A possibly new era for PRC offshore derivative transactions

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 (the 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.
 
Notably, the supplementary provisions to the Draft Rules seek to extend CSRC’s regulatory reach to cover overseas derivative transactions where “the relevant hedging transactions take place in China” (Article 50, paragraph 2). Such extension of jurisdiction may have significant implications (as explained below) to foreign investors investing in the PRC market through overseas over the counter (OTC) derivatives products such as total return swap (TRS), which is a popular indirect means for foreign investors to gain access to the The People’s Republic of China (PRC) market.

Current regulations on overseas TRS
 
Commercially, an offshore TRS arrangement commonly comprises two separate and distinct transactions:

• 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.
• 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, internationalised 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” (Article 2). 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 Draft Rules are as follows:
 
(A)    Applicability – The Draft Rules apply 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. Regarding offshore derivative transactions, the Draft Rules applies where (1) the derivative transactions between offshore operation institutions (which refer to the sell-side brokers) and offshore trading institutions (which refer to the buy-side investors) take place outside of China and (2) “the relevant hedging transactions take place within China” (Article 50, paragraph 2). Therefore, such transactions shall comply with obligations set out in Article 9, 12, 14 to 22 of the Draft Rules, summarised as followings. 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 within China. 

CSRC clarifies that the Draft Rules exclude the interbank derivatives market and OTC derivative markets organised by banking and insurance financial institutions. This indicates that the Draft Rules, once promulgated, only intend 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. 

(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 such data requested (Article 12). Moreover, the operation institutions also have a regular reporting obligation made to CSRC, on information of their business scale, transaction counterparty, underlying assets, holding positions, profits & losses, etc. (Article 35).
 
    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 new Articles 12 and 35 in the Draft Rules, aim 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 Draft Rules require 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.” (Article 14). When implementing the position limit system and the reporting system for large positions in derivatives trading or futures trading, “the positions of derivative 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.”  (Article 9)

     As at today, we see no explicit requirements (but for those in the Draft Rules) 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 derivative trading, indicating that the market conduct rules may directly apply to the ultimate investors of the swaps (Articles 15 to 22). 
 
    This indicates that those investors who access to Chinese market through derivative structures may face outright obligations to comply with Chinese rules including rules against market abuse.
 
The ambit of the Draft Rules, however, are in need of clarifications from the CSRC. For example, it is not entirely clear whether or not the derivative transactions with “the relevant hedging transactions take place within China” (i.e., (A) above) capture offshore derivative transactions where the offshore broker hedges via its affiliate or another PRC broker (as opposed to hedging via a direct market access regime). Moreover, there is also ambiguity as to whether derivative transactions (e.g., TRS) solely for the purpose of acquiring synthetic economic rights of stocks, as opposed to the stocks as the targeted assets via certain options products, are captured in the shareholding aggregation requirement (i.e. (C) above). 
 
Impact to the industry
 
Whilst the full force of the Draft Rules is subject to further clarifications by CSRC, its impact on the PRC overseas derivative market is significant and can be seen as China’s first step in excising its extraterritorial jurisdictions over these derivative transactions. Offshore financial institutions engaging in offshore derivative transactions such as offshore TRS arrangement should be aware of this potential repercussion.