CSRC Issued the Measures for the Supervision and Administration of Derivatives Trading – Second Draft issued
On 17 March 2023, the China Securities Regulatory Commission (“CSRC”) issued the Measures for the Supervision and Administration of Derivatives Trading (Consultation Paper) (the “Consultation Paper”). The Consultation Paper comprises draft rules aiming at unifying and aligning regulations for different aspects of the thriving derivatives market, increasing market transparency, as well as strengthening risk control.
The Consultation Paper seeks to extend CSRC’s regulatory reach to cover overseas derivative transactions. Such extension of jurisdiction may have significant implications (as explained below) to foreign investors investing in the PRC market through overseas OTC derivatives products such as total return swap (“TRS”), which is a popular indirect means for foreign investors to gain access to the PRC market.
On 17 November 2023, CSRC released the second draft of the Consultation Paper (“Second Draft”) to the public, soliciting comments. Whilst the Second Draft does not move much from the positions raised via the Consultation Paper, CSRC has also issued more detailed explanatory notes on its background. The Second Draft reiterates CSRC’s determination to apply an enhanced regulation over all derivatives markets (covering those exchange traded products and OTC products), through enhanced disclosure and reporting, central clearing and standardization of OTC derivatives where appropriate. The Second Draft also aims to prevent cross-market manipulation by asking investors of TRS to directly apply rules on market abnormality, disclosure of interest, short swing profit rule and trading restrictions as if they are carrying out cash trading. For ease of reference, we have added further notes in bold and starting with “Comments on the Second Draft” in the text below.
Notably the Second Draft was issued against the background of the very recent meeting of China’s Central Financial Commission (CFC) led by China’s Premier, which urged stronger supervision and prevention of financial risks in the financial industry, whilst the timeline for issuance is still unclear. CFC is dedicated to strengthening a centralised and unified leadership in the financial sector, whose key tasks include promoting a high-quality development in the financial sector (through policies and plans formulation, sectors coordination and supervising the implementation of the same), alongside mitigating risks.
Current Regulations on Overseas TRS
Commercially, an offshore TRS arrangement commonly comprises two separate and distinct transactions:
(1) The Offshore Swap: Dealings between an offshore investor (i.e. buy-side) on one hand, and an offshore counterparty (i.e., sell-side; e.g., a broker) on the other, outside of the PRC for the purpose of offering the offshore investor economic interest synthetically derived from Chinese market.
(2) The Hedging Transaction: The abovementioned offshore counterparty then hedges its position with respect to the Offshore Swap by investing into the PRC market through direct market access schemes such as QFI, various Connect Program, internationlised futures regime and the like, or back-to-back swap(s) with its PRC affiliates or other third party brokers.
In the past, Chinese regulators have focused on regulating the latter part of the arrangement, whereby sell-side is required to comply with the relevant laws and subject to scrutiny, facing increasing more restrictions to carry out the Hedging Transactions.
On 1 August 2022, the PRC Futures and Derivative Law took effect, bringing the former part of the arrangement under the possible supervision of the Chinese regulators, granting them with competent jurisdiction over trading activities that take place outside of the PRC which “disrupts the order of the domestic market and causes any damage to the lawful rights and interests of domestic traders”. Whilst it was clear that Offshore Swap is to be regulated, no concrete rules (or implementation rules) were put in place to provide the specific behaviors triggering such provision and the corresponding liability.
The Consultation Paper
Some of the main features of the Consultation Paper (including Second Draft) are as follows:
(A) Applicability – The Consultation Paper applies to (i) derivative markets organised by securities and futures trading venues; (ii) securities companies (i.e, securities brokers) and their subsidiaries engaged in the OTC derivative markets; and (iii) futures companies (i.e. futures brokers) and their subsidiaries engaged in the OTC derivative markets.
CSRC clarifies that the Consultation Paper excludes the interbank derivatives market and OTC derivatives markets organised by banking and insurance financial institutions. This indicates that the Consultation Paper, once promulgated, only intends to regulate those participants who are and/or asset classes which are within the purview of CSRC’s regulation, whilst excluding those derivatives linked to bonds, interest rate or currencies traded via China Interbank Bond Market.
Comments on the Second Draft: Through clarification of the Second Draft, it has been made clear that the derivatives transaction with “the relevant hedging transaction taking placing within China” is subject to enhanced disclosure requirements as summarised under Item B) below on sell-side brokers. On the other hand, all overseas derivatives transactions referencing to domestic assets shall follow requirements under Items C) and D) below on the buy-side investors. The indication now becomes clearer that all TRS referencing to domestic assets, regardless of whether the directly relevant hedging transaction takes place within China (for example those that hedge via intra-group squaring, back-to-back TRS or other market access regimes) would need to aggregate positions via swap with those via cash trading and apply market conduct rules as if cash trading is being carried out.
As a result, the step (1) of an offshore swap arrangement, i.e. the Offshore Swap, may also be subject to direct supervision and regulation of the CSRC due to the fact that the step (2), i.e., the Hedging Transaction, takes place and/or references to domestic assets within China.
(B) Obligation of the sell-side – the operation institutions (which refer to the sell-side brokers) shall keep a record of all its derivative transactions corresponding to the hedging transaction taking place within China, such as counterparties, trading contracts, trading strategies, trading details and etc. Upon request of the exchanges, those sell-side brokers shall provide any data requested. Moreover, the operation institutions also have a regular reporting obligation made to CSRC, on information of their own business scale, transaction counterparty, underlying assets, holding positions, profits & losses, etc.
Comments on the Second Draft: Most of such obligations stay in the Second Draft whilst “trading strategies” is no longer a requisite item for filing. In addition, while the Second Draft retains the annual and bi-annual reporting requirement, it has taken out detailed disclosable items in those filings, delegating discretion to exchanges.
Under the QFI rules, the sell-side as well as buy-side QFIs already have ad hoc obligations to provide to CSRC, upon the latter’s ad hoc request, their “overseas hedging transactions in connection with the QFI’s China investments”. The Consultation Paper aims to further reinforce the regulators’ power to review and assess any overseas derivatives transactions.
(C) Obligation of the offshore buy-side – look-through ownership and aggregation of positions acquired via derivatives and via cash trading would be required, as the Consultation Paper requires that “a derivative contract held by a trading institution with the stocks of a listed company or a company whose stocks are traded on any other national securities trading venue approved by the State Council (the "targeted stocks") as the targeted assets, shall be calculated in aggregation with the targeted stocks directly or indirectly held by the trading institution in accordance with the provisions of the securities trading venue.” When implementing the position limit system and the reporting system for large positions in derivatives trading or futures trading, “the positions of derivatives transactions and futures transactions directly and indirectly held by derivatives operation institutions and trading institutions in derivatives contracts with underlying assets linked to the same or similar assets shall be aggregated in accordance with the regulations of industry associations for derivatives, derivative trading venues, or futures trading venues.”
Comments on the Second Draft: Most of such obligations stay in the Second Draft whilst it has been made clear that only the derivatives contracts referencing to stocks with voting rights shall be aggregated with those via cash trading. As background, Chinese rules have detailed requirements on which securities were attached with voting rights. For example, under Chinese law, preference shares are shares with no or limited voting rights and, in most circumstances, are disregarded for the calculation of disclosure of interests.
As at today, we see no explicit requirements (but for those in the Second Draft) imposed on the offshore investors to aggregate their positions acquired via a common derivative transaction and those acquired via cash trading, if the transaction is only cash settled and the investors only gain synthetic economic interest.
(D) Prohibited trading activities – prohibition of fraudulent acts, insider trading, market manipulation, interest tunnelling, and other illegal behaviours through derivatives trading, indicating that the market conduct rules may directly apply to the ultimate investors of the swaps.
This indicates that those investors who access to Chinese market through derivatives structures may face outright obligations to comply with Chinese rules including rules against market abuse.
Impact to the Industry
Whilst the full force of the Consultation Paper is subject to further clarifications by CSRC, its impact on the PRC overseas derivatives market is significant and can be seen as China’s first step in excising its extraterritorial jurisdictions over these derivatives transactions. Offshore financial institutions engaging in offshore derivatives transactions such as offshore TRS arrangement should be aware of these potential repercussions.
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