2019.03.20 Natasha XIE、ZHANG Chi
It has been more than six years since the China Futures Association (“CFA”), a self-disciplinary organization under the supervision of the China Securities Regulatory Commission (“CSRC”), initiated pilot work relating to the establishment of risk management subsidiaries (“RMSs”) by futures brokers, with its December 2012 publication of the Guidelines on the Pilot Work Concerning Futures Brokers’ Establishment of Subsidiaries to Mainly Engage in Risk Management Services (the “Old Guidelines”). By February 27, 2019, according to the CFA website, 79 risk management subsidiaries had filed with the CFA.1 On February 15, 2019, the CFA released a new set of guidelines, the Guidelines on the Pilot Work Concerning Futures Brokers’ Risk Management Subsidiary Businesses (the “New Guidelines”), which replaced the Old Guidelines, and took effect on the date of issuance. Key elements of the New Guidelines are as follows:
Despite the six years that have passed since the Old Guidelines were introduced, the New Guidelines continue to treat RMSs as pilot businesses. This is indicative of the continuing cautious attitude of the regulatory authorities towards such business activity. The New Guidelines require that a futures broker shall take a prudent approach to establishing an RMS, that is, the brokers shall have first fully assessed their own business strength, reserve of talents and risk control capacities to determine whether they have the capacity to set up an RMS and shall have taken measures to adequately prepare for the establishment of an RMS. Additionally, futures brokers are required to first file with the CFA before engaging in such businesses.
The New Guidelines classify and provide definitions for six categories of RMS business activity, namely: (i) basis trading; (ii) services related to warehouse warrants; (iii) collaboration hedging; (iv) over-the-counter (OTC) derivatives business;2 (v) market making; and (vi) other businesses related to risk management.
i. Basis trading. An RMS provides customers with relevant quotation at a pre-determined price, or via a method of pricing or averaging price and conducts spot transactions with the customer.
ii. Warehouse warrant. An RMS provides services to customers by means of exchange, receipt pledge or agreed repurchase of the warehouse warrant of spot commodity.
iii. Collaboration hedging. In which an RMS enters into hedging transactions with its customers in order to mitigate all or partial price risks of the hedged items with the aim of managing the customer’s own market risks in the conduct of producing or operating spot commodities.
iv. OTC derivatives business. This new category is defined as business activity in which an RMS enters into an OTC transaction in accordance with an agreement drawn up with its counterparty. An OTC derivative refers to a contract traded out of a futures exchange, as approved by the State Council’s futures regulatory authorities, whose contract value is determined by one or several underlying assets. The underlying assets may include but are not limited to, commodities, stocks, indexes, funds, interest rates, exchange rates, credit or any of their derivatives. Such derivative contracts may include forwards, swaps, options or a combination of the aforesaid, and may have one or several characteristics of the same.
v. Market making. An RMS provides continuous quotes or responds to quotes for specific futures, options or other derivatives contracts in accordance with the relevant rules of the exchange.
When compared with the Old Guidelines, the New Guidelines impose more stringent requirements in terms of both the set-up of an RMS and the launch of a few types of risk management businesses. A futures broker that sets up an RMS is required to have its latest rating no lower than BB level of Class B for the filing of an RMS, no lower than BBB level of Class B if the RMS engages in OTC derivative businesses, and no lower than AA level of Class A if the RMS engages in the OTC derivatives business in which the underlying assets are individual stocks.
The New Guidelines provide for restrictions on any RMSs that fail to meet the relevant requirements. For example, if the parent company of an RMS fails to meet the relevant rating level, or its latest rating is Class D or lower for two consecutive years, the business size of such an RMS shall be restricted correspondingly, no new business shall be developed and any existing business shall be terminated at its expiry date unless the rating of such futures broker returns to the requisite level.
Growth in the RMS OTC options business has led to an increasing demand from RMS for capital. As a result, the CFA has substantially increased the minimum registered capital requirements for RMSs, and there are differing requirements according to the relative risk exposures of the various types of business. The New Guidelines explicitly stipulate that the paid-in capital of an RMS shall not be less than RMB 100,000,000. For an RMS engaging in the OTC derivatives business in which the underlying assets are individual stocks, the paid-in capital shall not be less than RMB 200,000,000.
The New Guidelines also set out various differentiated qualification requirements in relation to RMSs’ internal controls, business experience, and personnel qualifications.
The Old Guidelines provided a list of the prohibited behavior in an RMS’s business operations. The New Guidelines include various new items, including that an RMS and its employees shall not in the conduct of business operations violate the real name requirements for securities or futures accounts, and shall not use other person’s securities or futures account, or lend or authorize other person to use its own securities or futures account.
The New Guidelines list six categories of conduct which are specifically prohibited in the OTC derivatives service, namely: (i) entering into service agreement or making OTC derivatives transaction with an individual; (ii) entering into OTC derivative transactions or other business collaborations with an institution that is engaging in illegal securities or futures activities, as a result of failing to prudently evaluate the eligibilities of counterparties; (iii) providing financing to clients directly or in a disguised form; (iv) receiving a margin that exceeds the necessary amount for guaranteeing the performance of a contract; (v) using a margin in accordance with client’s instruction; and (vi) provide the means for other institutions to circumvent regulation or conduct regulatory arbitrage.
Futures brokers may establish an RMS wholly owned by it or jointly with other investors, though the equity stake held by a futures broker shall not fall below 51%. The New Guidelines further clarify that a futures broker, as the major shareholder of the joint venture RMS, shall not in any form transfer its controlling power over the RMS to other investors. In addition, each shareholder of an RMS shall exercise its right to vote in accordance with the proportion of its capital contribution, or its respective shareholding ratio. The percentage of the directors as recommended and designated by each shareholder in the members of the board of directors shall correspond to the proportion of each shareholder’s capital contribution or respective shareholding ratio. An RMS and its shareholders shall not conclude any agreements contrary to the above requirements by entering into any other contract or making any other arrangement. According to the New Guidelines, it will no longer be possible to implement any arrangement to transfer the management controlling power of an RMS that contravenes these regulations.
To ensure there is clear delineation between a futures broker and the operation of its RMS, the New Guidelines include the requirements to segregate personnel, properties and belongings, and to clarify the duties of both the parent and the subsidiary. The New Guidelines strengthen the supervisory requirements of a futures broker for its RMS. Futures brokers are required to formulate relevant internal policies for their RMSs, such as policies of internal control, compliance and risk management, to incorporate the compliance and risk control of RMS into the overall risk management system of the parent company, and to conduct, at least once a year, a compliance inspection on the RMS.
The requirements of the New Guidelines suggest that the regulatory mindset continues to be focused on the supervision of licensed financial institutions in an effort to minimize market risk at the source.
1. Please refer to http://www.cfachina.org/CXFW/zgsyw/xxgszgs/201804/t20180418_2494997.html.
2. The “pricing service” listed as item (iv) in the Old Guidelines has been replaced in the New Guidelines by “OTC derivatives business.”