The new Futures and Derivatives Law (中华人民共和国期货和衍生品法) (FDL) in China took effect on 1 August, 2022, for the first time recognising enforceability of close-out netting in the PRC’s futures and derivatives markets. On the same day, the International Swaps and derivatives Association (ISDA) published a netting opinion for the derivatives market in China.
The FDL is a much welcomed legislation by international market participants, as it provides the legal certainty they need on netting enforceability to trade with onshore Chinese counterparties. The new law also establishes a robust regulatory framework for the trading, settlement and clearing of futures and derivatives in China – and institutes an internationally accepted fundamental system for the continued growth and regulation of the futures and derivatives markets in China.
Having been passed earlier this year, the FDL explicitly aims to strengthen investor protection and regulations of the futures and derivatives market in China. According to the China Securities Regulatory Commission (CSRC), the new law provides “a strong legal guarantee for building a standardised, transparent, open, dynamic and resilient capital market and has a very important and far-reaching significance”.
Implications to the Derivatives Market
A key impact of the FDL in respect of the derivatives market is the express recognition of the enforceability of close-out netting provisions for over-the-counter derivatives documented under a master agreement. Article 32 provides that a master agreement, together with all supplementary agreements and confirmations with respect to specific transactions where applicable, constitutes a single legally binding agreement. Article 35 further states that the close-out netting provisions of the master agreement shall not be stayed, invalidated or revoked due to commencement of bankruptcy proceedings with respect to a party to the transaction.
Essentially, allowing counterparties to reduce their obligations to a single net payment through close-out netting would provide an important risk management tool to the parties, significantly reducing credit risk to the non-defaulting party. In turn, it would minimise any potential systemic risks to the financial system resulting from the bankruptcy or insolvency of a party.
As for reporting and filing requirements, Article 36 provides for the establishment of trade repositories for derivatives reporting. Detailed rules for reporting are yet to be promulgated. The FDL also mandates that the template master agreement must be filed with the relevant Chinese authorities. It is still unclear, however, whether compliance with this filing requirement is a pre-condition for the enforceability of close-out netting. We expect that additional regulations will be made in due course.
Margin Requirements for Non-cleared Derivatives
Currently, margin rules in the EU, UK and several other jurisdictions provide exemptions from posting margin for trades with firms in non-netting jurisdictions. This exemption is likely to fall away for Chinese entities now that China has a clean netting opinion, ISDA notes.
With Chinese entities becoming subject to margin requirements, this would pose “significant operational challenges”, as firms will have little time to re-negotiate documentation, put in place systems and processes for calculating and exchanging initial and variation margins, and establish custodial relationships, etc.
ISDA has written to regulators asking for a transition period allowing firms more time to put in place the necessary arrangements for margin exchange. UK regulators propose allowing a six-month transition period. Whether six months will be sufficient still remains a challenging issue, given the existing lack of infrastructure for margin exchange in China. It is hopeful that other jurisdictions will introduce their own proposals for relief.
A related point to note is that on September 1, 2022, phase six (the final phase) of the regulatory initial margin (IM) requirements will come into effect. The threshold for compliance, in respect of non-cleared derivatives, will fall to an average aggregate notional amount of just €8 billion – and this is expected to bring hundreds of new market participants into scope. Both existing and new in-scope entities will have to re-assess whether they will be required to exchange margins with their counterparties in China.
The Way Forward
As it currently stands, the trading of China's OTC derivatives still greatly lags behind other major jurisdictions. It accounted for just approximately 1 percent of global turnover in the derivatives market in 2019, according to a 2021 report by ISDA. Against this backdrop, by bringing China into alignment with internationally accepted standards in other developed derivative markets, the FDL is expected to give greater confidence to both domestic and foreign market participants – resulting in further healthy development and creating new opportunities for China's derivatives market going forward.