Rules On Participation Of Vietnamese Counterparties In Trading Of Commodity Derivatives
This is a working glimpse of Vietnam’s commodity derivatives market. We provide a quick overview, and then look at how Vietnamese entities can participate in the offshore commodity derivatives market.
Simply stated, when we refer to a commodity derivative, we mean a product whose value depends on the value of the underlying commodity. At maturity, a commodity derivatives transaction can be settled by either cash netting or by delivering the underlying commodity. Generic commodity derivatives include futures/forward contracts, option contracts, and swap contracts. Derivative products can be traded through exchange platforms or over-the-counter.
Regulations on trading derivatives exist in a series of regulations, including the FX Ordinance and Circular 211. Specifically, only licensed credit institutions may trade derivatives but we touch on a couple of small exceptions. Authorized traders include commercial banks, cooperative banks, banks for social policies, general finance companies, factoring finance companies, finance companies for consumer credit, finance leasing companies, and foreign bank branches (“Credit Institutions”).
A non-credit institution (eg, a local corporate) may trade derivatives with an offshore counterparty but only if it has State Bank of Vietnam’s (SBVN’s) approval. However, and oddly, there are no regulations on how to obtain approval. Absent such regulations, the reality is that a non-credit institution is not yet permitted to trade derivatives with an offshore counterparty.
Trading derivatives in the international market is a special foreign exchange activity. To trade, Credit Institutions require a Special Foreign Exchange Permit (“Special FX Permit”) from the SBVN. This Special FX Permit will specify the type of derivatives that can be traded and will have a definite term.
There are some exemptions. For a number of derivatives products, a Special FX Permit is not required, provided that the SBVN has created a set of rules to trade such products. As of the date of this analysis, exempt products include interest rate swaps and commodity derivative transactions.
For commodity derivative transactions specifically, and apart from the rules set out by SBVN, another set of rules also apply to transactions traded through Vietnam’s national centralized commodity exchange (ie, the Mercantile Exchange of Vietnam or “MXV”). We discuss both sets of rules.
Regulation on trading commodities derivatives by Banks
The first set of rules involves regulations on trading commodities derivatives by Vietnamese commercial banks and Vietnamese branches of foreign banks (“Banks”). These are provided in Circular 402. A Special FX Permit is not required to trade commodity derivatives. The rules are:
Commodity derivative products are defined under Article 3 of Circular 40. They are financial instruments provided by banks for hedging purposes. Article 5 of Circular 40 says hedging is the condition to trade derivative products.
That is to say, one cannot trade commodity derivatives to speculate.
Under Circular 40, only Banks are allowed to provide commodity derivatives (as a “vendor”). Although a Special FX Permit is not required, a Bank’s incorporation and operating license must permit basic foreign exchange activities and activities involving commodity derivatives. In practice, most commercial banks in Vietnam satisfy this requirement.
Furthermore, a Bank’s counterparties, including a Vietnamese enterprise (but excluding Credit Institutions) which engage the Bank to trade commodity derivatives (“Customer”) or a foreign party which engages the Bank to offset transactions (“Foreign Partner”), must also satisfy certain requirements provided in Circular 40. We discuss these requirements in section IV.
In Circular 40, the underlying commodities must be: (i) agricultural products; (ii) fuels; (iii) energy; or (iv) metals. The group excludes gold and commodities whose trading, exportation, or importation are illegal.
In addition, and depending on the type of transaction–exchange-traded or over-the-counter (“OTC”) –additional regulations may apply. We discuss these regulations in section IV.
Regulations on commodities derivatives traded via MXV
The second set of rules involves the MXV. MXV is the only centralized commodities trading exchange in Vietnam and is licensed by the Ministry of Industry & Trade (“MOIT”). Regulations on trading commodity derivatives via MXV are provided in Decree1583.
Under Decree 158, only members of the MXV (ie, commodity traders and brokers) are permitted to provide commodity derivatives products (as a vendor). To qualify, these members must meet requirements on legal capital among others and as set out by MXV (eg, infrastructure, personnel, etc.). Currently, MXV has approved 33 commodities traders and one commodity broker.
Any enterprise and/or individual may engage MXV members to trade commodity derivatives. Such a Customer must trade only via an account opened with an MXV member and it must maintain an escrow amount to secure the transaction. The amount of the escrow depends on the transaction and the trader/broker, but generally it may not be less than 5% of the proposed transaction.
There are additional rules which apply to transactions made via an offshore commodities exchange. We discuss these rules in section IV.
Under Decree 158, only commodities which have been registered/notified by the MXV to the MOIT may be traded. In addition, only certain types of commodities derivatives products are permitted to be traded. We discuss these rules in section IV.
Unlike hedging transactions by banks, there is no restriction (on the purpose to trade commodity derivative products on MXV). That is, an MXV member may trade commodity derivatives either for its own account or for the account of its Customers. Trading can be for speculative and/or for hedging purposes.
Access to offshore commodity derivatives markets on a cross-border basis
Vietnam committed when it became a member of the World Trade Organization (“WTO Commitments”) that an offshore provider may provide a Customer in Vietnam with the following cross-border financial services:
- provision and transfer of financial information, and related software by suppliers of securities services; and
- advisory, intermediation, other auxiliary securities-related services, including investment and portfolio research and advice on acquisitions and on corporate restructuring and strategy.
- provision and transfer of financial information, financial data processing and related software by suppliers of other financial services; and
- providing advisory, intermediation, and auxiliary financial services on the following activities (including credit reference and analysis, investment and indirect research and advice, advice on acquisitions on corporate restructuring and on strategy):
- acceptance of deposits and other repayable funds from the public;
- financial leasing;
- payment and money transmission services;
- guarantees and commitments;
- trading money market instruments, foreign exchange, exchange rate and interest rate instruments, bullion;
- money broking;
- asset management;
- settlement and clearing services for financial assets; and
- provision and transfer of financial information, financial data processing and related software by providers of other financial services.
Under its WTO Commitments, Vietnam did not make any commitment (or “unbound”4) that an offshore entity can provide trading services in connection with the following products on a cross-border basis (whether trading for its own account or for a customer’s account or whether on an exchange basis or in an over-the-counter market or on any other basis):
- money market instruments (including cheques, bills, certificates of deposits);
- foreign exchange;
- exchange rate and interest instruments including products such as swaps, forward rate agreements;
- derivative products including futures and options;
- transferable securities; and
- other negotiable instruments and financial assets.
Under the WTO’s system, the General Agreement on Trade in Services recognizes the right of a Member to regulate, and to introduce new regulations, on the provision of services within its territory. The WTO Guidebook issued by the MOIT provides that local regulations apply to “unbound” services.
Similar to Vietnam’s WTO Commitments, its commitments under other trade agreements [eg, EU-Vietnam Free Trade Agreement (EVFTA), or the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP)] are unbound for derivative products on a cross-border basis. Therefore, Vietnamese law applies.
Trading on an offshore commodity exchange via Banks
According to Circular 40, Banks are allowed to trade on an offshore commodity exchange and for the account of Customers. A foreign bank in Vietnam is not so permitted (at least, not unless they have a licensed branch in Vietnam).
Only (i) commodity futures products; and (ii) commodity option products (including call and put options) may be traded on an offshore commodity exchange. In addition, the tenor of the commodity derivative product must not be longer than the remaining term of the underlying contract.
In order to qualify, a Customer must satisfy all of the following requirements:
- have a valid underlying contract (for the commodity derivatives product);
- trade for hedging purposes only; and
- meet Bank’s standards to assure its financial ability to settle transactions.
When entering into a commodity derivatives agreement with a Bank, a Customer must use an escrow account to fulfill its obligations. Oddly, the minimum balance is not regulated, but is subject to the parties’ agreement and requirements of the offshore commodity exchange.
Trading on an offshore commodity exchange indirectly via the MXV
According to Decree 158, an MXV member may trade on an offshore commodity exchange for its own account or for the account of its Customers. A foreign commodity trader/broker is not so permitted.
Eligible Customers are Vietnamese traders, which can be any enterprise or individual, but with a business registration license. A licensed trader may export, import and carry out other trading activities (assuming the commodity is not subject to trading restrictions), even without being required to register a relevant business line into its business registration license.
Decree 158 is silent whether a bank qualifies as a Customer to engage an MXV member to trade commodity derivatives. Also Circular 40 does not govern the situation in which a Bank trades on an offshore commodity exchange via the MXV. Instead, under Circular 40, banks play a somewhat similar role as that of the MXV under Decree 158. We are, therefore, of the view that the SBVN did not intend to permit banks to trade commodity derivatives via the MXV.
MXV members (and their Customers) can trade commodity derivative products on an offshore commodity exchange, provided that the MXV and such offshore exchange have an agreement on interconnected transactions. Such an interconnection agreement must be reported to the MOIT. As of the date of this analysis, there are several offshore commodity exchanges which have interconnection partnerships with the MXV, including:
- Intercontinental Exchange (ICE), including ICE EU, ICE US, and ICE SG;
- Bursa Malaysia Derivatives Exchange (BMDX);
- London Metal Exchange (LME)
- Chicago Commodity Exchange (CME Group), including CBOT, COMEX, and NYMEX;
- Osaka Securities Exchange (OSE); and
- Singapore Commodity Exchange (SGX).
As mentioned in Section III, only certain commodities, which have been notified/registered with the MOIT by the MXV, are permitted for trading purposes. Currently, 38 types of commodities are permitted, including:
- Agricultural products: corn, mini-corn, soybean, mini-soybean, soybean oil, soybean meal, wheat, mini-wheat, Kansas wheat, and rough rice;
- Industrial raw materials: Robusta coffee, Arabica coffee, cocoa, sugar 11, white sugar, cotton, RSS3 rubber, TSR20 rubber, and crude palm oil;
- Metals: platinum, silver, copper, iron ore, copper LME, aluminum LME, lead LME, tin LME, zinc LME, nickel LME, e-mini copper, micro copper, e-mini silver, and micro silver; and
- Energy: Brent crude oil, mini Brent crude oil, WTI crude oil, e-mini WTI crude oil, micro WTI crude oil, natural gas, low sulfur gasoil, RBOB gasoline, and e-mini natural gas.
In addition, Decree 158 generally allows: (a) commodity forward contracts; and (b) commodity option contracts, to be traded via the MXV. As of the date of this analysis, only forward products can be traded; options products are not yet made eligible by the MXV.
We note that, references to a “forward contract” as an instrument traded on an exchange under Decree 158 may confuse. In an international context, a forward contract is not traded on an exchange, while a “futures contract” is. Although Decree 158 does not use the term “futures contract”, fundamentally both contracts have the same basic function: to allow counterparties to buy or sell a specific type and quantity of a commodity at a specified time at a predetermined price. As far as Vietnam and Decree 158 are concerned, the difference is just a matter of terminology, and it does not affect the nature of a forward/futures contract that is traded via the MXV.
Under Decree 158, at maturity, a Customer may choose to settle a commodity derivatives transaction either by cash netting or by delivering the underlying commodity. As of the date of this analysis, only cash netting is possible in Vietnam; that is delivery of the underlying commodity is not an option for the MXV. Generally, cash netting is carried out via an MXV clearing house. This is necessary to facilitate bank transfers, especially for outbound remittances.
Trading on an international OTC commodity derivatives market via Banks
Although Circular 40 regulates OTC commodity derivatives transactions, the regulations relate only to domestic OTC transactions. There are no specific regulations on cross-border OTC transactions. Despite the lack of regulations, however, Article 11 of Circular 40 does require a Bank to enter into an offsetting transaction with a Foreign Partner, ie, transactions with an opposite position which cancels out the transaction risks between the Bank and a Customer. The Foreign Partner must be licensed to trade products in its own country.
Since an agreement between a Bank and a Foreign Partner is required, a foreign bank/financial institution may not directly engage a Customer to trade OTC commodity derivatives. Neither may a foreign bank/financial institution enter into a commodity derivatives transaction with a Bank for any purpose other than to hedge the risks that relate to the derivative transaction between the Bank and the Customer. That is, an underlying commodities derivatives transaction between the Bank and the Customer must first be in place.
In order to enter into an offsetting transaction with a Bank, the Foreign Partner must be rated at least Baa/P-3 (by Moody’s Investors Service) or BBB-/A-3 (by Standard & Poor’s) or BBB /F3 (by Fitch Ratings). This requirement does not apply to transactions between the Vietnam branch of a foreign bank and its parent bank/its other branches.
Eligible products to offset transactions include:
- commodity swap products; and
- commodity option products (including: call, put, and collar5).
Of note, the scope of an offsetting transaction between the Bank and the Foreign Partner must be in sync with the underlying derivative transaction (between the Bank and the Customer). Specifically, the tenor and the commodities value of the offsetting transaction must be identical to the remaining term/commodities value of the underlying derivative transaction. In case any change in the underlying derivative transaction occurs, adjustments to the respective offsetting transaction must be made. When the Bank fails to do so (and so leaves a part of the underlying derivative transaction unhedged), it must promptly report to the SBVN.
Most derivative products are considered to be a component of the international financial market. In Vietnam, however, commodity derivatives are exceptions and are also considered, at least in part, as goods trading activities. As a result, transactions involving commodities derivatives are governed by two separate sets of rules: one made by the SBVN (whereby commodities derivatives are treated as foreign exchange products) and one by the MOIT (whereby they are treated as commodity trading transactions). As one can expect, this overlap has caused confusion within the business community. This, in turn, causes certain difficulties for Vietnamese enterprises to hedge risks arising out of commodity price fluctuations and to stabilize their production costs. In order for Vietnamese enterprises to participate fully in commodity derivatives transactions in offshore markets, we believe that discussions between the MOIT and the SBVN are necessary. The objective would be to formulate a common and unified framework to regulate commodity derivatives transactions.
Another notable shortcoming of current regulations is the strict restriction on access by foreign financial institutions to the Vietnamese market, particularly via cross-border options. Under the current rules, a Vietnamese enterprise must always engage an intermediary party, either a Bank or an MXV member, to “place its order” on an offshore commodity exchange or OTC market. This certainly causes delay and increases the risk of error. In case of transactions traded through the MXV, as we discussed above, there are certain options not available to the Customers due to MXV’s internal rules (and not because they are restricted by law). Problems arise when there are wild fluctuations in commodity prices. By not being allowed directly to engage foreign financial institutions, Vietnamese enterprises are denied the opportunity to take advantage of valuable market experience/know-how and technology infrastructure developed by these institutions.
We believe that, in order to promote commodity derivative trading in Vietnam, along with a long-term plan to strengthen the Vietnamese regulatory framework to reflect international best practices, one fairly simple approach, which can be achieved in the short term, is gradually to relax restrictions on cross-border commodity derivatives services.
Endnotes: General regulations on trading derivatives include:
- Foreign Exchange Ordinance No. 28/2005/PL-UBTVQH11 dated December 13, 2005, as amended by Ordinance No. 06/2013/UBTVQH13 dated March 18, 2013 (“FX Ordinance”); and
- Circular 21/2014/TT-NHNN of the State Bank of Vietnam (“SBVN“) dated August 14, 2014 regulating foreign exchange activities of credit institutions and foreign banks’ branches, as amended by Circular 28/2016/TT-NHNN of the SBV dated October 5, 2016 (“Circular 21”).