China's derivatives market

March 2006 marked the second anniversary of the date on which the rules on derivatives business by financial institutions in the PRC came into effect.
March 2006 marked the second anniversary of the date on which the rules on derivatives business by financial institutions in the PRC came into effect.

When they were issued by the China Banking Regulatory Commission (CBRC), the rules represented a significant shift in the official attitude towards derivatives, at least as far as financial institutions were concerned. Previously, such institutions could only engage in derivative transactions for ôhedgingö purposes but not for ôspeculativeö purposes pursuant to a circular issued by PeopleÆs Banks of China in 1995. The general rule of thumb, which still applies to corporates, was that derivatives could only be entered into for hedging purposes.

Now, upon obtaining derivatives approval from CBRC, PRC financial institutions can trade derivatives either to hedge against risks or to make a profit.

To date, most of the approvals have been issued to banks in the PRC, including foreign bank branches which need approval in order to book derivative transactions. CBRC is gradually approving other types of financial institutions.

The new regime has seen a flurry of activity in respect of OTC derivative trades between PRC banks and foreign counterparties. In addition to entering into derivatives for their own proprietary investments, domestic banks and foreign bank branches in the PRC have begun to offer derivative-linked products to their customers. To date, the focus has been on principal-protected USD structured deposits, which have been linked to a variety of offshore assets, including funds, structured notes, equity shares and stock indices.

The structured deposits have been offered to both institutional and retail customers. These include trust and investment companies which have obtained approval from the State Administration of Foreign Exchange (SAFE) to raise foreign currency funds from investors pursuant to so-called ôtrust plansö, and to invest the proceeds in principal-protected structured deposits with foreign bank branches in China.

Sensitivities and uncertainties remain in relation to products that are linked to the domestic equities market and also RMB-linked derivatives. The former intrudes upon areas regulated by the China Securities Regulatory Commission (CSRC). The latter, however, has seen some progress with the commencement of RMB/USD forward trading on the interbank market.

Encouragingly, the current trend appears to be towards opening up the market to a broader range of products and counterparties. This reflects the need to diversify investment channels in China for both RMB and foreign currency funds, and to move away from the traditional dependence on bank deposits and investment funds that invest solely in domestic equities.

There are still a number of outstanding legal and regulatory issues that need to be resolved before a comprehensive derivatives market can develop in China. These include the establishment of a framework for a greater variety of instruments (such as structured notes) and the participation in the market by a broader range of entities (such as fund management companies and securities companies). In addition, legal and regulatory reform is required to make the market more user-friendly in terms of the adoption of the ISDA architecture in areas such as close-out netting and collateral.

However, when considered along with other initiatives, such as the proposed Qualified Domestic Institutional Investor (QDII) Scheme, the derivatives market represents significant potential for the development of ChinaÆs financial markets.

For further information please do not hesitate to contact:

Andrew Malcolm, Partner
Tel: +852 2842 4803
email: [email protected]

Jian Fang, Partner
Tel: +86 21 2891 1858
email: [email protected]

Linklaters recently elected Chin-Chong Liew as a partner in its Hong Kong office. Chong joins Linklaters as Head of Derivatives and Structured Products for Asia (ex-Japan) from Allen & Overy, where he has held the position of partner since 2000.
Chong brings to Linklaters considerable experience in over-the-counter derivatives, structured equity, structured credit, market access and fund-linked products across Asia. A fluent Mandarin-speaker, Chong will also focus on continuing his development of derivative and structured products in China as the pace of deregulation in the PRC increases. A start date for Chong is not yet confirmed.