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BSP Relaxes Regulations on Derivative Activities

12.26.2007

BSP Governor Amando M. Tetangco, Jr. announced that the Monetary Board approved the amendments to BSP regulations governing derivative activities of banks and trust entities, including the guidelines on risk management and sale and marketing of derivatives.

The amendments seek to promote growth in the domestic capital market by expanding the range of available derivatives which a bank can originate, distribute or use, without need for prior BSP approval (also known as generally authorized activities).  The broadened generally authorized activities will provide banks, trust entities and their clients not only an additional avenue for investment diversification but also expanded opportunities for financial risk management arising from changes in interest rate, foreign exchange rate and other financial variables.  This is especially relevant to our exporters and OFWs who have clamored for means by which they can be protected from the depreciating US Dollar. 
Concomitant with the liberalization of authority to engage in derivative activities, the amendments introduce the corresponding enhanced supervisory framework over derivatives activities by strengthening risk management guidelines for derivatives activities and allocating BSP resources efficiently in the licensing and supervision of these activities.  Considering the complex nature of derivatives, the amendments endeavor to protect the investing public by providing stringent sales and marketing guidelines, including client suitability procedures and risk disclosure requirements, for banks and trust entities offering derivatives products to clients.

Under the new regulations, a bank can generally engage in any financial derivative transactions for the purpose of hedging its own risks, provided that Philippine Accounting Standards (“PAS”) requirements on hedging are met.  The range of generally authorized activities has also been expanded in terms of instruments and tenors. Under previous regulations, a Universal Bank (“UB”) or Commercial Bank (“KB”) can only deal (whether as dealer or end-user) with FX forwards and FX swaps with a tenor of 1 year or less.  However, the under the new Circular, a UB or KB can deal with currency swaps, interest rate swaps, forward rate agreements and analogous financial futures with longer tenors.  End-users are also classified according to financial sophistication in order to determine the requisite level of disclosures and other investor protection measures (i.e. the lower the financial sophistication, the more stringent the requirements for investment protection measures such as disclosures.). 

As a precaution, generally authorized derivative activities are limited to derivative instruments traded in an organized market, which has been defined as an exchange or BSP-recognized over-the-counter (“OTC”) market governed by transparent and binding market conventions on price transparency, trade reporting, market surveillance and orderly conduct / operations of the market.  To avoid undue speculative activity in the FX market, derivatives involving foreign currency and other foreign currency-denominated assets shall remain subject to pertinent FX rules and regulations, which were simultaneously liberalized to accommodate higher threshold for purchases of foreign exchange from the banking system. 

 
As a general rule, a bank or trust entity may engage in authorized derivative activities as long as it adopts effective risk management practices, has capital commensurate to the risks being taken and complies with pertinent securities laws, rules and regulations.  Authorized derivative activities may either be “generally authorized” and/or those permitted through additional authority/ies which require/s an application therefor.  To engage in derivative activities outside those generally authorized, banks and trust entities may apply for graduated Additional Derivatives Authorities, depending on the additional derivatives activities/instruments in which they wish to engage and the corresponding capability to support the undertaking of such activities.  The new additional authority structure veers away from imposing “one-size-fits-all” licensing requirements under the previous regulations which grant only one type of additional authority (i.e. Expanded Derivatives Authority).   A Type 1 Authority (Expanded Dealer Authority) enables UBs and KBs to deal with any type of derivatives in the capacity of a dealer and/or end-user.  A Type 2 Authority (Limited Dealer Authority), on the other hand, enables UBs and KBs with the capacity to act as dealer/end-user  for specified types of derivatives.   Any bank, including a  trust entity acting on behalf of a trustor, that wishes to transact as end-user in any derivative instrument outside those generally authorized may be issued a Type 3 Authority (Limited User Authority).  Thus, a thrift or rural bank, who wishes to transact with derivatives for purposes other than hedging, may apply for a Type 3 Authority.  A bank that wishes to facilitate the derivative transactions may get a Type 4 – Special Broker Authority.  This additional authority will be particularly relevant to thrift and rural banks who would want to retain the relationship with their clients even for derivative transactions, notwithstanding that they are not yet allowed to act as dealers thereof.

 The amendments also streamline the derivatives licensing process.  Annual renewal of the license, which was required under previous regulations, has been lifted and in lieu thereof, assessment of risk management capabilities for derivative activities shall be included during regular examination.  Holders of additional authorities who do not comply with provisions of the Circular, including risk management guidelines, shall be subject to appropriate sanctions, including curtailment of derivatives authority, which may be equivalent to the non-renewal of license.  The requirements on the submission of product manuals and bank certifications have likewise been scrapped.  Moreover, application for additional authorities has been centralized in a single unit within the BSP-SES to ensure consistent implementation of the requirements.

The new appendix on risk management provides a general framework for the comprehensive management of all relevant risks arising from derivative activities to ensure the prudent uses of derivatives.  Under the Appendix, the risk management system for derivative activities should be integrated with the risk management of all the other activities of the bank to ensure a wholistic picture of the bank’s risk profile.  Moreover, the Appendix shifts to a principles-based supervision on risk management and veers from the usual enumeration/checklist of requirements.  It also places responsibility of compliance with risk management standards on a bank’s board of directors and senior management.  

Furthermore, while the old Appendix 26 merely provided a sample disclosure statement for derivatives, the new Appendix 26 deals extensively with sales and marketing guidelines.  The amendments intensified requirements on disclosure and  introduced a more pro-active responsibility on dealing banks and trust entities to conduct client suitability tests.  As an added protection, a bank’s board of directors and senior management are made liable for acts committed by sales and marketing personnel.

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