On 3 December 2021, the People’s Bank of China (PBOC), the China Banking and Insurance Regulatory Commission (CBIRC), the China Securities Regulatory Commission (CSRC) and the State Administration of Foreign Exchange (SAFE) issued a set of draft rules governing the regulation of derivatives business in mainland China for public consultation.
Background
The Guidance provides for a wide range of regulatory requirements for regulated financial institutions conducting derivatives business, with the objective of promoting the healthy development of the onshore derivatives markets, protecting the rights of all relevant parties participating in such markets and preventing systemic risks. The Guidance lays out a comprehensive regulatory framework for the derivatives markets and consolidates the existing rules in this area.
The Guidance sets out a range of regulatory obligations on financial institutions conducting OTC derivatives business, including trade reporting and record keeping, investor protection (such as client suitability obligations, product assessment, selling practices and risk disclosures), internal control and governance and risk mitigation standards for the bilateral OTC derivatives market (including the promotion of central clearing, margin exchange and other requirements such as trade documentation).
In addition, the Guidance imposes requirements on related financial market infrastructure (FMI), such as the requirement to establish a robust and stable system to increase the efficiency of trading, clearing and settlement, and to provide objective, fair and transparent rules and procedures for the admission, trading, clearing of OTC derivatives. The Guidance also regulates trade associations and self-regulating organisations and imposes on them regulatory responsibilities such as the promotion of investor education.
We set out below a few notable points on the draft Guidance.
Scope of application
The Guidance is applicable to onshore licensed financial institutions which have been approved by the CBIRC and the CSRC in conducting “derivatives business” (Article 2)
The draft Guidance divides “derivatives business” into two categories: (i) exchange-traded business and (ii) over-the-counter (“OTC”) business. OTC business includes (i) derivatives business conducted by financial institutions in the organised OTC markets (such as the interbank market) and (ii) clientfacing OTC derivatives business such as one-to-one OTC transactions where a financial institution acts as the counterparty to an onshore enterprise, onshore individual or other onshore entity. Importantly, the Guidance seeks to regulate the OTC derivatives business of in-scope entities only and the regulatory requirements set out therein do not apply to exchange-traded business of financial institutions. The Administrative Regulation on Futures Trading will continue to govern futures products.
It is less clear how derivatives with embedded derivatives (such as structured notes, structured deposits, wealth management products and arguably some equity-linked instruments with embedded options and asset-backed securities) will fit into the regulatory environment introduced by the Guidance as they should possess the characteristics which define “derivatives”2 . Article 1 provides that trading in book-entry precious metals, commodities, foreign exchange, and other account-based products issued by financial institutions that do not involve the physical settlement of underlying assets will also be regulated with reference to the Guidance so it would appear that the Guidance would apply to structured products, structured deposits and wealth management products with embedded derivatives as well but further clarity would be helpful.
Client classification for the bilateral OTC derivatives market
The draft Guidance provides that financial institutions may only conduct bilateral OTC derivatives business with qualified investors in their client-facing OTC derivatives business (Article 7). The definition of “qualified investors” will be set out in detail by the relevant regulator. That article also sets out the suitability requirements, risk disclosure requirements, product design and other internal control and risk management requirements imposed on financial institutions in their client-facing OTC derivatives business.
The Article 7 requirements are broadly speaking investor protection measures for the bilateral OTC derivatives market. While these are useful measures when financial institutions conduct bilateral OTC derivatives trades with clients, the bilateral OTC derivatives markets are not confined to client trades. It would be helpful if the draft Guidance can clarify whether and how such investor protection measures will apply to bilateral OTC derivatives trades between financial institutions including cross-border institutional trades.
Dealing with individual investors
The draft Guidance provides, amongst other things, that financial institutions shall adhere to the principle that derivatives business should be carried out mainly for non-individual investors. Banks and insurance institutions are not allowed to carry out bilateral OTC derivatives transactions directly with individual clients, and shall not provide transaction services for non-hedging purposes to enterprises. Other financial institutions that need to provide derivatives transaction services to individual clients shall tailor more prudent participation requirements for individual clients (Article 8). That article then goes on to prescribe certain investor protection measures with respect to individual clients, including risk assessment and product and risk disclosure.
It appears that the Guidance will impose more stringent requirements on banks and insurance institutions in conducting derivatives business with individual investors. Since wealth management products are very common in the onshore markets with individual investors, it would be helpful for the regulators to clarify how the Article 8 restrictions and requirements apply to the wealth management business of financial institutions, or indeed whether it is their intention to include wealth management business within the scope of derivatives transactions under the Guidance. Separately, imposing a hedging purpose on derivatives trades when banks and insurance institutions deal with enterprises appear to create a non-level playing field: regulatory clarification on what “hedging” means and how this restriction will apply would be extremely helpful to the industry.
Cross-border derivatives business
The draft Guidance provides that financial institutions participating in (i) crossborder derivatives business or (ii) bilateral client-facing OTC derivatives business that involves hedging risks in the offshore markets, are required to follow the necessary reporting or approval procedures, control counterparty and trading venue risks, manage the concentration risk of transactions, and report any material incidents to the relevant financial administrative authorities in a timely manner, all in accordance with the relevant administration requirements of the CBIRC, the CSRS and the SAFE. Banks and insurance institutions are not permitted in principle to carry out cross-border OTC derivatives transactions for non-hedging purposes (Article 17). Under the current derivatives regulations applicable to banks, client-initiated trades and their related position squaring trades are categorised as non-hedging derivatives by banks. The prohibition of non-hedging cross-border derivatives may have unintended consequences in restricting banks’ ability to provide effective and meaningful risk management by way of derivatives to their onshore clients.
Article 17 also provides that the requirements imposed by the Guidance shall be referenced in foreign banks’ (onshore) branches when they conduct derivatives transactions and related activities. Offshore financial institutions participating in the onshore derivatives market shall comply with the regulations of the relevant financial regulator. In addition to the text of Article 17, the Accompanying Draft Notes also provides that the Guidance would apply to the onshore and offshore branches of banks and insurance institutions.
The Guidance therefore has a certain degree of extra-territoriality. The focus of the Guidance is on investor protection, risk management and internal governance and control of financial institutions when they conduct OTC derivatives business. Financial institutions are advised to formulate any response they have on the Guidance any by reference to the nature of these requirements. While it may make sense for some requirements to have an extra-territorial application, certain others may be best left to the regulations of the local jurisdiction(s) where the activities take place.
For further information, please contact:
Chin-Chong Liew, Partner, Linklaters
chin-chong.liew@linklaters.com
