Consolidated Positions of Derivative Trading and Futures Trading
First Draft v.s. Second Draft
JunHe’s Submission on First Draft
1. Art. 9 v.s. Current Art. 13
The CSRC may, based on the needs of market supervision, implement a position limit regime and a large position reporting regime for derivative trading.
When implementing the position limit regime and large position reporting regime for derivative trading or futures trading, if the derivative trading and futurestrading link to the same or similar assets, the positions relating to the derivative trading and futures trading directly or indirectly held by derivative operation institutions or trading institutions shall be calculated in aggregate in accordance with the provisions of the derivative industry associations, derivative trading venues or futures trading venues.
Whoever engages in hedging or other risk management activities may apply for an exemption of position limit according to the relevant provisions.
1. …We understand that it is uncommon in other jurisdictions to apply position limits to OTC derivative trading….
2. …Clarification is needed as to the purpose behind aggregating positions of futures with OTC derivative contracts as they are currently regulated separately.
Our Interpretations and Observations
We are pleased to see that the Second Draft adopts relevant suggestions and removes the previous Article 9 of implementing position limits and large position reporting regimes on derivative trading.
However, the Second Draft retains the requirements of aggregating positions of derivative and futures trading when implementing the position limits and large position reporting regimes for futures trading. According to the Drafting Statement, the CSRC points out that this is to improve the position limits and large position reporting regimes that have already been adopted for the futures market and prevent any evasion of regulations applicable to the futures market through derivative transactions. In our view, this means that futures exchanges may look through derivative trading and apply the “consolidated positions” to determine whether relevant trading institutions have complied with the position limits and large position reporting regimes for the futures market.
Trading Information Reporting Mechanism
First Draft v.s. Second Draft
JunHe’s Submission on First Draft
2. Art. 12.3 v.s. Current Art. 11.3
Derivative operation institutions shall record the data and information of the counterparties, contracts, trading strategies and the trading details of the derivative contracts relating to hedging transactions. Securities and futures trading venues may, based on the needs of monitoring, require derivative operation institutions to provide the foregoing data and information.
…It is unclear how derivative operation institutions should report the relevant trading information, including the reporting procedures and reporting templates. To ensure the operability of Article 12.3, more implementation details are expected to be formulated by the relevant exchanges. We suggest the relevant exchanges consider consulting the public and allowing sufficient time for market participants to ensure their readiness for reporting obligations.
Our Interpretations and Observations
The Second Draft slightly adjusts the requirement of derivative operation institutions for recording and reporting information on the derivative contracts relating to hedging transactions, namely, it amends the general recording scope of “data and information” to only “information” and removes “trading strategy” from the recording scope. This reflects the CSRC’s response to market participants’ comments that the“trading strategy” may vary trade-by-trade, which is not capturable data, and derivative operation institutions are not aware of the trading strategy of their clients on a trade-by-trade basis.
Notably, it still requires further clarification or detailed implementation rules on how offshore derivative operation institutions may discharge their trading information recording obligations. We will closely monitor any practice or regulatory developments as to when relevant exchanges would require derivative operation institutions to report relevant information.
Consolidated Positions of Derivative Trading and Physical Trading of Underlying Assets
First Draft v.s. Second Draft
JunHe’s Submission on First Draft
3. Art. 14 v.s. Current Art. 14
For the performance of information disclosure obligations or in the acquisition activities or other activities, a derivative contract held by a derivative operation institution or 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”) that have voting rights as the underlying assets shall be calculated in aggregate with the underlying stocks directly or indirectly held by the derivative operation institution or trading institution in accordance with the provisions of the securities trading venue.
1.We understand that Article 14 sets forth the requirement for aggregating physical stock positions with stock positions held indirectly through OTC derivative transactions for the purpose of information disclosure and listed-company acquisition activities. In practice, certain counterparties of derivative trading may not have the voting rights and investment decision-making power over the underlying assets. We would suggest the CSRC explicitly specify such circumstances when “consolidated positions” are not required.
2.As provided under Article 14, “consolidated positions” shall apply to information disclosure and listed company acquisition activities. We suggest the CSRC clarify that the calculation of “5% shareholders” for the purpose of short-swing profit restrictions and the application of Article 21.1 of this First Draft shall not include derivative positions.
Our Interpretations and Observations
The CSRC clarifies in the Second Draft that only where the derivative contract is linked to listed shares with voting rights, such derivative trading positions shall be calculated in aggregate with the physical trading positions of such underlying listed shares.
We have advocated to exclude derivative transactions where no voting rights and investment decision-making powers are passed on when aggregating derivative trading positions with physical trading positions of the same listed shares. The Second Draft provides only limited exemptions of aggregation, i.e., only listed shares without voting rights can be disaggregated. We suggest that the CSRC consider other exempted circumstances, such as, where a trading institution does not have the relevant voting rights and investment decision-making power over the underlying listed shares under the derivative transaction entered into with the derivative operation institution.
Besides, the CSRC does not adopt the comment that “consolidated positions” should not apply to the calculation of “5% shareholders” under the short-swing profit rules as well as the relevant provisions of the Measures. We expect that the CSRC may take a strict view and apply the “consolidated positions” to the calculation of “5% shareholders” under the short-swing profit rules as well as the relevant provisions of the Measures.
Prohibited Derivative Trading Activities
First Draft v.s. Second Draft
JunHe’s Submission on First Draft
4. Chapter 3 v.s. Current Chapter 3
We note that Chapter 3 has codified the existing self-regulatory rules and normative documents on prohibited OTC derivative trading activities (such as OTC options and swaps). We understand these existing self-regulatory rules and normative documents reflect the “enhanced regulation” and impose high requirements on domestic securities companies (and other operation institutions) to prudently carry out derivative business, which is adaptive to the current market development stage. However, since the Measures, as administrative regulations, have a higher legal effect, the relevant provisions should be more stable. We suggest the Measures be distinguished from time-sensitive self-disciplinary rules or regulatory policies, and only provide for illegal acts that are contained in the current laws and administrative regulations, such as illegal acts related to information disclosure, short-swing profit rules, fraud, insider trading, and market manipulation, rather than acts that breach self-disciplinary rules or normative documents.
Our Interpretations and Observations
The CSRC does not adopt the comment that the circumstances prohibited under these Measures should be limited to illegal acts that are explicitly specified in the current laws and administrative regulations. This indicates the CSRC’s intention to strengthen derivative market regulation. It is reasonably certain that these prohibited derivative trading activities under the current Chapter 3 will be retained in the final version of the Measures.
The Prohibition of Evading Shares Selling Restrictions and Enhancing Derivative Operation Institutions’ Obligations
First Draft v.s. Second Draft
JunHe’s Submission on First Draft
5. Art. 19 v.s. Current Art. 19
It shall be prohibited to circumvent the shareholding reduction rules and restricted shares rules through derivative trading.
Art. 21 v.s. Current Art. 21
A derivative operation institution shall be prohibited from engaging in derivative trading with shareholders of a listed company who holds 5% or more shares of such listed company, the de facto controller, directors, supervisors, and senior management personnel of such listed company, or with the shareholders who hold lock-up shares or restrictive shares if the underlying assets of the derivative trading are stocks of such listed company.
When the above paragraph applies, the shares held by a shareholder of the listed company and its persons acting in concert shall be calculated in aggregate.
A derivative operating institution shall conduct look-through verification of verify the real identity of a trading institution and the trading purpose and shall not conduct the transactions as provided in the first paragraph with any persons specified in the preceding two paragraphs or with the relevant products, legal persons and partnership enterprises controlled or established by them.
Article 21 expands the prohibited target clients under the current self-disciplinary rules1 to include any shareholders who hold lock-up shares or restrictive shares and widely prohibits derivative operation institutions from entering derivative transactions with them. We believe this restriction may have a negative impact on the legitimate trading activities of market participants. Additionally, it may be more appropriate to put Articles 19 and 21 under self-disciplinary rules or normative documents, to clearly define the boundary of illegal acts and violations.
Our Interpretations and Observations
Though we highlighted to the CSRC that the stringent restrictions under the previous Articles 19 and 21 may have a negative impact on the legitimate trading activities of market participants, the previous Articles 19, 21 and 20 have been retained in the Second Draft as follows: (1) It shall be prohibited to circumvent the shares selling restrictions of lock-up shares and restrictive shares through derivative trading (current Article 19). (2) (i) A derivative operation institution shall be prohibited from engaging in derivative trading with shareholders of a listed company who hold 5% or more shares of the listed company, the de facto controller, directors, supervisors, and senior management personnel of the listed company, or with shareholders who hold lock-up shares or restrictive shares if the underlying assets of the derivative trading are stocks of the listed company. (ii) When the above (i) applies, the shares held by a shareholder of the listed company and its persons acting in concert shall be calculated in aggregate. (iii) A derivative operating institution shall verify the real identity and the trading purpose of a trading institution and shall not conduct the transactions as provided in paragraph (i) with any persons specified in the preceding paragraphs (i) and (ii), or with the relevant products, legal persons and partnership enterprises controlled or established by them (current Article 21). (3) A derivative operation institution or trading institution shall be prohibited from concluding derivative trading with a counterparty when they know or ought to know that the counterparty conducts any of the prohibited activities as provided in Articles 15 to 21 hereof through derivative trading (current Article 22).
This reiterates the CSRC’s attitude towards cracking down on the evasion of selling restrictions of lock-up shares and restrictive shares through derivative transactions. In the current market environment, it seems certain that the Measures will eventually be promulgated to include those provisions.
Notably, the CSRC sets forth relatively higher KYC and compliance requirements for derivative operation institutions, i.e. derivative operation institutions are obliged to verify a client’s real identity and trading intention, and shall not enter into derivative transactions referencing the shares of a listed company with such listed company’s shareholders who are subject to various share selling restrictions, nor with the relevant products, legal persons and partnership enterprises controlled or established by them. If a derivative operation institution or trading institution enters into a derivative transaction with a counterparty when they know or ought to know that the counterparty conducts any of the prohibited activities, both contractual parties may be held liable for the breach of the regulation.
Overseas Institutions Engaged in Derivative Business in the PRC
First Draft v.s. Second Draft
JunHe’s Submission on First Draft
6.Art. 50.1 v.s. Current Art.48
Overseas operation institutions engaged in derivative trading business in China shall obtain approval from the CSRC and comply with the provisions of these Measures.
Form a legal perspective, we believe that the previous Article 50.1 may be regarded as imposing an administrative licensing requirement beyond the authorization of the FDL. …The FDL does not provide for an explicit administrative licensing requirement for overseas institutions engaged in derivative trading business in China ….
Our Interpretations and Observations
The CSRC has adopted our comment and removed the previous Article 50.1 that required an overseas operation institution engaged in derivative trading business in China to obtain approval from the CSRC and to comply with the provisions of these Measures.
Different Scenarios That Trigger Extraterritorial Effects
First Draft v.s. Second Draft
JunHe’s Submission on First Draft
7. Art. 50.2 v.s. Current Art.48
Where an overseas operation institution and an overseas trading institution conducts derivative trading outside China while the relevant hedging transactions take place within China, they shall comply with the relevant provisions of Article 12, and Article 14 to Article 22 Article 11 of these Measures.
Conducting derivative trading outside China that links to underlying assets in China shall be subject to Articles 13 to 22 of these Measures.
… We suggest that the extraterritorial effect of the previous Article 50.2 should only apply to offshore derivative trading if there is a “disruption of the domestic market order and damage to the legitimate rights and interests of domestic traders” as provided by Article 2.2 of the FDL ….
Our Interpretations and Observations
Pursuant to the Drafting Statement, the CSRC stated the purposes of the previous Article 50.2 are (i) to implement Article 2.2 of the FDL, which provides that “derivative trading and related activities that take place outside the PRC and disrupt domestic market order and damage the lawful rights and interests of domestic traders shall be handled and investigated for liabilities according to the FDL”, and (ii) to apply regulations equally to both domestic and overseas institutions so as to prevent regulatory arbitrage.
The current Article 48 clarifies the extraterritorial effect from the following two aspects: (i) the current Article 11 shall apply to an overseas operation institution where it conducts derivative trading outside the PRC but conducts the relevant hedging transactions within the PRC, that is, such an overseas operation institution shall perform the information recording and reporting obligations according to the current Article 11; and (ii) the current Articles 13 to 22 shall apply to offshore derivative trading as long as such derivative trading “relates to domestic underlying assets”, regardless if the relevant hedging transaction takes place within the PRC or not.
These amendments deliver a clear message to the market: all foreign participants shall avoid conducting any kind of activity that uses derivatives as a “channel” to circumvent regulation, for example, the three major types of activity explicitly prohibited by the current Articles 13 to 21: (i) not circumventing position limits, information disclosure requirements, or selling restrictions of lock-up shares and restrictive shares through derivative trading; (ii) not carrying out short-swing profit trading, insider trading, and market manipulation through derivative trading; (iii) derivative operation institutions should not enter into derivative transactions, with respect to the stocks of a listed company, with any of its major shareholders, de facto controllers, directors, supervisors, and senior executives, or with any of its shareholders who hold lock-up shares or restrictive shares of such listed companies.
