China - OTC Option Business – Further Moves To Tighten Regulation.
Legal News & Analysis - Asia Pacific - China - Regulatory & Compliance
6 June, 2018
The China Securities Regulatory Commission (“CSRC”) continues to tighten regulation in 2018. Against the backdrop of full-scale scrutiny of capital markets, the CSRC has been consistently tightening the regulatory reins on various business areas, with the order of priority based upon its assessment of the immediacy of potential risks. The latest action to come under the lens is the over-the-counter (“OTC”) option business.
Market observers may recall the issue of a regulatory circular on October 28, 2016, on the subject of OTC derivatives trading conducted by securities and fund operation institutions (“2016 Circular”) (see JunHe Client Alert “OTC Derivatives - No for Illegal Evasion”). More recently, due to concerns that potential risks could spiral out of control, and following the window guidelines released in April this year which suspend private funds and subsidiaries of futures companies from conducting OTC option trading, the regulators are now applying the brakes to securities brokers’ OTC option trading business activities.
Last week, the CSRC’s local agencies successively issued the Circular on Further Strengthening the Regulation of OTC Option Business by Securities Companies (“New Circular”) to securities brokers. In order to understand the current regulatory mindset and priorities, we have summarized the similarities and differences between the New Circular and the 2016 Circular for our clients’ reference.
I. Suitability of Investors
The 2016 Circular requires securities brokers to have familiarity with their clients with whom they undertake OTC derivative business and to ensure that correct products are being sold to appropriate clients. The New Circular requires that such clients must be professional institutional investors satisfying the requirements of the Measures on the Suitability Management of Securities and Futures Investors, and that they must meet the further following conditions,
(i)if it is a legal person, its net assets at the end of the previous year shall not have been less than RMB 50 million, financial assets shall not have been less than RMB 20 million, and it shall have at least three years relevant experience in securities, fund, futures, gold or foreign exchange investment,
(ii)if it is an asset management institution that trades on behalf of a product managed by it, the financial asset under its management at the end of the previous year shall not have been less than RMB 500 million, and the institution shall have at least two years experience in financial product management, and
(iii)if it is a product, it shall be a non-structured product duly established with assets under management (AUM) of no less than RMB 50 million, and the securities broker is required to verify the identity of the ultimate investor of such product and the limits on the agreed option fees and initial margin fees in proportion to the AUM.
The conditions set forth above and the subsequent window guidance given by the regulators relating to eligible counterparties will likely exclude the majority of private fund managers and at least some of the asset management plans currently operating in the market from being eligible counterparties.
II. Restrictions on Securities Broker Eligibility and Underlying Assets
Securities brokers that meet the criteria to engage in OTC option trading can be divided into two categories: first-class dealers and second-class dealers. First-class dealers are those that have been ranked as Class AA or higher for the past year and that have obtained an approval by the Institutional Department of the CSRC, while second-class dealers are those that have been ranked at Class A or higher for the past year and that have obtained a filing approval by the Securities Association of China.
Only first-class dealers are allowed to open dedicated trading accounts in the Shanghai and Shenzhen Stock Exchanges and to directly conduct individual stock hedging. By contrast, a second-class dealer can only hedge individual stock risks by entering into derivative transactions with first-class dealers.
Underlying assets of an OTC option transaction shall be either the indexes of the onshore market or non-ST or non-*ST stocks that have been listed on the Exchanges for at least six months and that have good liquidity. Compared to the 2016 Circular, the New Circular’s most effective device is to “restrict the supply”, that is, restrict the securities brokers’ capability to offer OTC option products.
However, it has given rise to concerns that concentrating transactions in the hands of the reduced number of qualified OTC dealers will ultimately increase market risk.
III. Prohibited Activities
The 2016 Circular only requires securities brokers to identify the true intention of a client for entering into an OTC derivatives transaction, while the New Circular expressly prohibits securities brokers from undertaking OTC option business with clients for the sole purpose of high leveraged speculation or where there is no real need for risk management.
Specifically, the 2016 Circular defines four types of prohibited activities in relation to OTC derivative businesses, i.e. (i) providing financing to clients directly or in a disguised form, (ii) collecting margins that are significantly beyond the need to guarantee contract performance, (iii) applying margins as instructed by clients, and (iv) providing services or convenience to facilitate any non-standard credit assets to circumvent regulation.
The New Circular further proposes new requirements that, no brokers shall:
(i)advertise to the public in any form through the internet or social-media, or encourage unqualified investors to trade OTC options,
(ii)trade securities for hedging directly as instructed by a client, or sell the hedging positions to a third party specified by such client,
(iii)conduct trading frequently,
(iv)enter into transactions with any “sensitive clients” in violation of certain provisions,
(v)conduct OTC option transactions in violation of certain provisions with any listed company or its affiliates or parties acting in concert where the underlying assets are the stocks issued by the listed company,
(vi)provide OTC option services for any suspected illegal financial activities or to any institutions having a potential conflict of interest,
(vii)facilitate off-balance-sheet non-standard credit assets or any other regulatory arbitrage activities or activities designed to circumvent regulation, or
(viii)allow others to trade under its name as a dealer directly or in a disguised form.
The New Circular is exhaustive in listing various kinds of prohibited activities, indicating the regulators’ determination to firmly suppress all activities that “evade regulation in the name of financial innovation”.
IV. Duties of Securities Brokers
The New Circular emphasizes that a securities broker shall verify the identity and source of funding of the investors and the contract terms of the relevant product, evaluate the suitability and legality of product design, and conduct continuous monitoring and evaluation on the trading activities of any counterparties. The requirements demonstrate the regulators’ clear thinking on their approach to regulation and supervision of the financial market and their intention to control the source of market risks by reining in licensed financial institutions. We also note that the New Circular has been issued to securities brokers by the CSRC’s local counterparts, offering the regulators with more freedom to make adjustments from time to time based on the development of market conditions.
Natasha (Qing) Xie, Partner, Jun He