) A derivative operation institution or trading institution shall be prohibited from concluding derivative trading with a counterparty when they know or ought to know that the counterparty conducts any of the prohibited activities as provided in Articles 15 to 21 hereof through derivative trading (current Article 22). This reiterates the CSRC’s attitude towards cracking down on the evasion of selling restrictions of lock-up shares and restrictive shares through derivative transactions. In the current market environment, it seems certain that the Measures will eventually be promulgated to include those provisions.Notably, the CSRC sets forth relatively higher KYC and compliance requirements for derivative operation institutions, i.e. derivative operation institutions are obliged to verify a client’s real identity and trading intention, and shall not enter into derivative transactions referencing the shares of a listed company with such listed company’s shareholders who are subject to various share selling restrictions, nor with the relevant products, legal persons and partnership enterprises controlled or established by them. If a derivative operation institution or trading institution enters into a derivative transaction with a counterparty when they know or ought to know that the counterparty conducts any of the prohibited activities, both contractual parties may be held liable for the breach of the regulation. | ||
| Overseas Institutions Engaged in Derivative Business in the PRC | ||
| First Draft v.s. Second Draft | JunHe’s Submission on First Draft | |
| 6.Art. 50.1 v.s. Current Art.48 | Form a legal perspective, we believe that the previous Article 50.1 may be regarded as imposing an administrative licensing requirement beyond the authorization of the FDL. …The FDL does not provide for an explicit administrative licensing requirement for overseas institutions engaged in derivative trading business in China …. | |
| Our Interpretations and Observations | ||
| The CSRC has adopted our comment and removed the previous Article 50.1 that required an overseas operation institution engaged in derivative trading business in China to obtain approval from the CSRC and to comply with the provisions of these Measures. | ||
| Different Scenarios That Trigger Extraterritorial Effects | ||
| First Draft v.s. Second Draft | JunHe’s Submission on First Draft | |
| 7. Art. 50.2 v.s. Current Art.48Where an overseas operation institution | … We suggest that the extraterritorial effect of the previous Article 50.2 should only apply to offshore derivative trading if there is a “disruption of the domestic market order and damage to the legitimate rights and interests of domestic traders” as provided by Article 2.2 of the FDL …. | |
| Our Interpretations and Observations | ||
| Pursuant to the Drafting Statement, the CSRC stated the purposes of the previous Article 50.2 are (i) to implement Article 2.2 of the FDL, which provides that “derivative trading and related activities that take place outside the PRC and disrupt domestic market order and damage the lawful rights and interests of domestic traders shall be handled and investigated for liabilities according to the FDL”, and (ii) to apply regulations equally to both domestic and overseas institutions so as to prevent regulatory arbitrage.The current Article 48 clarifies the extraterritorial effect from the following two aspects: (i) the current Article 11 shall apply to an overseas operation institution where it conducts derivative trading outside the PRC but conducts the relevant hedging transactions within the PRC, that is, such an overseas operation institution shall perform the information recording and reporting obligations according to the current Article 11; and (ii) the current Articles 13 to 22 shall apply to offshore derivative trading as long as such derivative trading “relates to domestic underlying assets”, regardless if the relevant hedging transaction takes place within the PRC or not.These amendments deliver a clear message to the market: all foreign participants shall avoid conducting any kind of activity that uses derivatives as a “channel” to circumvent regulation, for example, the three major types of activity explicitly prohibited by the current Articles 13 to 21: (i) not circumventing position limits, information disclosure requirements, or selling restrictions of lock-up shares and restrictive shares through derivative trading; (ii) not carrying out short-swing profit trading, insider trading, and market manipulation through derivative trading; (iii) derivative operation institutions should not enter into derivative transactions, with respect to the stocks of a listed company, with any of its major shareholders, de facto controllers, directors, supervisors, and senior executives, or with any of its shareholders who hold lock-up shares or restrictive shares of such listed companies. | ||
1. We note that under the current self-disciplinary rules of the Securities Association of China (SAC), securities companies are prohibited from conducting swap transactions or OTC options with so called “sensitive clients” that hold shares of a listed company, if the underlying assets of the swap transaction are the shares of such listed company. (See Article 32 of the Management Measures for the Swap Business of Securities Companies; Article 37 of the Management Measures on the OTC Option Business of Securities Companies.)
