Regulations governing the derivatives activities of banks

CIRCULAR NO. 594 Series of 2008

The Monetary Board, in its Resolution No. 1457 dated 21 December 2007, approved the following amendments to Section X602 and its subsections, Appendices 25 and 26 of the Manual of Regulations for Banks (“MORB”) regarding the regulations governing the derivatives activities of banks.

1. Statement of Policy

The Bangko Sentral ng Pilipinas (“BSP”) supports the development of the Philippine financial market by providing banks and their clients with expanded opportunities for financial risk management and investment diversification through the prudent use of derivatives.

A bank may engage in authorized derivatives activities, provided that the bank:

Understands, measures, monitors and controls the risks assumed from its derivatives activities;

Adopts effective risk management practices whose sophistication are commensurate to the risks being monitored and controlled; and

Maintains capital commensurate with the risk exposures assumed.

2. Section X602 and Subsections X602.1-X602.7 and X602.15 are hereby replaced as follows:

“Sec. X602 Derivatives. A bank may engage in financial derivatives activities in accordance with these guidelines.  The transacting bank shall have the responsibility to comply with the guidelines set out in this Section, including the relevant appendices, and other applicable laws, rules and regulations governing derivatives transaction.  In case of derivatives instruments involving foreign currencies and/or other foreign currency - denominated assets, the transacting bank shall observe the pertinent foreign exchange (“FX”) rules and regulations.  For purposes of these guidelines, a bank that transacts (i.e., transacting bank), whether as end-user, broker or dealer, in derivatives instruments is considered to be engaging in a derivatives activity. derivative is broadly defined as a financial instrument that primarily derives its value from the performance of an underlying variable.  For purposes of these guidelines, a financial derivative is any financial instrument or contract with all of the following characteristics:

(1) Its value changes in response to a change in a specified interest rate, financial instrument price, commodity price, FX rate, index of prices or rates, credit spread, credit rating or credit index or other variables not  prohibited under existing laws, rules and regulations (the “underlying”);

(2) It requires either no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and

(3) It is settled at a future date.

Financial derivatives activities shall also include transactions in cash instruments with embedded derivatives that reshape the risk-return profile of the host instrument, such as credit-linked notes (“CLNs”) and other structured products (“SPs”) .

A market participant may take any of the following roles in a derivatives transaction:

1. An end-user is defined as a financial market participant that enters, for its own account, in a derivatives transaction for legitimate economic purposes.  These purposes may include, but are not limited to, the following: hedging, proprietary trading, managing capital or funding costs, obtaining indirect exposures to desired market factors, investment, yield-enhancement, and/or altering the risk-reward profile of a particular item or an entire balance sheet.

An end-user may be classified according to its financial sophistication:

a. Market Counterparty – refers to any UB or KB, only with respect to the instruments for which it is authorized to engage in as a dealer.

b. Institutional Counterparty – refers to an institution which is not a market counterparty and has the level of net worth, knowledge, expertise, and experience to deal with financial derivatives.

c. Sophisticated Individual End-User – refers to an individual who has demonstrated to the bank as having the level of net worth, knowledge and experience in dealing with financial products, including financial derivatives.  An individual may register as a sophisticated individual end-user with the Centralized Applications and Licensing Group of the BSP.

d. Other End-user – This refers to all other institutional or individual clients not categorized as market counterparty, institutional counterparty or sophisticated individual end-user.

2.  A broker is a financial market participant that facilitates a derivatives transaction between a dealer and its client, for a fee or commission.  The counterparties to the derivatives contract are the client and an authorized dealer.

3. A dealer is defined as a financial market participant that engages in a derivatives activity as an originator of derivatives products or as market-maker in derivatives products.  A dealer can distribute its own derivatives products, including those of others.  A dealer can also act as broker and/or end-user of derivatives instruments.

§ X602.1 Generally Authorized Derivatives Activities.

A bank may engage in the following derivatives activities without need of prior BSP approval, provided it observes the provisions of Appendix 25 of the MORB and meets the conditions specified in this Subsection:

a. Universal banks (UBs) and Commercial banks (KBs) may transact in the following derivatives in the capacities specified:

1. As a Dealer.  A UB or KB may originate and distribute the following “organized market”-traded financial derivatives:

a. FX Forwards, FX Swaps, Currency Swaps and analogous financial futures with a tenor of three years or less; and

b. Interest Rate Swaps, Forward Rate Agreements and analogous financial futures with a tenor of ten years or less.

Provided that the issuance of sub-participation in any derivatives held as an end-user shall be deemed as undertaking the role of a dealer; Provided further that the dealer UB or KB observes the provisions of Appendix 26 and other pertinent securities laws, rules and regulations.

For purposes of this Section, an organized market refers to an exchange or a BSP-recognized over-the-counter market governed by transparent and binding market conventions on price transparency, trade reporting, market surveillance and orderly conduct / operations of the market. 2. As End-User.

a. A UB or KB, including its trust department, may enter in any financial derivatives transaction for the purpose of hedging its own risks; Provided that it observes all the requirements for hedging transactions under Philippine Accounting Standards (“PAS”).

b. A UB or KB may trade with counterparties in order to take positions for its own account in “organized market”-traded financial instruments enumerated under item 1 above. It can also take long positions in naked FX options with a tenor of three years or less.

c. Regular Banking Units (RBU) and Expanded Foreign Currency Deposit Units (EFCDU) of UBs and KBs, including its trust departments, may invest, for their own account, in the following SPs:

i. Principal-protected foreign currency-denominated SPs, the revenue streams of which are linked to interest rate indices,  interest rate instruments, listed equity shares or indices, FX rates, credit rating or index, or gold; Provided that the maximum contractual maturity shall be five years;

ii. Plain Vanilla Single-name CLNs where the reference asset is an obligation issued or guaranteed by the Republic of the Philippines.

Provided that the bank or trust entity shall comply with the following conditions:

Total carrying value of all investments in SPs shall not exceed one hundred percent (100%) of the bank’s qualifying tier 1 capital or 50% of a trust entity’s trust assets;

For investments in SPs under the Expanded Foreign Currency Deposit Unit (“EFCDU”), total carrying value of SPs as defined herein shall also not exceed 20 percent of the total FCDU assets; Provided that SPs which are not booked in an investment account (e.g., booked as inter-bank loans), for this purpose, shall be considered as part of theEFCDU assets.

An SP is considered principal-protected if the minimum all–in return for such investment is at least zero and such minimum all–in return is guaranteed by an entity (i.e. issuer or a third party) rated at least “A” or its equivalent by an international rating agency acceptable to the BSP or fully collateralized by an asset with equivalent credit quality

3. As a Broker .  A UB or KB may facilitate derivatives transactions between dealers and market and/or institutional counterparties and/or sophisticated individual end-users; Provided, that the UB/KB, acting as broker, ensures that its client fully understands its limited responsibility as a broker:  Provided further that the bank adheres to procedures for evaluating client suitability, including risk disclosures, as prescribed in Appendix 26; Provided finally that the bank complies with other pertinent securities laws, rules and regulations.

b. Thrift banks, rural banks and cooperative banks may enter in derivatives transactions as end-user with BSP-authorized dealers and brokers solely for hedging purposes; Provided that they observe all the requirements for hedging transactions under Philippine Accounting Standards (“PAS”).  A thrift, rural or cooperative bank may apply for a Type 3 Authority to enter into a derivatives transactions as end-user for purposes other than hedging, Provided that the applicant bank agrees to be covered by all regulations prescribing capital for market risk, notwithstanding any provision to the contrary.

c. A trust department of a UB or KB may transact, as an institutional counterparty, with financial derivatives instruments enumerated under Subsection 602.1 (a) (2) on behalf of its trustor/principal/s as may be authorized by such trustor/principal/s; Provided that the trust department observes the relevant provisions of Appendices 25 (i.e., risk management) and 26 (i.e., ascertaining client suitability to the derivatives product and minimum risk disclosures).  Trust entities other than that within a UB or KB may apply for a Type 3 Authority to enter on behalf of its trustor/principal/s a derivatives transaction under Subsection 602.1 (a) (2).  Any trust entity may also apply for Type 3 Authority in order to transact as end-user on behalf of its trustor/principal/s with derivatives instrument outside those enumerated under Subsection 602.1 (a) (2).

§ X602.2 Activities Requiring Additional Derivatives Authority.  A bank shall apply for prior BSP approval of additional derivatives authority to engage in all other financial derivatives activities not expressly allowed in Subsection X602.1.  A bank may apply for two or more additional authorities.  A bank applying for additional derivatives authority/ies must have and maintain a risk management system commensurate to the additional authority/ies being applied for, in accordance with the provisions of Appendix 25 and meet other conditions specified under this Subsection. a. Classification of Additional Derivatives Authority.

1. Type 1 –Expanded Dealer Authority

A UB or KB may apply for a Type 1 Authority.  A bank with Type 1 Authority may transact in any financial derivatives as a dealer; Provided, that a bank with Type 1 Authority shall comply with the sales and marketing guidelines prescribed in Appendix 26.  A bank with Type 1 Authority may likewise transact in any financial derivatives as a broker and an end-user.

The BSP expects banks applying for Type 1 Authority to institutionalize a (i) comprehensive and integrated risk management system; and (ii) sales and marketing practices that are deemed appropriate and adequate for the different derivatives activities it expects to engage in.  It must be rated at least CAMELS (or ROCA for branches of foreign banks) of “4” or better over-all, notwithstanding any provision to the contrary.

2. Type 2 –Limited Dealer Authority

A UB or KB may apply for a Type 2 Authority.  A bank with Type 2 Authority may operate as a dealer in specific types of derivatives products with specific underlying reference, as applied for by the bank, outside those financial derivatives instruments under Section X602.1 (a) (1); Provided, that a bank with Type 2 Authority shall comply with the sales and marketing guidelines prescribed in Appendix 26.  The Type 2 Authority also carries authority to transact as broker and end-user of the said specific derivatives instruments.

3. Type 3 – Limited User Authority

Any bank may apply for a Type 3 Authority.  A bank with Type 3 Authority may transact, as an end-user, in specific types of derivatives products, with specific underlying reference, as applied for by the bank, outside of those instruments under Section X602.1 (a) (2).  However, as regards a thrift, rural or cooperative bank and trust entity other than that within a UB or KB, a Type 3 Authority will enable said bank/entity to transact as end-user of a derivatives instruments as may be applied for by the bank.

4.  Type 4 – Special Broker Authority

A bank, other than a UB or KB, may apply for a Type 4 Authority.  A bank with Type 4 Authority may facilitate a derivatives transaction between a UB or KB, as dealer, and market and institutional counterparties and sophisticated individual end-users; Provided, that the bank, acting as broker, ensures that its client fully understands its limited responsibility as a broker and observes the provisions of Appendix 26.

A UB or KB may likewise apply for a Type 4 Authority to enable itself to broker derivatives transaction for or with Other End-users.

A bank with additional Type 1, 2 or 4 Authorities shall be responsible for complying with pertinent securities laws, rules and regulations.

For purposes of this Subsection, the types of derivatives are classified as follows: forwards, swaps and options.  Underlying reference pertains to the following: interest, FX, equity, credit and commodity.

b. Qualification requirements. A bank applying for additional authority to engage in expanded derivatives activities shall:

1. Demonstrate adequate competence in its general operations as evidenced by:

(a) CAMELS (or ROCA for branches of foreign banks) composite rating of at least “3” with a similar rating for Management;

(b) No unresolved major safety and soundness issues that threaten liquidity or solvency; and

(c) Substantial compliance with regulations on anti-money laundering, corporate governance and risk management.

2. Hold capital commensurate to the risks assumed or to be assumed from the derivatives activities.  The BSP expects a bank applying for or holding additional derivatives authority to have adequate capital to accommodate existing and future risks from additional and generally authorized derivatives activities as well as risks arising from the bank’s other business activities.   For this purpose, the BSP may require capital higher than the minimum required under prudential regulations.

3. Have and maintain a risk management system that conforms to the principles and complies with the minimum standards prescribed in Appendix 25.

c. Applicability to Trust Entities.  Trust entities may apply for Type 3 Authority, provided they comply with the requirements prescribed and observe the provisions of Appendix 26.

d. Application Procedures.  The applicant shall submit to the Capital Markets Specialist Group, Supervision and Examination Sector (“SES”) of the BSP a written application for additional derivatives authority/ies accompanied by:

1. A copy of the board resolution (or equivalent management review body in the case of branches of foreign banks or trust committee, in case of trust entities) approving the application for a specific type of derivatives authority;

2. A notarized certification signed jointly by the President, Treasurer and Compliance Officer of the applicant-bank (or two authorized signatories of equivalent rank of the trust committee in case of trust its entity), stating that the bank complies with all the requirements for the authority being applied for specified in Subsection X602.2; and

3. A list of the types of derivatives and underlying reference the bank intends to engage in, including the following information for each derivatives class or type:

a) Target customers for such derivatives;

b) The capacity in which the bank intends to engage in such derivatives;

c) Description of each type of derivatives and underlying reference with which it will deal;

d) Analysis of the risks involved in transacting in each type of derivatives;

e) Procedures/methodologies that the bank will implement to measure, monitor (including risk management reports) and control the risks inherent in the types of derivatives;

f) Relevant accounting guidelines, including pro-forma accounting entries;

g) Analysis of any actual or potential legal/regulatory restrictions; and

h) Process flow chart, from deal initiation to risk reporting, indicating the departments and personnel involved in identified processes.

4. Payment of a non-refundable processing fee amounting to:

Amount: Type 1 Authority          P  200,000.00 Type 2 Authority              100,000.00 Type 3 Authority                50,000.00 (for UBs and KBs) 25,000.00 (for other applicants) Type 4 Authority                 25,000.00

5. The BSP will not accept applications lacking any of the above-stated requirements.  The BSP, however, may require additional documents to aid its evaluation of the application. By virtue of the application, the applicant automatically authorizes the BSP to conduct an on-site evaluation of the applicant’s risk management capabilities, if this is deemed necessary.

6. Type 1 Authority shall be subject to approval by the BSP Governor, upon recommendation of the Deputy Governor, SES.  All other applications for additional authority/ies shall be subject to approval by the Deputy Governor, SES.

7. A bank whose application for additional derivatives authority/ies or an upgrade thereof (e.g. From Type 2 to Type 1 Authority) has been denied cannot submit a new application for additional derivatives authorities until after six months from receipt of denial.  The same rule applies for a bank whose authorities have been limited or downgraded.

8. A bank that holds an additional derivatives authority may apply for additional derivatives authorities (e.g., currently holding Type 3 Authority who wish to apply for Type 4 Authority) or an upgrade thereof only after the lapse of 6 months from the grant of the previous additional derivatives authority.

§ X602.3 Intra-group transactions.   All derivatives transactions between a bank and any of its subsidiaries and affiliates shall comply with minimum risk management standards for related-party transactions outlined in Appendix 25, as part of the bank’s internal control procedures. The BSP expects banks to establish internal reporting and monitoring system for derivatives activities for related-party transactions.  Failure to comply with minimum standards shall be a ground for citing non-compliance with provisions under Subsections X602.1 and X602.2 without prejudice to other BSP rules and regulations such as those related to corporate governance and unsafe and unsound banking practices.

§ X602.4 Accounting Guidelines.  A bank that engages in derivatives activities must strictly account for such transactions in accordance with PAS.

§ X602.5 Reporting Requirements.  A bank or trust department/entity engaged in any derivatives transaction shall submit, in addition to the derivatives reports enumerated under the BSP Financial Reporting Package (FRP), a monthly report on derivatives transactions/outstanding derivatives in the attached format (Annex “A”) within fifteen (15) banking days from end of the reference month.…