• COLL Division 7.4.E COLL Division 7.4.E Derivatives and forward transactions—QFC retail schemes

    Amended by QFCRA RM/2012-5 (as from 1st July 2013).

    • COLL 7.4.8 Derivatives and Forward Transactions Generally—QFC Retail Schemes

      (1) A transaction in a derivative or a forward transaction must not be effected for a QFC retail scheme unless the transaction is—
      (a) permitted under rule 7.4.9 (Permitted transactions in derivatives and forward transactions—QFC retail schemes); and
      (b) covered as required by rule 7.5.1 (Cover for transactions in derivatives and forward transactions—QFC retail schemes).

      Note Derivative is defined in the glossary.
      (2) If a QFC retail scheme invests in a derivative, the exposure to the underlying assets must not exceed the limits in part 7.3 (Investment diversification—QFC retail schemes), except as provided in subrule (4).
      (3) If a transferable security or money-market instrument embeds a derivative, the embedded derivative component must be taken into account in applying any limit under this chapter.

      Note See r (7) on working out whether an instrument embeds a derivative.
      (4) If—
      (a) a QFC retail scheme invests in an index-based derivative; and
      (b) rule 7.4.10 (Permitted financial indices—QFC retail schemes) applies to the index;

      the underlying constituents do not have to be taken into account in the application of part 7.3 to subrule (2) of this rule.
      (5) The relaxation under subrule (4) is subject to the operator complying with rule 7.3.1 (Prudent spread of risk—QFC retail schemes).
      (6) A scheme must not use transferable securities or money-market instruments that embed a derivative to circumvent this chapter.
      (7) Rule 7.4.3(3) (Investments linked etc to other assets as transferable securities—QFC retail schemes) applies to subrules (3) and (6) of this rule, with any necessary changes, for the purpose of working out whether a transferable security or money-market instrument embeds a derivative.

      Guidance on transferable securities and money-market instruments that embed derivatives
      1 Collateralised debt obligations (CDOs) or asset-backed securities using derivatives, with or without active management, will generally not be considered as embedding a derivative unless—
      (a) they are leveraged, that is, the CDOs or asset-backed securities are not limited recourse vehicles and an investor's loss can be higher than the investor's initial investment; or
      (b) they are not sufficiently diversified.
      2 If a transferable security or money-market instrument embedding a derivative is structured as an alternative to an OTC derivative, the requirements of rule 7.4.13 (OTC transactions in derivatives—QFC retail schemes) will apply. This will be the case for tailor-made hybrid instruments, such as a single tranche CDO structured to meet the specific need of a QFC retail scheme. These tailor-made hybrid instruments should be considered to embed a derivative. Such a product offers an alternative to the use of an OTC derivative for the same purpose of achieving a diversified exposure to a preset risk level to a portfolio of entities.
      3 The following list of transferable securities and money-market instruments, which is illustrative and non-exhaustive, could be assumed to embed a derivative:
      (a) credit linked notes;
      (b) transferable securities and money-market instruments if their performance is linked to the performance of a bond index;
      (c) transferable securities and money-market instruments if their performance is linked to the performance of a basket of shares, with or without active management;
      (d) transferable securities or money-market instruments with a fully guaranteed nominal value if their performance is linked to the performance of a basket of shares, with or without active management;
      (e) convertible bonds;
      (f) exchange bonds.
      4 Transferable securities and money-market instruments that embed a derivative are subject to the requirements of this chapter applying to derivatives. It is the operator's responsibility to ensure that these requirements are complied with. The nature, frequency and scope of checks performed should depend on the characteristics of the embedded derivatives and their impact on the scheme, taking into account its investment objectives, strategies and policy and its risk profile.
      Derived from QFCRA RM/2010-05 (as from 1st January 2011)

    • COLL 7.4.9 Permitted Transactions in Derivatives and Forward Transactions—QFC Retail Schemes

      (1) A transaction in a derivative by a QFC retail scheme must—
      (a) be in an approved derivative; or

      Note Approved derivative is defined in r 7.1.8.
      (b) if the transaction is in an OTC derivative—comply with rule 7.4.13 (OTC transactions in derivatives—QFC retail schemes).
      (2) The underlying of a transaction in a derivative by a QFC retail scheme must—
      (a) comply with part 7.2 (Investments generally—QFC retail schemes) and this part; or
      (b) consist of any 1 or more of the following to which the scheme is dedicated:
      (i) financial indices that are permitted financial indices under rule 7.4.10 (Permitted financial indices—QFC retail schemes);
      (ii) interest rates;
      (iii) foreign exchange rates;
      (iv) currencies.

      Note Dedicated is defined in the glossary.
      (3) A transaction in an approved derivative by a QFC retail scheme must be effected on, or under the rules of, a derivatives market that is an eligible market.

      Note Eligible market is defined r 7.1.7.
      (4) A transaction in a derivative must not cause a QFC retail scheme to diverge from its investment objectives, strategies and policy as stated in the constitutional document and the latest filed prospectus.

      Note Constitutional document is defined in r 3.1.1. Latest filed prospectus is defined in the glossary.
      (5) A transaction in a derivative must not be effected by a QFC retail scheme if the intended effect is to create the potential for an uncovered sale of any of the following:
      (a) transferable securities;
      (b) money-market instruments;
      (c) units in collective investment schemes;
      (d) derivatives.

      Note Transferable security is defined in r 7.1.6.
      (6) For subrule (5), a sale is not considered uncovered if the requirements mentioned in rule 7.4.12 (3) (Requirements to cover sales—QFC retail schemes) are met in relation to the sale.
      (7) Any forward transaction by a QFC retail scheme must be made with an eligible bank.

      Note Eligible bank is defined in the glossary.
      (8) A QFC retail scheme must not effect a transaction in a derivative on a commodity.

      Note Commodity is defined in the glossary.
      Amended by QFCRA RM/2016-1 (as from 19th September 2016)

    • COLL 7.4.10 Permitted Financial Indices—QFC Retail Schemes

      (1) For rule 7.4.9 (2) (b) (i) (Permitted transactions in derivatives and forward transactions—QFC retail schemes), a permitted financial index is a financial index that meets all the following requirements:
      (a) the index is sufficiently diversified (see subrule (2));
      (b) the index represents an adequate benchmark for the market to which it refers (see subrule (3));
      (c) the index is published in an appropriate way (see subrule (4)).
      (2) For subrule (1) (a), a financial index is sufficiently diversified if—
      (a) it is composed in such a way that price movements or trading activities for a component do not unduly influence the performance of the whole index; and
      (b) its components are at least as diverse as the investments of a QFC retail scheme are required to be under part 7.3 (Investment diversification—QFC retail schemes).
      (3) For subrule (1) (b), a financial index represents an adequate benchmark for the markets to which it refers if—
      (a) it measures the performance of a representative group of underlyings in a relevant and appropriate way; and
      (b) it is revised and rebalanced periodically, following criteria that are publicly available, to ensure that it continues to reflect the markets to which it refers; and
      (c) the underlyings are sufficiently liquid, allowing users to replicate it if necessary.
      (4) For subrule (1) (c), a financial index is published in an appropriate way if—
      (a) its publication process relies on sound procedures to collect prices, and calculate and subsequently publish the index value, including pricing procedures for components for which a market price is not available; and
      (b) material information is provided on a wide and timely basis on matters such as index calculation, rebalancing methodologies, index changes, and any operational difficulties in providing timely or accurate information.
      (5) If the composition of underlyings of a transaction in a derivative does not satisfy the requirements mentioned in subrule (1) for a permitted financial index, the underlyings for that transaction may be regarded as a combination of the underlyings if they satisfy the requirements of rule 7.4.9 (2) (Permitted transactions in derivatives and forward transactions—QFC retail schemes).

      Guidance on financial indices underlying derivatives
      1 An index based on derivatives on commodities or an index on property may be regarded as a permitted financial index under rule 7.4.10 if it meets all the requirements of the rule.
      2 If the composition of an index is not sufficiently diversified to avoid undue concentration, its underlying assets should be combined with the other assets of the scheme in assessing compliance with the requirements of rule 7.5.1 (Cover for transactions in derivatives and forward transactions—QFC retail schemes) and part 7.3 (Investment diversification—QFC retail schemes).
      3 To avoid undue concentration, if derivatives on an index composed of assets in which a QFC retail scheme cannot invest are used to track or gain high exposure to the index, the index should be at least diversified in a way that is equivalent to the diversification achieved for the scheme by part 7.3.
      4 If derivatives on that index are used for risk-diversification purposes and the exposure of the scheme to the index complies with part 7.3, there is no need to look at the underlying components of the index to ensure that it is sufficiently diversified.
      Derived from QFCRA RM/2010-05 (as from 1st January 2011)

    • COLL 7.4.11 Delivery of Property Under Transactions in Derivatives and Forward Transactions—QFC Retail Schemes

      A transaction in a derivative or a forward transaction by a QFC retail scheme that will or could lead to the delivery of property for the scheme may be entered into only if—

      (a) the property can be held for the scheme; and
      (b) the operator, having taken reasonable care, decides that delivery of the property under the transaction will not happen or will not lead to a breach of these rules.

      Note Property and breach are defined in the glossary.
      Derived from QFCRA RM/2010-05 (as from 1st January 2011)

    • COLL 7.4.12 Requirement to Cover Sales—QFC Retail Schemes

      (1) An agreement must not be made by or on behalf of a QFC retail scheme to dispose of property or rights unless—
      (a) the obligation to make the disposal and any other similar obligation could immediately be honoured by the scheme by delivery of property or the assignment of rights; and
      (b) the property or rights mentioned in paragraph (a) are owned by the scheme at the time the agreement is made.
      (2) Subrule (1) does not apply to a deposit.

      Note Deposit is defined in the glossary.
      (3) Subrule (1) does not apply if—
      (a) the risks of the underlying financial instrument of a derivative can be appropriately represented by another financial instrument and the underlying financial instrument is liquid; or
      (b) the operator or independent entity has the right to settle a derivative in cash, and cover exists within the scheme property that falls within 1 or more of the following asset classes:
      (i) cash;
      (ii) liquid debt instruments (for example, government bonds of first credit rating) with appropriate safeguards (in particular, haircuts);
      (iii) other liquid assets having regard to their correlation with the underlying of the financial derivative instrument, subject to appropriate safeguards (for example, haircuts if relevant).
      (4) In the asset classes mentioned in subrule (3), an asset may be considered as liquid if the financial instrument can be converted into cash in no longer than 7 business days at a price closely corresponding to the current valuation of the instrument on its own market.
      Derived from QFCRA RM/2010-05 (as from 1st January 2011)

    • COLL 7.4.13 OTC Transactions in Derivatives—QFC Retail Schemes

      (1) A transaction in an OTC derivative under rule 7.4.9 (1) (b) (Permitted transactions in derivatives and forward transactions— QFC retail schemes) must be—
      (a) with an approved counterparty (see subrule (2)); and
      (b) on approved terms (see subrule (3)); and
      (c) capable of valuation (see subrule (5)); and
      (d) subject to verifiable valuation (see subrule (6)).

      Note OTC derivative is defined in the glossary.
      (2) For subrule (1) (a), a counterparty is an approved counterparty only if the counterparty is an eligible bank.

      Note Eligible bank is defined in the glossary.
      (3) For subrule (1) (b), the terms of a transaction are approved terms if, before the transaction is entered into, the independent entity is satisfied that the counterparty has agreed with the operator—
      (a) to provide a reliable and verifiable valuation in relation to the transaction corresponding to its fair value at least daily and at any other time at the operator's request; or
      (b) that it or an alternative counterparty will, at the operator's request, enter into a further transaction to sell, liquidate or close out the transaction at a fair value at any time.

      Note Close out is defined in the glossary.
      (4) For subrule (3) (b), fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.
      (5) For subrule (1) (c), a transaction in a derivative is capable of valuation if the operator, having taken reasonable care, decides that, if the transaction were entered into, it would be able to value the investment throughout the life of the derivative with reasonable accuracy on a basis of—
      (a) an up-to-date market value that the operator and independent entity have agreed is reliable; and
      (b) if paragraph (a) does not apply—a pricing model that the operator and independent entity have agreed uses an adequate recognised methodology.
      (6) For subrule (1) (d), a transaction in a derivative is subject to verifiable valuation if the operator, having taken reasonable care, decides that, if the transaction were entered into, the valuation of the investment would be verified throughout the life of the derivative by—
      (a) an appropriate third party independent of the derivative's counterparty, at an adequate frequency and in such a way that the operator can check it; or
      (b) a department within the operator that is independent of the department in charge of managing the scheme property and is adequately equipped to verify the valuation.
      (7) Without limiting rule 4.2.3 (Oversight functions of independent entity—all QFC schemes), the independent entity must take reasonable care to ensure that the operator has systems and controls that are adequate to ensure compliance with this rule.
      Derived from QFCRA RM/2010-05 (as from 1st January 2011)

    • COLL 7.4.14 Risk Management for Transactions in Derivatives and Forward Transactions—QFC Retail Schemes

      (1) The operator of a QFC retail scheme must use a risk management process that enables it to monitor and measure, as frequently as appropriate, the risks associated with—
      (a) the scheme's derivatives and forward positions; and
      (b) their contribution to the overall risk profile of the scheme.
      (2) The operator must tell the Regulatory Authority about the following details of the risk management process before using the process:
      (a) the methods for estimating risks in derivative and forward transactions;
      (b) the types of derivatives and forward transactions to be used within the scheme together with their underlying risks and any relevant quantitative limits.
      (3) The operator must tell the Regulatory Authority in advance about any material change proposed for the details of the risk management process mentioned in subrule (2) (a) or (b).

      Guidance on risk management process
      1 The risk management process for a QFC retail scheme should take account of the investment objectives, strategies and policy of the scheme as stated in the constitutional document and latest filed prospectus.
      2 The independent entity should take reasonable care to review the appropriateness of the risk management process in accordance with its functions under these rules.
      3 The operator is expected to demonstrate more sophistication in its risk management process for a QFC retail scheme with a complex risk profile than for a QFC retail scheme with a simple risk profile. In particular, the risk management process should take account of any characteristic of non-linear dependence in the value of a position to its underlying.
      4 The operator should take reasonable care to establish and maintain the systems and controls appropriate to its business that are required by CTRL.
      5 The risk management process should enable the re-calculation required by rule 7.5.3 (Continuing nature of limits and requirements for derivatives and forward positions—QFC retail schemes) to be undertaken at least daily or at each valuation point, whichever the more frequent.
      6 The operator should undertake the risk assessment with the highest degree of care if the counterparty to the derivative is an associate of the operator or the credit issuer.
      Derived from QFCRA RM/2010-05 (as from 1st January 2011)