Asialaw - Clarity for Corporate Counsel

Permissible Financial Derivatives

Date: March 2005

Keywords (click to search): [securitization]

The increasing availability of sophisticated financial derivative products for Philippine banks and other financial institutions has prompted the Philippine central bank Bangko Sentral ng Pilipinas (BSP) to issue a series of circulars prescribing further refinements on their ability to engage in financial derivatives transactions.

In Circular 297-01 of 2001, the BSP laid out the following general guidelines for financial derivatives transactions by Philippine banks and other financial institutions:

· Universal banks and commercial banks with expanded derivatives licence may trade, sell, deal and take positions in currency swaps and forwards of any tenor, as well as all other derivatives for their own account or on behalf of their customers.

· Financial institutions (FIs) supervised by the BSP with regular derivatives licence may sell derivatives products to their customers on condition that the FIs hedge such derivatives and that the risk being hedged already exists with the FIs themselves.

· Universal banks and commercial banks without derivatives licences may trade, sell, deal and take positions for their own account or on behalf of their customers in currency swaps and forwards with tenor of one year or less. They may also sell other derivative products of licensed entities to their customers, provided that such customers currently have risks with the banks that they wish to hedge.

· Banks and other BSP-supervised FIs with or without derivatives licence may engage in derivatives transactions purely as end-users, on condition that the board of directors of such banks and FIs shall, in their approvals for the use of derivatives, clearly specify the derivatives products to be used and the type of transactions to be hedged. Moreover, such end-user financial derivatives transactions must be limited to hedging purposes only, any such dealings shall only be with licenced/authorized counterparties and any such end-user transactions shall be reported regularly to the board of directors.

As of 2001, the BSP delineated the authorized derivatives transactions of banks and FIs, principally on the basis of the type of banking institution as well as the type of derivatives licences the relevant financial institution possessed. With the exception of currency swaps and forwards, no special guidelines were issued on the basis of the type of financial derivative product. By reference to subsequent regulations of the BSP, the terms 'derivative' or 'derivative product' in Circular 297-01 referred generically to "financial contracts whose values depend on the values of one or more underlying assets or indices" (BSP Circular 360-02).

From the second half of 2003, the BSP began to indirectly refine the parameters set out in Circular 297-01 by focusing on specific financial derivative products. These include new regulatory issuances relating to credit-linked notes, foreign currency-denominated structured, products and securities overlying securitization structures, which indentify the FIs that may transact such products. Thus, with the issuance of new circulars on a product-specific basis, the BSP's Circular 297-01 should be deemed to have been amended accordingly.

Guidelines for the capital treatment of banks' investments in credit-linked notes and similar credit derivative products, such as credit-linked deposits and credit-linked loans, were approved in December 2003.

In Circular 417, series of 2004, credit-linked notes were defined by the BSP as pre-funded credit derivative instruments under which note holders effectively accept the transfer of credit risks pertaining to assets issued by reference entities.

In early 2005, the BSP issued Circular 466, series of 2005, which provided the structure under which universal and commercial banks without expanded derivatives licences could invest in certain specified structured products without the need for prior Monetary Board approval. It should be noted that the BSP expressly excluded from the scope of the circular asset-backed securities, credit-linked notes and other similar instruments, given that these products are the subject of separate BSP circulars.

Likewise in early 2005, with a view to fostering the development of a market for new financial products in the country and to providing banks with expanded opportunities for investment diversification, the BSP issued Circular 468, series of 2005, which set out certain rules governing the investment by banks in securities overlying securitization structures.