Bucking the trend: Derivatives market liberalisation in China

In contrast to regulatory efforts in the US and Europe, China’s lawmakers are pushing for greater liberalisation of domestic derivatives, as Isda’s Jing Gu writes

In international markets, insurance companies and securities companies have been important players in the over-the-counter derivative sector for a while – but not in China. Financial derivatives have been viewed primarily as banking products since they first appeared in China. Banks have not only used OTC derivatives to hedge their own assets or liabilities but also provided hedging products to corporates and sold a variety of structured wealth management products to individual investors. However, things have started to change now and Chinese banks may soon find themselves facing competition from a group of newcomers.

Until the China Securities Regulatory Commission (CSRC) issued the “Provisions on the Investment Scope of the Proprietary Trading Business of Securities Companies and Related Issues” (the “Proprietary Business Regulation, or PBR”) in April 2011, it was not clear what OTC derivatives transactions a Chinese securities company could conduct. In practice, some securities companies entered into RMB interest rate swaps for hedging purposes after consulting CSRC. The PBR provided clarification on this point and confirmed that securities companies may enter into derivative transactions for hedging purposes.

The regulation sets out a list of financial products which a securities company may invest in for its own proprietary business. For any financial product not listed, the securities company would have to set up a subsidiary to invest in the product, for which it may not provide financing or security. Accordingly, any derivatives transactions which are not for hedging purposes would have to be pushed out to a subsidiary – much like the “swaps pushout rule” under the US Dodd-Frank Act.

The drive for derivatives

In the past year, CSRC has embarked on a big effort to promote innovation in the securities industry, including encouraging the development of derivatives. Working groups were set up to study OTC equity derivatives and a proposal made to remove the hedging requirement for certain qualified securities companies. On October 31, 2012, CSRC issued a consultation paper on amendments to the PBR.

The proposal allows firms with a proprietary securities business qualification to enter into exchange-traded or OTC financial derivatives transactions regardless of whether these are for hedging purposes. For non-qualified firms the rules are unchanged. The proposed amendments to the PBR came into effect on November 16, 2012.

Policies over derivatives trading by insurance companies were relaxed on October 23, 2012 when the China Insurance Regulatory Commission (CIRC) issued their first piece of regulation on this issue – the “Interim Measures on Insurance Funds’ Participation in Financial Derivatives Trading” (the “Interim Measures or IM”). According to the IM, PRC-incorporated insurance (holding) companies, insurance companies and insurance assets management companies (“insurance institutions”) are allowed to enter into financial derivatives transactions for hedging purposes¹.

In addition to derivatives trading in the domestic market, CIRC also permitted insurance companies to trade financial derivatives in international markets in its long-awaited “Implementing Rules of the Interim Measures on Overseas Investments by Insurance Companies” (the “Implementing Rules, or IR”). Qualified insurance companies are now permitted to trade interest rate forwards, interest rate swaps, interest rate futures, forex forwards, forex swaps, stock index futures and stock index call options and other types of derivatives for hedging purposes².

These transactions are subject to four rules. Firstly, speculative trades are prohibited: the aggregate value of the derivatives transaction cannot exceed 102% of the value of the underlying assets. The option fees, expenses and security deposits paid in a transaction in aggregate cannot be more than 10% of the value of the underlying asset. Derivatives transactions should be marked-to-market on a daily basis and the exposure to each counterparty cannot exceed 1% of the total assets of the company in the previous year. And finally the counterparty has to sign an Isda Master Agreement with the manager of the insurance fund and the master agreement has to be authorised by the insurance company.

Insurance companies are prohibited from investing in physical commodities, precious metals, certificates representing precious metals, or commodity derivatives under the IR. They are also prohibited from obtaining financing from securities institutions for the purpose of buying securities or naked short selling.

The relaxation of the policies on financial derivatives trading in China goes against the tide of current regulatory trends in the EU and US. It is encouraging to see that Chinese regulators have realised that the financial market in China faces very different issues from those in the US and EU and have continued their efforts in market liberalisation. It remains to be seen how rapidly the derivatives business of Chinese firms will grow as there are a number of infrastructure issues that need to be dealt with before the market can take off. What we do know is that there have to be sound risk management practices and processes in place for China’s financial derivatives market to develop in an efficient and sound manner.

Jing Gu is assistant general counsel, Asia at the International Swaps and Derivatives Association, based in Hong Kong

¹ The permissible hedging transactions are defined in article 5 of the IM. The definition appears to be more flexible and wider than the hedging concept previously understood in the domestic market

² See article 29 of the Implementing Rules