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Kick off for China’s Risk Regime Focus China’s new derivatives regulations come into full force on December 1 after a nine-month transition period. But the regulations, in the early stages at least, are unlikely to lead to a dramatic shift in the way licensed banks do business. Nick Sawyer reports. 14 It’s been more than six months since China’s new derivatives regulations came into force in March. Since then, the country’s banking regulator, the China Banking Regulatory Commission (CBRC), has been inundated with licence applications from domestic financial institutions and foreign banks with branches onshore, all keen to get derivatives licences in place before the end of a nine-month transition period on November 31. Banks have spent the early part of the year getting to grips with the licensing procedure, clarifying any ambiguities within the new regulations, and working out their business models. The licences are now filtering through, with ABN Amro, Bank of Tokyo-Mitsubishi, Citigroup, Credit Suisse First Boston (CSFB), Deutsche Bank, HSBC, ING, Mizuho Bank and Standard Chartered among those to receive approval from the CBRC. But with the transition period now coming to an end, the new regulations will be tested in practice as the regime comes into full force as of December 1. From that date, only licensed financial institutions will be able to offer derivatives products onshore in China. The regulations, which were published in February after two years of consultations between the CBRC, foreign and domestic banks, and the International Swaps and Derivatives Association (ISDA), offer a broad definition of the term ‘derivative’, allowing licensed institutions to trade a wide scope of derivatives products without needing caseby-case approval from the regulator. The rules also specify which financial institutions can trade derivatives, set out the licensing procedure and outline risk management requirements for dealers. Under the regulations, approved financial institutions – defined as domestic banks, onshore branches of foreign banks, trust and investment companies, finance companies, financial leasing firms and auto financing companies – will be able to offer derivatives products directly to customers, including domestic corporates, as a dealer or market maker, as well as trade derivatives on their own account as an end-user. Targeting Chinese corporates For foreign banks, the regulations create something approaching a level playing field. Previously, offshore banks could trade foreign currency-denominated derivatives with Chinese financial institutions that had the appropriate foreign exchange licences, but were prohibited from tapping the corporate sector. Now, “Licensed foreign banks will be able to target Chinese corporates directly.” onshore branches of foreign banks with a derivatives licence will be able to target Chinese corporates directly, opening the way for a potentially dramatic increase in the universe of onshore counterparties. Nonetheless, in the near term at least, there’s unlikely to be a sea change in the way banks do business in China. Few foreign banks have the credit appetite to deal with the vast majority of small to medium sized corporates, while the absence of available credit data is likely to hamper attempts to put credit lines in place. Chinese banks, on the other hand, already have existing relationship with domestic corporates. “The market will be more competitive with the involvement of foreign banks,” says the head of derivatives trading at one of the major Chinese banks in Beijing, which has been granted a derivatives licence by the CBRC. “But there are still many advantages for Chinese banks to trade derivatives with Chinese corporates. One is the long business relationship between the banks and corporates, while some Chinese corporates have an internal rule whereby they can only deal with Chinese banks. Also, Chinese banks would generally price the credit charge for the corporate lower than foreign banks.” Foreign banks are, for the most part, likely to focus on the larger Chinese corporates and the Sino-foreign joint venture companies, many of which are subsidiaries of multi-national companies that already have credit lines in place with the foreign banks overseas. “Our focus will be on the larger corporates, for example, those we know already or have credit lines with,” says Shen Yan, managing director and head of fixed-income sales, non-Japan Asia, at CSFB in Hong Kong. “The first batch of customers we will be targeting are the multi-national corporations and the Chinese companies that have large international operations. With smaller companies, it will take time for us to get to know them better.” Several foreign banks are already beefing up their credit risk management departments with an eye to setting up credit lines with a wider range of corporate counterparties in China. However, it seems likely that the majority of foreign banks’ business will continue to be with domestic financial institutions, many of Shen Yan, CSFB, Hong Kong SWISS DERIVATIVES REVIEW 26 – NOVEMBER 2004
“There’s no rule saying banks can’t offer structured products.” Focus which hedge the derivatives transactions they conduct with corporate customers by trading back-to-back with foreign bank counterparties. “I’d say even a year after we have the derivatives licence, Chinese financial institutions will still make up 95% of the total notional of swaps we do onshore,” says one derivatives head, at a global bank in Hong Kong. Derivatives as tools for profit However, in another significant change to the regulatory regime, financial institutions will be able to use derivatives as end-users to generate profit. Under the previous regime, derivatives could only be used for hedging and not speculative purposes, a rule imposed by the country’s central bank, the People’s Bank of China (PBOC), in 1995. What’s more, if a transaction was judged to be speculative, the validity of the contract could be called into question. That’s what happened following the collapse China’s Guangdong International Trust and Investment Corporation (Gitic) in 1999, when a Chinese court ruled that several swaps transactions with foreign banks were speculative. The contracts were deemed invalid as a result, prompting some foreign banks to stop doing business with Chinese counterparties. The new regulations do not specifically repeal the 1995 PBOC Notice, and several banks and law firms have queried this point with the CBRC over the last few months. “That’s been one of the questions the banks have been asking the CBRC: can you state the PBOC 1995 Notice is no longer valid,” says one Hong Kong-based banker. “The official answer is that the CBRC cannot change the rules that other people make, but the regulations do say that where there is any discrepancy between the new rules and previous regulations, the new rules shall prevail. So that has given us some comfort.” However, while many of the uncertainties in the regulations have been clarified, there are still some aspects of the new regulations that are causing some confusion. For instance, while it’s clear that financial institutions are allowed to use derivatives for generating profit, does the ‘hedging only’ requirement still apply to Chinese corporates? The CBRC only regulates financial institutions, so makes no reference to whether corporates can use derivatives as a means to enhance yields on excess cash through the use of structured investment products. “It’s not dealt with in the rules. The rules only apply to financial institutions,” says Chin-Chong Liew, partner in the derivatives practice at law firm Allen & Overy, in Hong Kong. “There’s no single law that makes it clear, but looking at other laws and requirements and understanding the regulatory framework, you come to that conclusion [that they can only use derivatives for hedging].” Self-regulation to fill the gap? Others, however, argue that there is some scope for the selling of structured products to corporates in deposit or note form, so long as banks are careful in their due diligence procedures, ensure the product is suitable for the firm and appropriate authorisation is obtained from board members. “At least as far as the [derivatives] regulations are concerned, there’s no rules saying banks can’t [offer structured products to corporates],” comments another Hong Kong banker. “But we would look to do principal protected products, we would also look as to how big a percentage of the corporate’s capital is at risk, and we would look at whether the corporate had proper authorisation from senior management or even the board of directors. We would probably look on this to be self-regulatory as it is in Hong Kong or the US, rather than rely on a set of rules emerging.” The regulations themselves do set out a list of due diligence requirements for financial institutions conducting derivatives in China. Dealers must assess the suitability of their counterparties and determine whether they understand the risks and whether the transaction meets their business objective. The regulations state that dealers can to some extent rely on written documents provided by the counterparty in “good faith”. When it comes to corporates, the bank must disclose the risks and outline various scenarios that could lead to losses. They also need to obtain a letter of confirmation from clients stating that they are aware of the risks involved in the transaction. However, there has been some question over the level of detail required, what format the confirmation should take, and whether this information will be sufficient to prove customers were aware of the risks in a Chinese court. “I don’t think the regulators themselves have so far established what the criteria really mean, and ultimately it will be for a court to decide,” says Paget Dare Bryan, partner at law firm Clifford Chance, in Hong Kong. “Therefore playing it safe is going to be the best advice you can give to a client. Banks need to consider the risk warnings very seriously and apply them to the deal they are actually looking at, rather than the generic wording that they might be more used to using in interbank trades.” Questions also remain on the products banks are allowed to structure under the new regulations. While the rules themselves are very broad in their definition of derivatives, the CBRC states that a financial institution engaging in derivatives involving foreign exchange, stocks, commodities or exchange-traded derivatives must comply with other applicable regulations. As it stands, banks are barred from conducting equity and commodity transactions, both regulated by the China Securities Regulatory 15 SWISS DERIVATIVES REVIEW 26 – NOVEMBER 2004
Page 1 and 2: SWISS DERIVATIVES ISSUE 26 - NOVEMB
Page 3 and 4: Contents Contents SWISS FUTURES AND
Page 5 and 6: Dear Members and Friends of SFOA Ed
Page 7 and 8: Focus Treasury. Then came Ginnie Ma
Page 9 and 10: “This approach moves us in the di
Page 11 and 12: WHEN YOUR FIRST NAME IS “NEW,”
Page 13: Focus Union’s regulators in terms
Page 17 and 18: The rush of endless opportunity. Li
Page 19 and 20: Further your future: team up with a
Page 21 and 22: “Investor interest in gold was re
Page 23 and 24: A new standard in the derivatives i
Page 25 and 26: “The Stone Age didn’t end becau
Page 27 and 28: A blazing sponsor for Friday night
Page 29 and 30: CNBC Europe reporting live from Bü
Page 31 and 32: A fascinating presentation by ballo
Page 33 and 34: “Swiss taxation is very advantage
Page 35 and 36: “These results seriously question
Page 37 and 38: D O W J O N E S I N D E X E S THE D
Page 39 and 40: “ ‘Carry’ strategies and even
Page 41 and 42: Education Chart 2 Overbought zone (
Page 43 and 44: Bollinger Bands Let’s briefly rev
Page 46 and 47: Emerging Markets A Perspective on E
Page 48 and 49: Profile IFRI - The International Fi
Page 50 and 51: Profile 50 Official Publication of

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