Structure Products Asia 2006

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1 Structure Products Asia 2006 China Structured Products : Innovation and Evolution Chin-Chong Liew Partner and Head of Derivatives & Structured Products Asia (Ex-Japan) 23 November 2006 Hong Kong

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4 Chinese Derivatives A Brief History Massive scandals & chaos (onshore & offshore) Pledge repo principal agreement New Derivative Rules Title transfer repo principal agreement before PBOC Notice GITIC QFII Warrants market Opening of RMB re-launched Inter-Bank Bond Forwards Opening of RMB- FX Forwards & Swaps market Emergence of equity linked structured deposit Regulations for private wealth management WTO Interest Rate Swap market Permitted stock loans and short selling QDII RMB Master Agreement Bankruptcy Law 3

5 Current State of Play.

6 China Derivative Products Unprecedented growth in derivative and structured products in China over the last 18 months Fast expanding range of: Onshore derivative products Chinese counterparties Onshore derivative products Currency Interest Rate Fixed Income Equity Commodity and Credit Structured Deposits Offshore investments through QDII products 5

7 Onshore Currency Derivative Products RMB/FX forwards and swaps Inter-bank foreign exchange market (CFETS) Forward: USD 7.5 billion, swaps: USD 3 billion (Jan. June 2006) By filing and not approval: 74 members (forwards) and 61 members (swaps) with qualification (by Oct. 2006) Any tenor and any exchange rate End-user market Banks with RMB spot licence and derivatives approval By filing and not approval: 53 banks (forwards) and 21 (swaps) banks (by Oct. 2006) Any tenor and any exchange rate Not yet RMB/FX interest rate swap or currency options 6

8 Onshore Interest Rate Derivative Products RMB Interest Rate Swap Trial basis National Interbank Funding Centre RMB fixed/floating interest rate swaps RMB 29.1 billion (Mar. Oct. 2006) By filing and not approval: 44 members with qualification (by Oct. 2006) 7

9 Onshore Fixed Income Derivative Products Inter-bank Bond forward Volume: RMB 17.8 billion in 2005 Repurchase transactions Pledge repos (RMB 15.7 trillion in 2005) Title transfer repos (RMB 222 billion in 2005) Inter-Bank and on-exchange Bond lending transactions Collective capital trust plans by trust & investment companies 8

10 Onshore Equity Derivative Products Warrants Shanghai Stock Exchange and Shenzhen Stock Exchange (18 July 2005) First after nine-year ban: Baosteel (22 Aug. 2005) Issued by controlling shareholders and securities companies Securities Lending Pilot programme conducted by securities companies (CSRC, 30 June 2006) Structured Funds under Securities Funds Law 9

11 Other Onshore Derivative Products Less common derivative products onshore: Commodity derivatives Credit derivatives 10

12 Onshore Structured Deposits Currency and interest rate-linked structured deposits from 1999 First equity linked deposit in August 2005 (by Standard Chartered on DJIA index) Regulatory regime in place: private wealth management regulations and risk management guidelines published by CBRC in Sept Commodity and equity linked deposits may not be offered by PRC banks initially, but restrictions uplifted in December 2005 (and replaced with consultation process with regulator by product type) Booming business since then (RMB60 billion sold by a major Chinese commercial bank during first 10 months of 2006) Total deposits in China RMB32.8 trillion and household deposit savings RMB15.8 trillion 11

13 Onshore Structured Deposits Investors may be PRC individuals and corporates Minimum denomination: USD5K or RMB50K equivalent CBRC approval (if return protected) or reporting Know-your-client and risk disclosure requirements Plain language, necessary illustrations and worse case scenario Quanto structured deposits to hedge RMB/foreign currency exchange rate risk Cash-settled and linked to foreign equity index or equity basket (or commodity) No physical settlement and not linked to A shares or futures 12

14 Qualified Domestic Institutional Investors (QDII) Scheme QDII the opposite to QFII Who can be QDIIs? Commercial Banks Fund Management Companies Securities Companies Insurance Companies 13

15 QDII - Commercial Banks Operation and foreign exchange rules in place Comprehensive wealth management service collective investment program onshore sale of investment products investing in fixed income products but not rated below BBB may not directly invest in equities, equity related structured products recent market practice equity index linked products and possibly equity fund linked products? USD12.6 billion exchange quota approved for 13 commercial banks (investment quota unrestricted) Wealth management advisory service 14

16 QDII Commercial Banks Is it fixed income product? Yes Is it relatively high risk product? No Yes Business development Risk diversification Hedging Yes No not equity not equity related structured product not commodity derivatives not below BBB 15

17 QDII Commercial Banks Structure and Fund Flows Individual Investors Institutional Investors Bank onshore Onshore Custody Account Onshore Custodian offshore Offshore Custodian Agent Securities Custody Account Offshore Settlement Account Offshore Custodian Agent Securities Depository and Clearing Institution 16

18 QDII - Others Fund Management Companies Collective investment Client s own foreign exchange Investing in securities portfolios including shares Pilot program, no operation rule, only foreign exchange rules USD500 million investment quota approved for Hua An Fund Management Co., Ltd. Insurance Companies Foreign exchange proceeds can be invested in principal and interest guaranteed structured products Subject to investment quota (in proportion to the total assets of the company) RMB proceeds may be converted into foreign currency for overseas investment USD3.5 billion investment quota approved for 11 insurance institutions Detailed operational rules to be issued 17

19 Cross-border Derivative Products -Selling structured products to onshore Chinese counterparties (banks, insurance companies, foreign-invested enterprises or QDIIs) Currency (other than RMB) Interest Rate (other than RMB) Credit (including cash and synthetic CDOs) Equity (including Equity CPPI) Commodity (including freight and emission certificates) - Private banking activities with offshore funds or with non-residents - Offering market access products to nonresidents giving exposure to Chinese market 18

20 Some Challenges.

21 Securities Law Challenge Does the sale and distribution of offshore Securities in PRC comply with the PRC Securities Law Definition of securities under PRC Securities Law Wealth Management Products v. Foreign Securities Regulators view: CBRC, CSRC Rules on Derivative Securities to be made? 20

22 NDF/NDS Challenge Are cross-border non-delivery RMB/FX forward/swap allowed under PRC law? No clear rule Late 2005, development of quanto products Sporadic transactions and SAFE was aware SAFE Circular Huifa [2006] No. 52 (20 October 2006) - No domestic institution and individual shall participate in any overseas RMB-FX derivative transactions in any manner without SAFE approval Informal view that Circular directed at transactions principally dealing with RMB/FX so does not apply if no express RMB/FX element or if principal underlying is another asset (and RMB/FX element is ancillary) 21

23 Mis-selling Challenge The structured products are getting increasingly complex in China - what can be done to avoid mis-selling particularly to the retail? Risk Disclosures, KYC and product suitability requirements under regulations for QDII Principal or Agent? QDII v. offshore entity, as principal-to-principal No contractual relationship between Chinese investors and offshore entity To review or not to review? Reputational and franchise risks 22

24 Documentation Challenge What agreement (preferably master agreement) can be used to document OTC derivatives with Chinese counterparties? Offshore v. Onshore documentation CFETS RMB Master Agreement (July 2006) for inter-bank market RMB/FX Forward and Swaps A Chinese Master Agreement? Appropriate documentation with end-users in PRC Need for PRC law governed ISDA onshore? 23

25 Netting Challenge Is netting enforceable against a Chinese counterparty in its insolvency? Distinction between Netting and Set-off Set-off before commencement of liquidation Existing Bankruptcy Law : After commencement of liquidation but before finalisation of property distribution plan: Creditor could apply to the liquidation committee to set off Unpredictable and not a self-help remedy Automatic Early Termination of transactions New PRC Enterprise Bankruptcy Law (passed on 27 August 2006 and effective on 1 June 2007) 24

26 Collateral Challenge Are collateral arrangements granted by Chinese counterparty enforceable? Outside China - Security interest : SAFE registration - Title transfer Re-characterisation risk not material but efficacy of netting doubtful Inside China Security interest: limited Title transfer: recognised? Property Law reform 25

27 Prospects.

28 The Way Forward? - New Financial Futures Exchange in Shanghai - Subsidiarisation of foreign banks in China - Risk Management Framework for Securities Companies and Insurance Companies (such as that for Banks)? - Basle II implementation? - Further market reform? 27

29 Questions? 28

30 Contact us Yuan Cheng Consultant, Beijing phone Fang Jian Partner, Shanghai phone Wendy Kao Managing Associate, Shanghai phone Ice Xu Associate, Shanghai phone Zhirong Zhou Associate, Shanghai phone Chin-Chong Liew Head of DSP Asia (ex Japan) Partner, Hong Kong phone Benjamin Liu Managing Associate Hong Kong phone John Xu Associate, Hong Kong phone Martin Wong Associate, Hong Kong phone Simon Zhang Associate, Hong Kong phone

31 Structure Products Asia 2006 China Structured Products - Innovation and Evolution Chin-Chong Liew Partner and Head of Derivatives & Structured Products Asia (Ex-Japan) 23 November 2006 Hong Kong

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