Liu Yi

Run Ming Law Office

liuy@runminglaw.com

Amid large losses suffered by many state-owned enterprise such as Air China, China Eastern Airlines and China Southern Airlines resulting from their entering into (often complicated) financial derivatives transactions, the State-owned Assets Supervision and Administration Commission of the State Council (Sasac) recently issued its State-owned Assets Supervision and Administration Commission of the State Council, Circular on Further Strengthening the Regulation of Financial Derivatives Transactions of Centrally-governed Enterprises (国有资产监督管理委员会关于进一步加强中央企业金融衍生业务监管的通知).

The issuance of the Circular aims at clamping down on speculative derivatives transactions which have caused huge losses to Central SOEs. However, as with previous rules and regulations, it fails to define what constitutes a “speculative transaction”. It also remains to be seen whether any senior personnel of a Central SOE will lose their job under the accountability system for which the Circular calls.

The main provisions of the Notice can be summarised as follows:

1. Clean-up of existing transactions
The Circular orders all central government controlled enterprises (Central SOEs) to conduct a review of financial derivatives transactions into which they have entered, such as futures, options, forwards, swaps and their combination, in order to check internal control and risk management and evaluation of product risks. Those speculative transactions – including those which exceed the original approved scope, have too large a position, or have too long a duration – must be ceased immediately. Central SOEs which entered into financial derivatives transactions without government approvals are required to go through the relevant examination and approval procedures, and to reduce or liquidate their holdings. They are not permitted to enter into new transactions before approvals are granted.

Central SOEs are required to put in place a real-time monitoring system so as to gradually establish a mark-to-market system, and to reduce their holdings as appropriate to minimise losses for certain financial derivatives transactions: those which fall within the scope of hedging and do not now incur losses at the moment but have the following features:

(i) large size;

(ii) long maturity;

(iii) many uncertainties embedded in the transactions; and

(iv) large risk positions involved in the transactions.

2. Internal risk control
The Circular reiterates the need for Central SOEs to be aware of risk and to step up internal approval procedures for financial derivatives transactions. Any financial derivatives transactions, including the type of derivatives, value of hedging transactions, products, stop-loss limit and authority of employees at different levels, require the approval of board of directors or the equivalent decision-making body of Central SOEs. They must ensure that all government approvals are secured for financial derivatives transactions where applicable, and filings with Sasac are effected in respect of such financial derivatives transactions. The Circular also prohibits those Central SOEs which are highly leveraged, or which have incurred heavy losses, or which are having cash flow problems from entering into financial derivatives transactions.

The Circular requires Central SOEs to put in place dedicated risk control system or manual specifying the duty of relevant business units and personnel, type of business, products to be traded, scale of business, stop-loss limit, reporting line for individual risk reports, emergency plan, etc. They should also establish a clear authorisation system for the delegation of authority and monetary value in each authorisation. The Circular also requires that options and other over-the-counter transactions into which Central SOEs will enter must be evaluated by an independent third party for purposes of product risk and counterparty credit risk.

Central SOEs should hedge their risk positions by using financial derivatives with a simple structure, good liquidity and controllable risk. For those Central SOEs intending to enter into offshore financial derivatives transactions, they should select overseas agents and traders with due diligence. Central SOEs must also verify their valuation results with their counterparties promptly.

3. Adhere to hedging principle
The Circular again warns Central SOEs to take caution when consider entering into financial derivatives transactions. They should strictly adhere to the hedging purpose when entering into financial derivatives transactions, so as to match such transactions with the type, scale, direction and maturity of spot goods. They may not enter into speculative transactions in any form.

The Circular requires Central SOEs to select simple financial derivatives products which are closely related to their main business, and comply with accounting principles applicable to hedging transactions.

4. Reporting requirement and management accountability
Central SOEs are required under the Circular to file reports with Sasac with 10 business days at the end of each calendar month on financial derivatives transactions they have entered into and their assessments of the transactions.

Central SOEs are also required to establish and improve management accountability systems to define the responsibility of relevant personnel involved in financial derivatives transactions.