2023.03.23 XIE, Qing (Natasha)、ZHANG, Chi (Austin)、LUO, Danchen
To implement the Futures and Derivatives Law which took effect on August 1, 2022, the China Securities Regulatory Commission (CSRC) issued the Measures for the Supervision and Administration of Derivatives Trading (Consultation Paper) on March 17, 2023 (the "Consultation Paper" or the "Measures"). The intention is to unify the regulation of the derivatives market within the jurisdiction of the CSRC at a departmental regulation level. We note that Article 50, Paragraph 2 of the Measures stipulates that, “Where an overseas operation institution and an overseas trading institution conduct a derivatives transaction outside China while the relevant hedging transactions take place within China, they shall comply with the relevant provisions of Article 12, and Articles 14 to 22 of these Measures.” This is the first time that the CSRC has proposed to regulate derivative transactions wherein both parties are foreign institutions. Our introduction and analysis below focuses on this provision.
I. Higher-Level Legal Basis for Extraterritorial Jurisdictions
Article 2 of the Futures and Derivatives Law provides for extraterritorial applications and stipulates that, “Futures trading, derivatives trading and related activities taking place outside the territory of the People’s Republic of China that disrupt domestic market order and impair the legitimate rights and interests of domestic traders, shall be handled and investigated for legal liability in accordance with this Futures and Derivatives Law.” This article provides a higher-level legal basis for Article 50, Paragraph 2 of the Measures. As mentioned in the previous JunHe Client Briefing “’Constant Efforts Ensure Success’ — Marking the Formal Promulgation of the Futures and Derivatives Law”, paralleling other cross-boundary investment schemes such as QFI, Stock Connect, and internationalized commodities futures products, foreign institutional investors indirectly trade domestic assets through trading overseas OTC derivatives products that link to domestic underlying assets such as stocks, bonds and their derivatives, as well as commodity derivatives. Such overseas OTC derivatives products (for example, Total Return Swap (TRS)) are usually tailor-made by foreign investment banks or foreign brokers for their institutional clients and could enable foreign investors to gain economic exposure to domestic underlying assets indirectly. Although the Futures and Derivatives Law does not explicitly prohibit or restrict such OTC derivatives trading, the legality and compliance of such overseas OTC derivatives trading may need to be further reviewed depending on how PRC regulators exercise the extraterritorial jurisdiction with the authorization of Article 2 of the Futures and Derivatives Law.
II. The Meaning of “Hedging Transactions Taking Place within China”
Article 50, Paragraph 2 of the Consultation Paper would apply only to derivatives transactions taking place outside China while the relevant hedging transactions take place within China, but it is unclear how to define “relevant hedging transactions taking place within China”. On a related note, Article 10 of the Provisions on Issues Concerning the Implementation of the Measures for the Administration of Domestic Securities and Futures Investment by Qualified Foreign Institutional Investors and RMB Qualified Foreign Institutional Investors provides that, “The CSRC, based on its regulatory needs, may require QFIs to report their overseas hedging positions related to domestic securities and futures investments.” However, it is unclear how the “overseas hedging positions” would be defined either. If “hedging transactions taking place within China” referred to in Article 50, Paragraph 2 will cover any and all relevant transactions taking place within China, Article 50, Paragraph 2 would apply if an overseas TRS transaction links to any underlying assets listed and traded in a market regulated by the CSRC and the overseas operation institution acquires, holds or sells any positions of such underlying assets. This means that the way the PRC regulator interprets “hedging transactions taking place within China” would directly define the application of such a provision, i.e., whether a derivatives transaction concluded between an overseas operation institution and an overseas trading institution should be subject to Article 12, and Articles 14 to 22 of the Measures.
III. Compliance Requirements for Overseas Derivatives Transactions
Should Article 50, Paragraph 2 of the Measures apply to overseas derivatives transactions, the counterparties of such overseas derivatives transactions shall be subject to the following requirements:
3.1 Record of Transaction and Reporting Obligations
According to Article 12 of the Measures, derivatives operation institutions conducting hedging transactions on securities and futures trading venues shall comply with the provisions of the securities and futures trading venues. Securities and futures trading venues may provide necessary facilities such as position limit exemption for hedging transactions of derivatives operation institutions and strengthen the monitoring of hedging transactions. Derivatives operation institutions shall record the data and information of the counterparties, contracts, trading strategies and the trading details of the derivatives contracts relating to hedging transactions. Securities and futures trading venues may, based on the needs of monitoring, require derivatives operation institutions to provide relevant data and information. We understand this requirement is similar to the rules relating to QFI if it applies to overseas derivatives transactions, that being said, the relevant exchanges may, based on their monitoring needs, require foreign derivatives operation institutions to report their overseas derivative transactions relating to domestic hedging transactions.
3.2 Looking-through for Shareholding Aggregation
Article 14 of the Measures states that, “For the performance of information disclosure obligations or in the acquisition activities or other activities, 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 "underlying stocks") as the underlying assets, shall be calculated in aggregate with the underlying stocks directly or indirectly held by the trading institution in accordance with the provisions of the securities trading venue.” This is an explicit requirement for aggregating shareholdings through both exchange trading and OTC derivatives trading. It reflects the regulator’s intention to strengthen integrated regulation over the OTC derivatives markets and the securities and futures markets to prevent the circumvention of regulation through derivatives transactions, as well as to collect information to better monitor the overall risks in both the exchange markets and the OTC markets.
3.3 Prohibited Trading Activities
The Measures codify practices and set out an independent chapter called “prohibited trading activities” (Articles 15 to 22) to prohibit illegal securities and futures activities and activities that circumvent regulations through derivatives transactions. The Measures stipulate that (1) it is prohibited to commit, through derivatives trading, any illegal acts or violations such as fraud, insider trading, market manipulation, interest tunneling and circumvention of regulations; (2) it is prohibited to indirectly conduct “short-swing” trading as provided by Article 44 of the Securities Law through derivatives trading; (3) any insiders aware of inside information or any person who obtains such inside information by illegal means shall be prohibited in securities and futures transactions from engaging in insider trading through derivatives trading; (4) it is prohibited to manipulate the securities markets or futures markets through derivatives trading, or to manipulate the derivatives markets through means such as securities trading, futures trading, or commodity trading; (5) it is prohibited to circumvent the rules on shareholding reduction and restricted shares through derivative trading; (6) a derivatives operation institution or trading institution is prohibited from concluding derivatives trading with a counterparty when they know or ought to know that the counterparty conducts prohibited activities as stated in Article 15 to Article 19 of the Measures through derivatives trading; (7) a derivatives operation institution is prohibited from engaging in derivatives trading with major shareholders, the de facto controller, directors, supervisors, and senior management personnel of a listed company, or with the shareholders who hold restrictive shares or hold shares subject to shareholding reduction restrictions if the underlying assets of the derivatives trading are stocks of such a listed company; and (8) listed companies and companies whose stocks are traded on any other national securities trading venue approved by the State Council shall be prohibited from, in violation of the relevant provisions, concluding derivatives trading with stocks issued by themselves as the underlying assets.
The above provisions are not new rules in the context of domestic derivatives trading regulations, which were reiterated in the self-disciplinary rules of the Securities Association of China (SAC) and mentioned in certain circulars released by local CSRC bureaus in the past few years. Under the Administrative Measures on TRS Businesses of Securities Companies, for example, which was released by the SAC on December 3, 2021, a securities company is prohibited from: (1) conducting TRS transactions with any listed company or its affiliates or parties acting in concert where the underlying assets are the stocks issued by such a listed company in violation of the relevant rules; (2) facilitating regulatory arbitrage activities or other illegal activities or violations; (3) in a disguised form, functioning as a “channel” for counterparties.
It remains to be seen whether Article 50, Paragraph 2 of the Measures would broadly apply to overseas derivatives transactions with domestic underlying assets such as domestically listed stocks, bonds and their derivatives as well as commodity derivatives and whether the CSRC is prepared to take the first step to claim extraterritorial jurisdiction over overseas activities by formulating this provision. Foreign institutional clients are advised to pay close attention to legislative developments and assess their position from a compliance perspective.