The SAC Proposed Rules for TRS Business

2021 has witnessed remarkable developments in China’s legislation of the over-the-counter (OTC) derivatives businesses. First and foremost, the Draft Futures and Derivatives Law was tabled for review to the Standing Committee of the National People’s Congress (“NPC Standing Committee”) twice in 2021 (April and October respectively), where the provisions related to OTC derivatives business were the focus of both deliberations. Secondly, “Yi Hang Liang Hui Yi Ju” (i,e. PBOC, CBIRC, CSRC, SAFE) jointly released the Guiding Opinions on Promoting the Regulation of Derivatives Business (Consultation Paper) (“Guiding Opinions”) to regulate OTC derivatives businesses specifically, which undoubtedly will have a profound impact on the OTC derivatives businesses of financial institutions such as commercial banks. In the meantime, the self-regulatory organizations supervised by the China Securities Regulatory Commission (CSRC) have been improving the management of OTC derivatives businesses. Coincidentally, on the same day that the Guiding Opinions were released, the Securities Association of China (SAC) released the Administrative Measures on TRS Businesses of Securities Companies (“TRS Measures) and the Opinions on the Application of Self-Disciplinary Rules No. 4 - Opinions on the Application of the Provisions on the Management of Margins under the Administrative Measures on TRS Businesses of Securities Companies (“Opinions on Application of the Provisions on Margins”). The TRS Measures have inherited the regulatory principles and mechanisms embodied in the Administrative Measures for Over-the-Counter Option Businesses of Securities Companies ("Option Measures"), issued by the SAC in September last year, and provide comprehensive regulations for securities companies engaging in TRS businesses in terms of dealer management, investor suitability management, underlying assets and contracts management, margin management, risk control, prohibited activities, data reporting, supervision and monitoring. The TRS Measures remain generally consistent with the current regulatory requirements and policies. However, the simultaneous release of the TRS Measures and the Guiding Opinions leads us to speculate that the prudent regulation of OTC derivatives businesses by the CSRC may be duplicated in the banking industry that is regulated by the China Banking and Insurance Regulatory Commission (CBIRC). The possibility cannot be excluded that regulators may regulate the banking industry by reference to the regulatory requirements applicable to the securities industry in terms of OTC derivatives businesses. Below we have highlighted some of the key points of the TRS Measures to facilitate further discussion.

1.Qualification Requirements for TRS Business

The TRS Measures apply to any TRS transaction conducted between a securities company and counterparties over-the-counter or in a venue recognized by the SAC. A TRS is a swap agreement in which the parties pay each other the returns on an agreed date, and one party (or both parties) will make the payments based on the performance of the underlying assets. As with the Option Measures, the TRS Measures require securities companies to be oriented towards serving the real economy and serving a clients’ asset allocation and their risk management needs when engaging in TRS businesses. The first-class dealers for OTC option transactions that have been recognized by the CSRC and the second-class dealers for OTC option transactions that have been filed with the SAC (collectively, the "Dealers") may both engage in the TRS businesses. Securities companies that are not recognized by the CSRC, nor filed with the SAC to be qualified dealers, are allowed to conduct TRS transactions with qualified dealers for proprietary trading purposes only and shall not conduct TRS transactions with outside clients. The Option Measures will apply to the management and adjustment of a dealer’s qualification. The TRS Measures also prohibit securities companies from engaging in OTC option businesses in a disguised form by nesting, splitting or combining with other derivatives contracts to form non-linear TRS contracts. Before this, due to the difficulty in obtaining a no-objection letter for carrying out OTC options businesses, there have been market practices in which OTC options businesses were carried out in a concealed form of non-linear TRS transactions. In line with the tightening of the management of dealer qualifications for OTC options businesses as proposed in the Option Measures, the TRS Measures also explicitly prohibit any OTC option businesses to be carried out in a disguised form of TRS transaction, thereby imposing higher compliance requirements for securities companies engaging in OTC businesses. 

2.Genuine Needs of the Counterparties and Risk Disclosure

Like the Option Measures, the TRS Measures require the counterparties with whom a securities company conducts a TRS transaction to have a genuine need for asset allocation and/or risk management, as well as satisfying the requirements for a professional institutional investor under the Measures on the Suitability Management of Securities and Futures Investors. Undoubtedly, private fund managers will become one of the main types of such qualified counterparties provided they have been verified to have a genuine need of asset allocation and risk management. According to the TRS Measures, a securities company shall conduct comprehensive due diligence on the counterparties to verify whether they have genuine needs, whereby a securities company shall take necessary measures such as collecting supporting documents from the counterparties and doing public research on the counterparties.

The TRS Measures require securities companies to fully understand the counterparties, disclose fully any risks and conduct TRS transactions with only qualified counterparties. Under the previous Business Rules for Over-the-Counter Financial Derivatives Trading by Securities Companies, securities companies were only required to perform risk disclosure obligations according to the financial derivatives contracts when conducting derivatives trading with professional counterparties; under the TRS Measures, it is mandatory for financial institutions to fully disclose trading risks even when conducting TRS transactions with professional institutional investors.

3.Look-through Principle 

The look-through principle is strictly implemented in the TRS Measures regarding the suitability of investors and the restriction of underlying assets. Firstly, if the counterparty is a product, it shall be a lawfully manufactured non-structured product and a single ultimate investor of the product shall meet the criteria of a professional investor under the Measures on the Suitability Management of Securities and Futures Investors if it holds more than 20% interest in the product. A securities company shall perform the duty of Know-Your-Customers (KYC) on the counterparties and conduct due diligence on a wide range of issues such as the counterparties' genuine needs, sources of funding and the contractual basis. Interestingly, the TRS Measures use the term "counterparty" throughout the section of “investor suitability management”, rather than "investor" as used in the Option Measures, or "qualified investor" as used in the Guiding Opinions, which is more in line with the public understanding of the roles of parties to derivative transactions. Second, the TRS Measures stipulate that the underlying assets linked to TRS transactions shall have a fair market value and good liquidity, such as stocks, stock indexes and bulk commodities, with the exclusion of private products such as private funds and asset management plans, as well as OTC derivatives, unless otherwise approved by the CSRC. In this respect, it further requires securities companies to establish a mechanism for looking through down to the underlying assets of TRS transactions and to keep records of the “looking-through” process for each transaction and strictly prohibits investing in non-standardized assets in any disguised form by taking advantage of linking multiple layers of underlying assets. Furthermore, securities companies are not allowed to engage in new TRS transactions nor extend the old TRS transactions to which the underlying stocks are subject to special treatment or delisting procedures taken by the exchanges. From the above, we can see that the CSRC adheres to the look-through principle in the regulation of OTC derivatives businesses.

4.Prohibited Activities

Consistent with the Option Measures, the TRS Measures define several types of prohibited activities, i.e. (1) unlawfully entering into transactions with any “sensitive clients”. A securities company shall not conduct TRS transactions with any listed company or its affiliates or parties acting in concert where the underlying assets are the stocks issued by the same listed company in violation of certain rules, nor with any entity that is suspected of being involved in illegal financial activities or having a potential conflict of interest; (2) facilitate regulatory arbitrage activities or other illegal activities or violations. A securities company shall not provide services for illegal off-balance-sheet arrangements, the misappropriation of funds, or other activities that circumvent the regulatory requirements for such as information disclosure, investment scope, trading restrictions, and leverage limitations, nor lend its dealer qualification to others directly or in a disguised form; (3) in a disguised form, function as a “channel” for counterparties. A securities company shall not lend securities accounts to counterparties, shall not directly conduct hedging transactions as instructed by counterparties, nor apply margins as instructed by counterparties. These activities were also prohibited according to certain circulars previously released by the local bureaus of the CSRC and are reiterated and unified in this TRS Measures as self-disciplinary rules, showing the CSRC’s prudent regulation of OTC derivatives businesses. By imposing these requirements on securities companies, we believe that the CSRC aims to guide the compliant engagement of OTC derivatives businesses of all market participants.

5.Management of Margins

The Opinions on Application of the Provisions on Margins have specified requirements for the management of margins, namely, (1) if a securities company conducts TRS transactions that link to stocks, narrow-based stock indexes and their products or credit debts, (i) the margins collected from a single counterparty shall not be less than 100% of the notional principal of the TRS contract; (ii) if a securities company conducts equity-based TRS transactions with a single counterparty, in the four prescribed circumstances, the margin collected from the counterparty shall cover the risk exposure of the transactions or derivatives and shall not be less than 25%, whichever the higher of the notional principal of the counterparty’s long position and short position; and (2) if the TRS transactions link to other underlying assets, the percentage of margins collected by a securities company shall be subject to the Opinions on Application of the Provisions on Margins. Additionally, the SAC has the power to adjust the foregoing margin management requirements as appropriate according to regulatory requirements, market and business developments, and the dealer’s ability and level of compliance and risk control.

6.Reporting and Record Filing

Under the guidance of the SAC, the Inter-Institutional Price Quoting and Service System is responsible for the construction and maintenance of the OTC transactions reporting database and undertakes the daily monitoring of TRS businesses. A securities company shall report information regarding TRS transactions under the master agreement of each of the SAC, NAFMII and ISDA, showing the position of the regulators on the uniform regulation of all TRS transactions concluded under different master agreements. The TRS Measures also require securities companies to keep all TRS transaction records and relevant documents, accounts, original vouchers and other materials for at least 20 years.

In summary, the TRS Measures contribute to the improved self-regulatory regime of OTC derivatives businesses, which fully reflects the principles of prudent regulation. We expect that the TRS Measures will guide the market practice for a long time, while leaving a little to the imagination that the regulatory principles and regimes embodied therein may provide a model for the future regulation of banking OTC derivatives businesses outside the jurisdiction of the CSRC.