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)