RISK MANAGEMENT
Margin Trading and Securities Lending in China
January 18, 2007
Paget Dare Bryan, Clifford Chance - Wang Wai Li, Clifford Chance

August 2006 marked an important development in China's securities market - on a trial basis, China will allow certain elected securities companies to engage in margin trading and securities lending business. Effectively, securities companies will be able to offer margin trading in listed securities to clients and also to lend listed securities to clients for on-sale by those clients, in each case on a collateralised basis. These will provide new trading opportunities to investors who are keen to invest and trade more aggressively and who are prepared to be exposed to greater investment risks.

The conduct of margin trading and securities lending business in China is highly regulated. On 30 June 2006, the China Securities Regulatory Commission (CSRC) issued the Trial Administrative Measures for Margin Trading and Securities Lending Business of Securities Companies (Trial Measures) and the Guidelines on Internal Control for the Conduct by Securities Companies of Margin Trading and Securities Lending Business on a Trial Basis (Internal Control Guidelines), both of which became effective from 1 August 2006. On 20 July 2006, the CSRC further issued the Measures for the Administration of Risk Control Indicators of Securities Companies (Risk Control Indicator Measures), which became effective from 1 November 2006. It is expected that the two stock exchanges in China, the China Securities Depository and Clearing Corporation (CSDCC) and the Securities Association of China (SAC) will also issue a number of related regulations to detail the implementation of the new measures in the coming months.

As a result of this new development, qualified foreign institutional investors (QFIIs) may be able, in due course, to borrow listed securities and enter into margin trades. In light of their experiences gained in foreign securities markets, when permitted, QFIIs may have an advantage over the domestic investors who will be engaging in margin trading and securities lending for the first time. It is still not clear at the time of writing whether the Trial Measures will also apply to the B-share market. If the Trial Measures apply, foreign exchange issues will need to be considered. For example, as B-share investors are typically foreign entities or individuals, any PRC securities company that chooses to engage in margin trading and securities lending in the B-share market will also have to be approved to conduct foreign exchange lending business.

Eligibility Requirements for Securities Companies and Their Clients

A securities company in China may apply to the CSRC for approval to engage in margin trading and securities lending only where it satisfies the following requirements (as specified in the Trial Measures):

• It has been examined by the SAC and confirmed by them to be an 'innovative securities company'. According to the relevant SAC rules, 'an innovative securities company' is a company that satisfies certain prudential requirements. These include the company having formulated and strictly implemented a system that places clients' funds in the custody of an independent third party, and the company abiding by minimum net capital requirements and liquidity ratios, etc. A list of 'innovative securities companies' has been published by the SAC on their website

• It has been conducting brokerage business for a minimum of three years

• It has an established corporate governance and effective internal management control system, and is able effectively to identify, control and prevent operational risks and breaches

• No administrative nor criminal punishment has been imposed on the company, its directors, supervisors nor senior management in the preceding two years, and that none of the company, its directors, supervisors nor senior management are currently under investigation by the CSRC or otherwise subject to a rectification order of the CSRC at that time

• The company is in good financial standing and that over the preceding two years, it has satisfied continuously all regulatory requirements in respect of its business operations

• Its net capital has been at or above RMB1.2bn in the preceding six months

• All clients' assets are accounted for and properly maintained

• Its proposal of how it will place funds under third party custody has been approved by the CSRC, and that the schedule of implementation of that plan has been clearly established

• It has a centralized administration in respect of trading, settlement clearing, managing client accounts and monitoring risks

• It has established standards and centralised systems for monitoring accounts that were opened or/are being operated otherwise than in accordance with applicable laws and regulations

• It has prepared a practical and feasible business plan and an internal administration system for implementing margin trading and securities lending business on a trial basis and that it has all necessary professional personnel, computer systems, funds and securities for conducting such businesses

Once approval from the CSRC to engage in margin trading and securities lending has been obtained, the securities company must also apply to the CSRC for a new Securities Business Operation Permit. This new permit would expand the business scope of the securities company to include the offering of margin trading and securities lending business.

Before providing margin trading or securities lending to clients, securities companies are required to carefully assess and determine their identity, creditworthiness, assets, income, securities investment experience, investment preferences and risk appetite. Securities companies may not offer margin trading or securities to clients who:

• are not able to provide the information required by the securities company

• have traded with the securities company for less than six months

• have not placed their funds with third party custodians

• are not deemed to have sufficient securities investment experience

• are incapable of taking risks or have previously incurred material defaults

• are shareholders or related parties to the securities company

Accounts to be Opened by the Securities Company

In order to carry out margin trading and securities lending business, a securities company must open, in its own name, four accounts with the CSDCC and two accounts with commercial banks. The four accounts to be opened with the CSDCC are:

1. A special securities account for securities lending

This account is for the sole purpose of booking the securities to be lent to and returned by the clients. It is not to be used to trade securities by the securities company. Securities companies may only lend to clients the securities booked in this account.

2. A securities settlement account for margin trading and securities lending

This account is for settling the securities of clients' margin trading or securities borrowing transactions.

3. A cash settlement account for margin trading and securities lending

This account is for settling the income from the clients' margin trading or securities borrowing transactions. Further rules are due to be issued by the CSDCC in respect of this account and the securities settlement account for margin trading and securities lending.

4. A client's collateral securities account for margin trading and securities lending

This account is to be used for booking securities entrusted by clients to securities companies to collateralise amounts owed to the securities companies from their margin trading and securities lending transactions. The Trial Measures expressly provide that securities companies are to hold the securities in this account on trust for their clients as a nominee holder. For each client, the securities company must also open a sub-account under the collateral securities account.

The two accounts to be opened with commercial banks are:

(a) A special cash account for margin trading

This account is to be used for depositing funds that are to lend to clients and for receiving funds returned by clients. Securities companies may only lend to clients amounts deposited in this account.

(b) A client's collateral cash account for margin trading and securities lending

Similar to the client's collateral securities account for margin trading and securities lending, this account is to be used for depositing cash collateral provided by clients for amounts owed by the clients to the securities companies arising from their margin trading and securities borrowing transactions. The securities companies may only hold cash in this account on trust for the clients. Also for each client, the securities company must open a sub-account under this account. For ease of reference, please see diagram below that illustrates the different types of accounts that are required to be opened in the name of the securities company and the clients, with each of the CSDCC and the commercial banks.

Execution of Contracts

Prior to conducting margin trading or securities lending, a securities company and its client must execute certain contracts required under the Trial Measures. The contracts must incorporate mandatory provisions set out in the Requisite Clauses for Margin Trading and Securities Lending Contracts, which, according to the Trial Measures, will be issued by the SAC in due course. Before such contracts are signed by the clients, the securities company must explain how the margin trading and securities lending will be conducted and the content of the contracts to the client, and require the client to sign a transaction risk disclosure letter that specifies certain risks involved in such business. According to press reports, the SAC will publish a standard form risk disclosure letter in due course. It should be appreciated that a client may only maintain margin trading facilities and securities lending business with one securities company in China.

Following execution of the margin trading or securities lending contracts, the securities companies must then open a client's securities collateral account(a sub-account of the client's collateral securities account for margin trading and securities lending) with the CSDCC and a client's cash collateral account (a sub-account of the client'scollateral cash account for margin trading and securities lending) with a commercial bank in the name of the client. The client's securities collateral account will maintain a record of all securities collateral and the client's cash collateral account will maintain a record of all the cash collateral provided by the client.

Collateral

The Trial Measures require a client to provide collateral to their securities company to cover the profits under the margin trading or securities lending transactions. Collateral may be in the form of cash or securities. The securities provided as collateral and all securities purchased by a client by way of margin trading will be deposited in client's collateral securities account for margin trading and securities lending, while the cash provided as collateral and all the income received by the client from selling securities borrowed from the securities company will be deposited in the client's collateral cash account for margin trading and securities lending. All securities and cash held in these accounts will be aggregated as collateral for the client's obligations to the securities company. The value of the collateral provided by a client must be maintained at not less than the minimum collateral maintenance ratio for that particular client as prescribed by the relevant stock exchange.

Securities companies may not dispose of the collateral other than in certain specified circumstances. These include where the minimum ratio fails to be maintained. From time to time, a securities company may require the client to provide further collateral within a certain period, failing which the securities company may dispose of the collateral in accordance with its contract with the client. Securities companies may also dispose of the collateral when settling margin trading or securities lending, or meeting cash, securities, interest, taxes or fees, or liquidated damages due and outstanding by the client. The client may call for all securities and cash amounts that remain in the accounts following full repayment of their obligations to the securities company.

Rights and Entitlement

Securities companies must hold the securities that are deposited in the client's collateral securities account for margin trading and securities lending of that client on trust for that client. Such securities will accordingly be treated as securities of the client (and not of the securities company) and the client will therefore be subject to applicable disclosure requirements in respect of such securities. A securities company must exercise rights against securities issuers in its name in the interests of the clients.

Internal Control Guidelines

Prior to engaging in margin trading or securities lending, securities companies must establish internal rules and precautions in order to segregate the margin trading and securities lending business from their own securities assets management businesses, securities proprietary trading businesses, and investment banking businesses.

Each securities company must also formulate and implement rules on decision-making and authorisations for margin trading and securities lending. The decision-making powers and the authorisations to conduct such business must vest with the headquarters of the securities company. A branch of the securities company may not conduct margin trading and securities lending without prior approval of their headquarters.

Each securities company must establish rules and procedures dealing with client selection, the granting of facilities and authorisations. Each securities company must also prepare a standard margin trading and securities lending contract that is consistent with the Trial Measures and which incorporates mandatory provisions to be published by SAC.

Risk Control Requirements

The Risk Control Indicator Measures require a securities company conducting margin trading and securities lending business to comply with the following requirements:

• the margin trading volume of a single client must not exceed 5% of net capital of the securities company

• the amount of securities lent to a single client must not exceed 5% of the net capital of the securities company

• the market value of the securities in one company provided by a client as collateral must not exceed 20% of the total market value of such securities

• a risk reserve calculated at 10% of the total margin trading volume with clients must be maintained

• a risk reserve calculated at 10% of the total securities lending volume with clients must be maintained

Margin trading volume means the total principal amount lent to clients, while securities lending volume means the total market value of securities lent to clients on that lending date. It appears that the latter does not need to be marked to market.

It was reported that the CSRC is likely to approve initially five securities companies to conduct margin trading and securities lending business on a trial basis. Reportedly, CITIC Securities Co., Ltd., China International Capital Corporation Limited and Guotai Junan Securities Co., Ltd. are likely to receive such approval.

Copyright © ChinaForum 2007