Financial Derivative Transactions for Licensed Commercial and Specialised Banks

MONETARY BOARD CENTRAL BANK OF SRI LANKA 29 November 2017 BANKING ACT DIRECTIONS No. 06 of 2017 1 FINANCIAL DERIVATIVE TRANSACTIONS FOR LICENSED COMMERCIAL BANKS AND LICENSED SPECIALISED BANKS The Monetary Board issues the following Directions on Financial Derivative Transactions for Licensed Commercial Banks (LCBs) and Licensed Specialised Banks (LSBs).

1. Empowerment under the Banking Act 1.1 In terms of Sections 46(1) and 76J(1) of the Banking Act, in order to ensure the soundness of the banking system, the Monetary Board is empowered to issue Directions to all or any LCB and LSB, respectively, regarding the manner in which any aspect of the business of such banks is to be conducted.
2. Applicability 2.1 These Directions will cover derivative transactions in foreign currency of LCBs and LSBs which are authorised to offer such derivative transactions in terms of the Foreign Exchange Act of Sri Lanka. The LCBs and LSBs shall hereinafter be referred to as Eligible Banks (EBs). 2.2 These Directions shall be applicable to the Domestic Banking Units (DBUs) and Off-shore Banking Units (OBUs) of EBs.
3. Commencement of derivative transactions 3.1 LCBs which intend to engage in financial derivative transactions shall notify its interest, prior to the commencement of the initial transaction, to the Director of Bank Supervision (DBS) with a copy to the Director of International Operations Department of the Central Bank of Sri Lanka (CBSL). 3.2 LSBs shall obtain the written approval of DBS to engage in each derivative specified in 5.2.
4. Board approved policies and procedures 4.1 EBs shall have in place Board approved policies and procedures on derivative transactions and risk management framework to identify, quantify and evaluate the exposures, manage risk and monitor performances related to derivative transactions. 4.2 EBs shall ensure that appropriate expertise and capacity building are in place to engage in financial derivative transactions.

MONETARY BOARD CENTRAL BANK OF SRI LANKA 29 November 2017 BANKING ACT DIRECTIONS No. 06 of 2017 2 5. General Terms and Conditions 5.1 Derivatives transactions may be entered into for the following purposes: a) End User (EU) Deals: Transactions for the purpose of hedging EBs own assets and liabilities (other than the assigned capital and retained earnings) and managing their own risk profile as may be necessary from time to time, however, not for speculative purposes. b) Non Market Maker (NMM) Deals: Transactions executed by EBs with their customers, i.e., any party other than an EB or with another EB with the intention of making a spread. In these transactions an EB shall not take any market risk into its own books and shall cover the transaction on the same day on a back-to-back basis with another EB in Sri Lanka or with a foreign counterparty. c) Derivative Market Maker (DMM) Deals: Transactions executed by EBs with their customers or with another EB while taking the market risk into its own books. 5.2 Derivatives permitted under these Directions are as follows: a) Swaps b) Options c) Forward Rate Agreements d) Forward Contracts e) Swaptions f) Such other instruments as may be specified by the Monetary Board from time to time. 5.3 EBs shall ensure the following: a) all derivatives offered to customers are based on valid underlying transactions which include current account transactions and permitted capital account transactions. b) the use of permitted derivatives is only for the purpose of hedging or managing the risk arising from assets or liabilities of customers or valid transactions and not for speculative purposes.

MONETARY BOARD CENTRAL BANK OF SRI LANKA 29 November 2017 BANKING ACT DIRECTIONS No. 06 of 2017 3 c) the notional principal amount, including any leverage of the derivative shall not exceed the outstanding amount of the underlying transaction/asset or liability or the underlying exposure. 5.4 EBs shall use products listed in 5.2 above to enter in to back to back transactions with a foreign counterpart. 5.5 EBs are permitted to hedge contingent exposures or such risks arising from balance sheet exposures of their customers. 5.6 EBs may allow importers and exporters to hedge their exposure including a contract based on estimated transaction value. The estimated transaction value shall be determined based on their audited financials or by averaging the preceding three contract values or immediately preceding contract value, whichever is higher, subject to confirmation by an EB. 5.7 Parties may unwind/sell back a derivative partially or fully, if they consider such a derivative is no longer required, as follows: a) all derivative contracts once unwound are eligible to be rebooked, subject to the terms specified in these Directions. b) any customer who wishes to unwind a derivative contract before maturity while the underlying transaction still exists may do so with the marked-to-market loss charged to such customer. c) a marked-to-market gain (financial gain) should not be paid to the customer. d) the rate benefit, if any, may be passed to the customer at the time of rebooking. 5.8 In case of insolvency, if the claim of the counterparty provides for the netting of the mutual transaction between the insolvent party and the creditor, the amount payable by one party shall be set off against the amount payable by the other party, and only the net balance shall be paid or received.

MONETARY BOARD CENTRAL BANK OF SRI LANKA 29 November 2017 BANKING ACT DIRECTIONS No. 06 of 2017 4 5.9 The cost of a derivative transaction with non-residents shall be paid out of repatriable funds and/or inward remittances through normal banking channels. 5.10 All derivatives entered in to by an EB under Directions on Financial Derivative Products issued on 01 August 2009 (Ref: 33/03/001/0029/002) and Directions to Authorized Dealers on Forward Contracts in Foreign Currencies issued on the 11 March 2010 (Ref: 06/04/02/2010) can be continued till the maturity of the underlying transactions, adhering to the previously issued Directions. The unwound derivative contracts entered under previous Directions can be rebooked only under the terms of the new Directions. 5.11 Contracts may be entered into with customers whose underlying transactions are established with another authorised dealer provided documentary evidence is furnished by the said authorised dealer on each transaction. 6. Prohibited Activities 6.1 EBs shall not engage in facilitating derivative transactions on behalf of any foreign counterpart to resident customers unless the resident customer has obtained specific approval of the Head of the Department of Foreign Exchange of CBSL. 6.2 EBs shall not enter in to derivative transactions in respect of any foreign currency exposures or risks arising from foreign currency deposits or retained earnings, held overseas. 6.3 Derivatives involving making of an upfront payment other than option premiums, in any currency by EB to the customer shall not be permitted. 7. International Swap and Derivative Association (ISDA) 7.1 EBs shall sign ISDA Master Agreement with the counterparty for derivatives, unless otherwise both parties agree to refrain from signing ISDA. 7.2 EBs shall obtain a written consent from the counterparty where it was agreed to refrain from signing ISDA.

MONETARY BOARD CENTRAL BANK OF SRI LANKA 29 November 2017 BANKING ACT DIRECTIONS No. 06 of 2017 5 7.3 EBs shall maintain transaction specific agreements and records. 8. Customer Awareness 8.1 EBs shall ensure that the customers clearly understand the risks of the derivative transactions and that the customers have established sufficient measures to monitor and manage the risks arising from the prospective transactions entering into. 8.2 EBs shall provide adequate information on the transaction, especially with regard to the conditions and clauses to be incorporated into the product indicating the relevant benchmarks, fixing rates, strike prices and premium as the case may be, and a detailed risk scenario analysis to ensure the highest level of transparency. 8.3 EBs shall obtain a written confirmation from the customer prior to entering into a derivative transaction that the customer has understood the nature of the products and their inherent risks. 8.4 EBs shall obtain an undertaking in writing from customers that their total value of the derivative transactions with all EBs do not exceed the exposure or the value of underlying transactions. 8.5 EBs shall also satisfy themselves on a professional analysis, of the institutional capacity and the overall suitability of the customer to engage in the derivative products offered by EB prior to entering into such contracts. 9. Eligible Currencies 9.1 EBs shall conduct derivative transactions in designated currencies as per the request of the customer and in accordance with internal policies approved by its Board of Directors. 10. Tenure 10.1 EBs shall ensure that the date of maturity of the derivative contract shall correspond to the maturity date of the underlying transaction and shall not, under any circumstance, extend beyond the date of the underlying transaction, and the maximum maturity period of a derivative transaction shall not exceed ten (10) years.

MONETARY BOARD CENTRAL BANK OF SRI LANKA 29 November 2017 BANKING ACT DIRECTIONS No. 06 of 2017 6 11. Reference/ Valuation Benchmark 11.1 The parties involved shall be free to use any benchmark with sufficient transparency on mutual agreement for reference and valuation purposes. 12. Reporting 12.1 EBs shall submit to the International Operations Department of CBSL on a monthly basis within 15 days from the end of the month, a statement of the transactions undertaken within the month in the format attached in Annex I. 13. Definition The following definitions shall be applicable for purposes of these Directions. 13.1 Derivative A derivative is a financial instrument or a contract as defined in Sri Lanka Accounting Standards. 13.2 Foreign Counterpart A foreign counterpart shall mean: a) A bank outside Sri Lanka b) An internationally recognised derivative exchange 13.3 Permitted Derivative Transactions a) Swaps A swap is a bilateral agreement to exchange cash flows at specified intervals (payment dates) during the agreed-upon life of the transaction (maturity or tenure). Entering into a swap typically does not require the payment of a fee. Under this direction EBs are eligible to enter into interest rate, cross-currency and commodity swaps. b) Options An option is an agreement that gives the buyer, who pays a fee (premium), the right but not the obligation to buy or sell a specified amount of an underlying asset at an agreed upon price (strike or exercise price) on or until the expiration of the contract (expiry). A call option is an option to buy the underlying and a put option is an option to sell the underlying. Under this Direction EBs are eligible to issue options based on an underlying interest rate, currency and commodity.

Annex I Banking Act Directions No. 06 of 2017 Financial Derivative Transactions for Licensed Commercial Banks and Licensed Specialised Banks Bank - ……………………………………………………………….. Month /Year………/………… Table 01 - Monthly Derivative Product Transactions Product Type: Swaps Deal Date Product Counterparty/ Customer Notional Principal Maturity Date Nature of underlying transaction Details of back to back transaction Uncovered Exposure Reference Benchmark Remarks Currency Amount Table 02 - Monthly Derivative Product Transactions Product Type: Forwards Deal Date Counterparty /Customer Buy/Sell Maturity Date Currency Amount Forward Rate Back to Back Deal (Y/N) Back to Back Counterparty Underlying Transaction Remarks

Annex I Banking Act Directions No. 06 of 2017 Financial Derivative Transactions for Licensed Commercial Banks and Licensed Specialised Banks Table 03 - Monthly Derivative Product Transactions Product Type: Currency Options Deal Date Counterparty/ Customer Option Exercise Date Bank Call Bank Put Strike price Back to back Deal (Y/N) Back to back counterparty Nature of underlying transaction Remarks CCY* Amount CCY* Amount *CCY - Currency Table 04 - Monthly Derivative Product Transactions Product Type: Options Deal Date Counterparty/ Customer Product Maturity Date Currency Amount Deal Rate Back to back Deal (Y/N) Back to back counterparty Underlying transaction Remarks

Annex I Banking Act Directions No. 06 of 2017 Financial Derivative Transactions for Licensed Commercial Banks and Licensed Specialised Banks Table 05 - Transaction Cancelled and Wound-up (Premature) To be reported within 15 days from the end of the month to the International Operations Department of the Central Bank of Sri Lanka through dfx@cbsl.lk. Deal Date Product as reported to CBSL Customer/ Counterparty Notional Principle Reference to original transaction already reported to the CBSL Original Date of Maturity Date of cancellation or winding up Details of Back to Back Transaction Reference/ Benchmark Remarks/ Reasons for cancellation