China releases derivatives guidelines

China’s banking regulator has finally published its long-awaited derivatives guidelines, bringing to an end 18-months of stop-start consultations with the banking sector and removing some of the legal uncertainties that have plagued the country’s derivatives market.

The new rules, which will come into force on March 1, specify which financial institutions can trade derivatives – including Chinese banks, foreign financial institutions, trust and investment companies and financial lease companies – and outline the licensing procedures and risk management requirements for derivatives traders.

Under the new guidelines – first mooted as a draft consultation document in July 2002, before disappearing from view until last October, when new draft guidelines were published – financial institutions will be able to trade foreign currency-denominated interest rate, credit and currency derivatives on behalf of clients and on their own account once they have received approval from the country’s regulator, the China Banking Regulatory Commission (CBRC).

In a change from the October draft guidelines, the finalised regulations stipulate that financial institutions can use their own assets to conduct ‘profit-oriented’ transactions, an inclusion which will radically change the scope of the Chinese derivatives market. Under the current regulatory framework, derivatives transactions can only be used for hedging and cannot be used for speculative purposes, a rule that has been in place since 1995. In last October’s draft, this was changed to allow banks to conduct ‘arbitrage-like’ transactions, a phrase felt to be too narrow by some observers.

“The fact that it talks of profit-oriented is better than arbitrage, because with arbitrage, it could be interpreted that banks are still not able to take any market risk,” says Chin-Chong Liew, a partner at law firm Allen & Overy in Hong Kong. “Now it’s profit-oriented it seems to indicate that so long as your purpose is to make profits, then you should be able to take market risk.”

Elsewhere, the regulations confirm risk management and personnel requirements outlined in the previous drafts. Licensed institutions must have sound risk management and internal control systems, along with an accounting system for derivatives transactions. In addition, the dealer must ensure the derivatives product is suitable for that client, does not exceed its risk appetite and meets its objectives. In a change from the October draft, however, the final document elaborates on what information that bank needs in order to fulfil its due diligence obligations.

While the new rules come into effect next month, there is a six-month transition period during which financial institutions can apply for licences. “Until the end of that six-month period, life goes on as normal and you can rely on existing rules,” adds Liew.