alerts & publications
Considering All The Options - China's onshore trading of Renminbi optionsApril 8, 2011
Last week, on Friday, 1st April 2011, China began the domestic trading of Renminbi (RMB) options against other currencies. Although initial trading was thin, with reports that many Chinese banks are still familiarising themselves with the new product, this was nonetheless an important event. As well as illustrating the continuing evolution of the RMB as a more global, flexible and indeed volatile currency, it has significant implications for China’s capital account.
In this Client Alert, O’Melveny lawyers consider how it is intended that these RMB options will work and what their introduction could mean for China - and the rest of the world.
Quick read: What is a currency option?
A currency option is a derivative contract under which one party pays a premium in return for the right - but not the obligation - to buy or sell a certain currency at a particular price (the ‘strike price’) on a specific date or during a specific period. A call option grants the right - but not the obligation - for a buyer of the option to acquire a currency from the other party at a specified price. A put option which grants the right - but again not the obligation- for a buyer of the option to sell a currency to the other party.
Major step - but limited in scope
Trading of these new derivatives will be limited in scope, at least at first.
- Hedging, not speculation: Only businesses using options for real trading and investment purposes will be permitted to trade them.
- Businesses can trade put and call options - but can only purchase them: Businesses can purchase both put and call options. However, except for limited reverse closings or squaring positions, they are not permitted to sell options. This restriction is no-doubt designed to prevent short-selling and keep trading confined to genuine hedging.
- European-style options: The options will be European-style, meaning they will only be able to be exercised upon a particular date (the date on which the contract expires) and not any other time. This gives less flexibility than, for example, an American-style option (which can be exercised at any time before a particular date).
- Full amount settlement: The general position is that if a business elects to exercise an option, it will be required to pay the full amount of the strike price.
- Experience requirements: Banks looking to trade options will be required to have at least more than three years’ experience in trading fx forwards and also relevant experience in trading fx options.
- Limited market: Only banks or financial institutions that are members of the China Foreign Exchange Trading System will be permitted to offer these option products to their clients.
These restrictions and the strict vetting procedures for banks mean that initial volumes of these derivatives may be low.
The domestic trading of RMB options against other currencies follows a series of recent measures aimed at giving businesses in China more ways to manage their growing exchange rate risk. Until recently, the choices available to these businesses were rather limited, with only relatively simple products such as RMB forwards being available. This is changing. Earlier this year, the State Administration of Foreign Exchange (SAFE) announced that as from 1 March 2011, banks would be allowed to trade currency swaps for corporate clients. The introduction of these RMB options now makes another key hedging tool available.
Quick read: What is a forward?
A forward is a contract where two parties agree to buy or sell assets at a specified future time at a price agreed today.
However, the significance of the introduction of these RMB options goes beyond ‘simply’ offering companies a new risk management tool. As all of those who deal with China are acutely aware, China’s capital account is relatively closed. Nevertheless, from RMB accumulation in Hong Kong to trade flows in RMB, cross-border RMB loans to support RMB bonds and outbound acquisitions in RMB, the pressures on this capital account have been steadily mounting. The introduction of these RMB options is an important indication that now policy makers in China are prepared to consider easing controls on the country’s capital account even further. Were any future developments to include a move towards the trading of RMB securities, we could see that China’s capital account is, for all intents and purposes, open, albeit on a de facto basis.
Quick read: What is China’s closed capital account?
A country’s capital account is a major component of its balance of payments, reflecting the net change in the national ownership of assets. China’s capital account is relatively closed, with controls in place to restrict the flow of capital across the country’s borders. There are some benefits to this - economies with extensive capital restrictions have had some past success in avoiding external imbalances and pressures and China’s closed capital account has been credited with shielding it from the worst of the recent Asian and global financial crises. But there are also concerns that a closed capital account can create other problems, with issues such as the lack of external market discipline and the potential misallocation of resources domestically amongst the more quoted. In the midst of China’s ongoing financial reform, the question of whether, when and how to liberalise China’s capital account is an important, and increasingly pressing, one for the country’s policy makers.
For those interested, the following information is available (in Chinese):
- SAFE circular on RMB options: here.
- China Banking Regulatory Commission (CBRC) has published a Q&A (in Chinese) on the revised Provisional Administrative Rules Governing Derivatives Activities of Banking Financial Institutions: here.
- SAFE Notice on Designated Banks’ RMB-FX Cross Currency Swaps Business with Their Clients published in January 2011: here.
If you would like further details, please contact the following lawyers at O’Melveny & Myers.
O'Melveny & Myers LLP is a foreign law firm registered with the Ministry of Justice of the People's Republic of China. Under current Chinese regulations, we are allowed to provide information concerning the effects of the Chinese legal environment, but we are not authorized to practice Chinese law or to render legal opinions in respect of Chinese law. We work in cooperation with a number of Chinese law firms. Should you require a legal opinion in respect of any Chinese law matter, we would be happy to assist you in obtaining one from a Chinese firm.
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