Circular 4/2006 — Derivatives Operations

CIRCULAR 4/2006 by which the Rules to which multiple banking institutions, brokerage houses, investment companies, and limited-purpose financial companies must adhere in the conduct of derivatives operations are made known.

A logo appears at the margin, stating: Bank of Mexico.

CIRCULAR 4/2006

The Bank of Mexico, based on Articles 28 of the Political Constitution of the United Mexican States, sixth and seventh paragraphs; 24, 26, 27, and 36 of the Bank of Mexico Law; 46, fraction XXV, 103, fraction IV, and 106, fraction II and penultimate paragraph of the Credit Institutions Law; 176 of the Securities Market Law; and 15, second paragraph of the Investment Companies Law; as well as Articles 8, third and fourth paragraphs, 10, 14 in relation to 25, fraction II, which grants the General Directorate of Financial System Analysis the authority to participate in the issuance of provisions, and 17, fraction I, of the Internal Regulations of the Bank of Mexico; having heard, where appropriate, the opinions of the Secretariat of Finance and Public Credit and of the National Banking and Securities Commission, with the objective of promoting the sound development of the financial system and considering that it is convenient to modify the regulation regarding derivatives operations, with the purpose of:

i) Simplifying the authorization scheme granted by this Central Institute to enter into said operations; ii) Suppressing the reports of auditors and consultants; iii) Establishing a regime of indefinite and general authorizations for the conduct of this type of operation; iv) Incorporating the possibility for multiple banking institutions to conduct credit derivatives operations; v) Adding new underlyings; vi) Expanding the range of operations that investment companies may conduct, and vii) Incorporating limited-purpose financial companies into the regulation in this matter.

It has resolved to issue the following:

RULES TO WHICH MULTIPLE BANKING INSTITUTIONS, BROKERAGE HOUSES, INVESTMENT COMPANIES, AND LIMITED-PURPOSE FINANCIAL COMPANIES MUST ADHERE IN THE CONDUCT OF DERIVATIVES OPERATIONS

1. DEFINITIONS

For brevity, the following terms, in singular or plural, shall be understood as:

Risk Asset: the asset whose Credit Risk is transferred, in whole or in part, from the Protection Buyer to the Protection Seller.

Reference Asset: the asset used to determine when a Credit Event occurs. The Reference Asset and the Risk Asset may be the same.

Brokerage Houses: legal entities authorized to operate as such in terms of the Securities Market Law.

Protection Buyer: the person who, by virtue of their participation in a Credit Derivatives Operation, protects themselves, in whole or in part, from the Credit Risk of a Risk Asset.

CNBV: the National Banking and Securities Commission.

Credit Default Swaps:
a) operations in which the Protection Buyer is obligated to pay a premium to the Protection Seller, in exchange for the latter delivering the agreed consideration in the event that a Credit Event occurs.

Total Return Swaps:
a) operations in which the Protection Buyer is obligated to pay the Protection Seller the cash flows from a Risk Asset, as well as the upward changes in the value of said Risk Asset, and the latter in turn is obligated to pay the former an interest rate plus the downward changes in the value of the Risk Asset, it being possible to agree that, in the event that a Credit Event occurs, the first party will deliver the Risk Asset and the second party the agreed amount.

Business Day: the day that is a business day both in the United Mexican States and in the market or markets where the settlement of the operation takes place.

Currencies: the United States dollar, as well as any other foreign currency freely transferable and immediately convertible into the aforementioned currency.

Entities: Multiple Banking Institutions and Brokerage Houses.

Foreign Financial Entities:
those authorized to act as financial entities by the competent authorities of the countries in which they are incorporated.

Credit Event: the event that, if it occurs, obliges the parties to a Derivative Operation to fulfill the obligations stipulated in the contract under the agreed terms.

Settlement Date: the Business Day on which the fulfillment of the obligations agreed upon in the Derivative Operations is due.

Management: the Management of Authorizations, Inquiries, and Legal Control of the Bank of Mexico.

Intermediary: the Entities that obtain authorization from the Bank of Mexico to conduct Derivative Operations in terms of sections 3.1.1 to 3.1.3 of these Rules.

Multiple Banking Institution: legal entities authorized to operate as such in terms of the Credit Institutions Law.

Settlement: the fulfillment of the obligations of the parties in a Derivative Operation.

Markets: Recognized Markets and over-the-counter markets.

Recognized Markets: MexDer, Mexican Derivatives Exchange, S.A. de C.V., located in Mexico City, Federal District; as well as any other market established in countries that belong to the Technical Committee of the International Organization of Securities Commissions.

Credit Derivatives Operations:
Credit Default Swaps, Total Return Swaps, and Credit-Linked Notes.

Derivative Operations: interchangeably, Forward Operations, Option Operations, Swap Operations, and Credit Derivatives Operations.

Forward Operations: purchase or sale operations of an Underlying, in which the parties agree that their obligations will be fulfilled at the agreed price and on a date subsequent to the date of agreement.

Option Operations: operations in which the buyer, by paying a premium to the seller, acquires the right, but not the obligation, to buy or sell an Underlying at an agreed price, on one or more Business Days, and the seller is obligated to sell or buy, as appropriate, said Underlying.

Swap Operations: operations in which the parties agree to exchange cash flows during a specific period.

Credit Risk: the possibility of incurring a loss when a Credit Event occurs.

Investment Companies: legal entities authorized to operate as such in terms of the Investment Companies Law.

Sofoles: legal entities authorized to operate as Limited-Purpose Financial Companies in terms of the Credit Institutions Law.

Underlyings: the rates, assets, securities, prices, indices, or operations that are the subject of a Derivative Operation, as indicated in section 2 of these Rules.

Credit-Linked Notes:
struments or securities that pay a return and whose value is conditioned on the performance of a Risk Asset and that, in the event of a Credit Event, the issuer of the instrument or security (Protection Buyer) delivers to the investor (Protection Seller) the Risk Asset or the agreed amount.

Protection Seller: the person who, by participating in a Credit Derivatives Operation, covers their counterparty, in part or in total, from the Credit Risk of a Risk Asset.

2. UNDERLYINGS

2.1 Entities may only conduct Derivative Operations on the following Underlyings:
a) Stocks, a group or basket of stocks, or securities referenced to stocks, that trade on a stock exchange; b) Price indices on stocks that trade on a stock exchange; c) National currency, Currencies, and investment units; d) Price indices related to inflation; e) Gold or silver; f) Nominal, real, or super-interest rates, which include any debt security; g) Loans or credits, and h) Forward, Option, and Swap operations on the underlyings referred to in the preceding subsections.

2.2 Brokerage Houses, in order to carry out Derivative Operations in over-the-counter markets on the Underlyings indicated in subsection a) of section 2.1, must settle such Operations as follows: i) it must not be in kind, and ii) it must not be carried out within a period of less than four Business Days.

2.3 Investment Companies and Sofoles may only carry out Derivative Operations with Underlyings included in section 2.1 of these Rules that, according to their investment regime or corporate purpose, respectively, are authorized to operate.

3. AUTHORIZATIONS

3.1 ENTITIES

3.1.1 Entities require authorization from the Bank of Mexico to conduct Derivative Operations as Intermediaries.
To this end, the aforementioned Entities must submit a request for authorization to the Management containing the following:
i) Types of Derivative Operations they intend to conduct; ii) Markets in which they intend to operate, and iii) Underlyings.
Additionally, they must accompany their request with a communication issued by their Audit Committee stating that the Entity complies with the requirements set forth in the Annex of these Rules for Derivative Operations and for the Underlyings they intend to operate.

3.1.2 Entities that obtain authorization to act as Intermediaries may enter into Derivative Operations, operate in Markets or on Underlyings, that have not been specified in the request referred to in section 3.1.1 of these Rules, provided that:
a) They give written notice to the Management 15 calendar days in advance of the date on which they intend to carry out the operations in question, regarding the following:
i) The new type of Derivative Operations they intend to conduct; ii) The new Markets in which they intend to operate, and/or iii) The new Underlyings. b) They attach a new communication in terms of what is stated in the third paragraph of the aforementioned section 3.1.1.

3.1.3 Multiple Banking Institutions authorized to act as Intermediaries must send to the Management, during the month of March of each year, a communication issued by their Audit Committee stating that the institution in question complies with the requirements set forth in the Annex of these Rules, in relation to those Derivative Operations they conduct and the Underlyings that are the subject of said operations.
Brokerage Houses must send the communication referred to in the preceding paragraph during the month of May of each year.
However, when the Bank of Mexico deems it appropriate, it may request that the Entities present the aforementioned communication on dates other than those indicated in the preceding paragraphs.

3.1.4 Entities may conduct Forward Operations, without being subject to the provisions of these Rules, when:
a) The Settlement Date does not exceed four Business Days after the date of agreement, or b) Their counterparty is the issuer of the debt security that is the subject of the operation and it is a primary issuance.
Multiple Banking Institutions, when entering into Forward Operations as provided in subsections a) and b) above with Underlyings that are gold, silver, Currencies, or securities, must observe what is provided in Circular 2019/95 issued by this Central Institute. Brokerage Houses, when entering into said operations with Underlyings that are gold, silver, or Currencies, must adhere to the provisions provided in Circular 115/2002 issued by this Central Bank, and when they are securities, to the provisions issued by the CNBV.

3.1.5 Entities may conduct Derivative Operations without the need to comply with the requirements provided in sections 3.1.1 to 3.1.3, when such operations are exclusively intended to hedge risks inherent to the Entity.
For the above effect, such Entities must: i) have a risk management and control unit or, failing that, hire specialists to value, measure, and monitor such risks, and ii) periodically inform their board of directors regarding the conduct of these operations and their limits.

Entities that have previously obtained an authorization to conduct Derivative Operations as established in section 3.1.1, may conduct said Operations for hedging purposes complying with what is established in subsection ii) of the preceding paragraph.

3.1.6 Entities that conduct Derivative Operations in terms of section 3.1.5 will not have the status of Intermediaries.

3.2 INVESTMENT COMPANIES

Investment Companies may conduct Derivative Operations subject to the general provisions issued by the CNBV and without requiring authorization from the Bank of Mexico. These operations may be conducted in any Market.

3.3 SOFOLES

Sofoles may only carry out Derivative Operations with the purpose of hedging inherent risks without requiring authorization from the Bank of Mexico. For the above effect, such Sofoles must have a risk management and control unit or, failing that, hire specialists to value, measure, and monitor such risks. Likewise, they must periodically inform their board of directors regarding the conduct of these operations and their limits.

3.4 OTHER DERIVATIVES OPERATIONS OR WITH OTHER UNDERLYINGS

The Bank of Mexico may authorize Derivative Operations or with underlyings other than those provided in these Rules. To this end, interested Entities, Investment Companies, and Sofoles must submit a written request for authorization to the Management describing the operation they intend to conduct or the respective underlying.

4. AUTHORIZED COUNTERPARTIES

Entities may conduct Forward, Option, and Swap Operations with any person.

Entities that conduct Derivative Operations for the hedging of their own risks in terms of 3.1.5, may only carry them out with Entities authorized by the Bank of Mexico to act as Intermediaries, with Foreign Financial Entities, or in Recognized Markets.

Multiple Banking Institutions may only conduct Credit Derivatives Operations with other Multiple Banking Institutions, with other Mexican financial intermediaries authorized to conduct such operations, or with Foreign Financial Entities.

Investment Companies and Sofoles may only conduct Derivative Operations with Entities authorized by the Bank of Mexico to act as Intermediaries or with Foreign Financial Entities.

5. DOCUMENTATION

Derivative Operations, except Credit-Linked Notes, that Entities conduct among themselves and with other national or foreign financial entities, as well as those conducted by Investment Companies and Sofoles with their authorized counterparties, shall be documented in master agreements, which must contain guidelines and directives contained in international contracts, such as those approved by the International Swaps and Derivatives Association, Inc., provided that this does not go against applicable national provisions. Credit-Linked Notes must be documented in an issuance deed.

Derivative Operations that Entities enter into with clients other than those provided in the preceding paragraph must be carried out under master agreements agreed upon with them.

Derivative Operations and their characteristics may be agreed upon through the form that the master agreement itself establishes. The foregoing, provided that Entities, Investment Companies, and Sofoles register said operations and invariably confirm them through any means that leaves a written record of the celebration of the corresponding operation, on the same day they celebrate it.

In the event that the use of electronic, computing, or telecommunications means is agreed upon for the agreement of operations, the reciprocal identification keys and the responsibilities entailed by their use must be specified.

6. GUARANTEES

Entities, Investment Companies, and Sofoles may guarantee the fulfillment of Derivative Operations with cash deposits, credit rights in their favor and/or securities or values from their portfolio.

Regarding Derivative Operations carried out in over-the-counter markets, only the guarantees mentioned in the preceding paragraph may be granted, when the counterparties are credit institutions, Brokerage Houses, Foreign Financial Entities, Investment Companies, specialized investment companies for retirement funds, Sofoles, as well as any other counterparty that authorizes the Bank of Mexico.

Entities and Investment Companies may in no case receive subordinate obligations as guarantee for the fulfillment of the Derivative Operations they enter into. Likewise, Entities may not receive shares issued by financial entities or holding companies of financial groups as guarantee.

7. FORMS OF SETTLEMENT

The Settlement of Derivative Operations may be effected through the delivery of the previously determined Underlyings or a sum of money, in accordance with the nature of the operation and what the parties agree.

8. OPERATIONS ON BEHALF OF THIRD PARTIES

Entities may carry out Derivative Operations on behalf of third parties in accordance with what is provided in Circular 1/2005, which contains the "Rules to which credit institutions; brokerage houses; insurance institutions; guarantee institutions; limited-purpose financial companies and the Rural Financial Institution must adhere, in fiduciary operations".

Additionally, Brokerage Houses, when carrying out Derivative Operations in compliance with a mandate or commission, must adhere to what is provided in the Securities Market Law, as well as in other applicable provisions.

9. OPERATIONS WITH RELATED PARTIES

Entities that carry out Derivative Operations with related parties or on Underlyings whose issuers or obligors are related parties, must observe what is provided to that effect in the Credit Institutions Law and in the Securities Market Law, for Multiple Banking Institutions and Brokerage Houses, respectively.

10. PROHIBITIONS

10.1 Entities, Investment Companies, and Sofoles must not enter into Derivative Operations in contravention of what is provided in these Rules.

10.2 Entities must not charge commissions for the Derivative Operations they enter into, except in cases where they act on behalf of third parties in accordance with what is established in section 8 of these Rules.

10.3 Entities must not offer the conduct of Derivative Operations at the counters of their branches.

10.4 Entities must not enter into Derivative Operations when the respective Underlying does not have a market reference rate or price, except: i) that their counterparty is a credit institution, Brokerage House, or Foreign Financial Entity, or ii) when Derivative Operations are conducted with the Underlyings indicated in subsection g) of section 2.1 of these Rules.

10.5 Brokerage Houses, Investment Companies, and Sofoles must not enter into Credit Derivatives Operations.

10.6 In Credit Derivatives Operations, the Protection Buyer and the Protection Seller may not assign their rights or obligations to third parties, unless the terms of the assignment are provided for in the contracts in which these operations are documented.

11. LIMITATION, SUSPENSION, OR REVOCATION OF OPERATIONS

The Bank of Mexico may limit, suspend, or revoke the authorizations granted to Entities to conduct Derivative Operations when:
a) They infringe the applicable provisions to the operation in question; b) They cease to meet any requirement of the Annex of these Rules;

c) Have a capitalization index lower than that provided for in the applicable provisions; d) Fail to provide the information requested by Banco de Mexico under item 12 of these Rules, either from the Entity itself or from the companies referred to in the second paragraph of said item, or provide it late, incorrectly, or incompletely; e) Conduct operations in contravention of the sound uses or practices corresponding to such operations, and f) The Entities themselves so request.

12. INFORMATION
    Entities, Investment Companies, and Sofoles must provide Banco de Mexico's Financial System Information Directorate with information regarding the Derivative Operations they conduct, in the format and deadlines requested.
    In this information, Entities must include details regarding Derivative Operations conducted by financial entities with respect to which they are direct or indirect owners of shares with voting rights representing at least fifty-one percent of the paid-in capital; have control of the general shareholders' meeting; are able to appoint the majority of the members of the board of directors; or, by any other means, control the aforementioned financial entities.

13. SANCTIONS
    Entities and Sofoles that fail to comply with the provisions contained in these Rules will be sanctioned by Banco de Mexico in accordance with the Banco de Mexico Law and other applicable provisions.
    Investment Companies that fail to comply with the provisions contained in these Rules will be sanctioned by the CNBV in accordance with the Investment Companies Law.

TRANSITIONAL PROVISIONS
FIRST.- The provisions contained in these Rules will enter into force on January 15, 2007.
SECOND.- From the entry into force of these Rules, items M.52 to M.52.53.2, as well as Annex 8, all of Circular 2019/95, addressed to Multiple Banking Institutions, are repealed.
Authorizations granted by Banco de Mexico to Multiple Banking Institutions prior to the entry into force of these Rules, to conduct financial operations known as derivatives with the status of Intermediary, will become void on May 31, 2007; therefore, Multiple Banking Institutions interested in conducting Derivative Operations with such status after that date must request authorization in accordance with item 3.1.1 of these Rules, no later than April 2, 2007. THIRD.- From the entry into force of these Rules, the "Rules to which brokerage houses must adhere in their financial operations known as derivatives" addressed to brokerage houses, contained in Circular 10-266 dated December 26, 2002, jointly issued by the CNBV and Banco de Mexico, are repealed. Authorizations to conduct financial operations known as derivatives with the status of Intermediary, granted by Banco de Mexico to Brokerage Houses prior to the entry into force of these Rules, will become void on July 31, 2007; therefore, Brokerage Houses interested in conducting Derivative Operations with such status after that date must request authorization in accordance with item 3.1.1 of these Rules, no later than May 31, 2007. FOURTH.- Authorizations to conduct financial operations known as derivatives granted by Banco de Mexico to Sofoles under communication S33/15382 dated February 28, 2002, addressed to the then Mexican Association of Limited Purpose Financial Companies, A.C. (AMSFOL), will become void from the entry into force of these Rules, without it being necessary to request a new authorization from Banco de Mexico to continue conducting such operations.

ANNEX
REQUIREMENTS FOR ENTITIES INTENDING TO CONDUCT DERIVATIVE OPERATIONS

I. MANAGEMENT REQUIREMENTS.
1.- The General Management must establish and the Board of Directors must specifically approve:
a) The objectives, goals, and general procedures for operation with clients and other intermediaries in the market. b) The maximum tolerances for market, credit, and other risks considered acceptable for the Entity in the market, and c) The approval procedures for new financial products related to these products. 2.- The General Management must designate and the Board of Directors must approve a risk monitoring area, different from the risk-taking areas, directly dependent on the General Management, whose purpose will be:
a) To measure, evaluate, and monitor market and credit risks arising from these instruments. b) To communicate, as soon as known, to Management any deviation from the established limits so that operations to eliminate risks can be carried out. c) To report daily to the General Management and systematically to the Board of Directors regarding the Entity's operation in the market. 3.- The General Management and a committee designated by the Board of Directors must be involved, in a systematic and timely manner, in the monitoring of market, credit, liquidity, and other relevant market risk management. Likewise, they must establish a review program for the objectives, goals, and operational and control procedures, as well as for risk tolerance levels, at least semi-annually and whenever market conditions warrant it. 4.- The General Management must have a contingency action procedure that allows it to act when it is detected that policies, procedures, internal controls, the managerial information system, or risk tolerance levels are deficient, or when violations of laws, norms, or circulars occur. 5.- The General Management and a committee designated by the Board of Directors must establish a Professional Ethics Code that governs the conduct of involved personnel. 6.- The General Management must implement a continuous training program directed at operators, support staff, the risk monitoring area, and in general, all personnel involved in the handling and control of these instruments.

II. OPERATIONAL REQUIREMENTS.
7.- The different areas responsible for market operation and supervision must have established specific objectives, goals, and operational and control procedures, as well as the maximum acceptable risk tolerances per area, which must be consistent with the general guidelines established by the General Management. 8.- The Entity must have at least two competent operators, duly trained and instructed, and as an additional requirement, at least one of them with recognized experience in the market. In addition, they must know the operational and control policies and procedures, as well as the ethical standards governing the Entity. 9.- The Entity must have a system that allows the risk monitoring area and the responsible persons of the operation area to systematically and timely supervise the activity of operators and promoters of market operations. 10.- The Entity must have a system that allows operators to monitor their assigned positions, as well as verify compliance with their limits. 11.- The Entity must have systems that allow the processing of operations, valuation, and risk control, preferably in real time, both in operation and in the support area. 12.- The Operations Area jointly with the risk monitoring area must establish valuation models consistent with the technology developed to date, which have been reviewed by the support area and are known to the market operation operators.

III. INTERNAL CONTROL REQUIREMENTS.
III.1 General.
13.- The activities and responsibilities of operation personnel and support personnel must be adequately defined and assigned to the corresponding directorates.
14.- Operational and control manuals must be established in writing and made known to operation and support personnel, in such a way as to allow the correct execution of their functions in each of the involved areas such as: credit, promotion, operation, registration, confirmation, valuation, settlement, accounting, and monitoring of all concluded operations. 15.- The Entity must establish internal criteria for the adequate analysis, evaluation, selection, and approval of limits to clients wishing to participate in the purchase or sale of Derivative Operations. 16.- Procedures must be established to ensure that all concluded operations are covered by a signed master contract, and are duly documented, confirmed, and registered. 17.- Procedures must be established to ensure that these financial operations and their derivatives approved by the General Management have adequate operational support for their functioning and control. 18.- Without prejudice to the guidelines established by the Entity itself, an audit function must be established, which must review, at least once a year, compliance with operational and internal control policies and procedures, as well as adequate documentation of operations. 19.- Data processing systems, risk management systems, and valuation models must have adequate backup and control, including data recovery.

III.2 Monitoring.
20.- The risk monitoring area must have daily access to the operation and support systems to measure and evaluate risks arising from operations, and must also provide daily to the General Management and systematically to the Board of Directors with duly verified reports that correctly and timely show the risks taken by the Entity.

III.3 Operation, Registration, and Verification.
21.- Operational and control manuals must contain policies, procedures, and mechanisms such as telephone recordings and reciprocal written confirmations of all terms agreed upon by the parties to ensure the truthfulness and authenticity of concluded operations. Unconfirmed operations, as well as those not reported by operators within a maximum period of 24 hours, must be investigated immediately, systematically, and timely, registered once clarified, and corrective actions determined; likewise, necessary actions must be taken to avoid the recurrence of this type of irregularity. 22.- All confirmations must be executed by support personnel and they will be the only ones who can receive confirmations from counterparties, which must be duly compared with operation personnel reports daily, and in case of doubt, with the day's recording. 23.- The Entity must establish procedures to systematically verify that during the validity of operations, they are duly covered by a master contract, registered, accounted for, confirmed, and included in all reports.

III.4 Valuation.
24.- Valuation and risk measurement models must be validated by experts who are independent of those who developed said models and of operation personnel, at least once a year.
25.- The risk monitoring area must directly gather information from reliable external sources that allow it to value the operations of the current portfolio.

III.5 Accounting.
26.- Support personnel must verify their records daily with those of the operators and compare both databases with accounting.
27.- Operations must be accounted for in accordance with the norms established by the authorities.
28.- Settlements must be made by support personnel under duly authorized instructions, verified amounts, and with the confirmation of counterparties.
29.- Operational and control manuals must contain written procedures to investigate operations not covered by the Entity and/or by the clientele, and report the results to Management for corrective actions, maintaining records of the investigation in a systematic manner.

III.6 Guarantees.
30.- Operational and control manuals must show written procedures that allow defining, if applicable, the guarantees to be established in this type of operation.

III.7 Legal.
31.- The Entity must have procedures to verify master contracts, sheets, and other formats that bind the Entity and the counterparty to the due fulfillment of their obligations before they are signed.

Respectfully,
Mexico, D.F., December 18, 2006.- BANCO DE MEXICO: The Director General of Financial System Analysis, José Gerardo Quijano León.- Rubric.- The Director of Central Banking Provisions, Fernando Luis Corvera Caraza.- Rubric.
For any queries regarding the content of this Circular, please go to the Directorate of Authorizations, Queries, and Legal Control, located at Avenida 5 de Mayo number 2, sixth floor, Colonia Centro, Mexico, Distrito Federal, C.P. 06059, or to the phones 5237.2308, 5237.3200, or 5237.2317. (R.- 242184)