China’s new law, the Futures and Derivatives Law (FDL), has provided formal recognition of enforceability of close-out netting in derivatives transactions. The FDL was enacted by the Chinese People’s Congress in April 2022 and became effective from 1 August 2022. Since enforceability of close-out netting is the single most important mechanism for the effective operation of the derivatives market, the FDL is hugely significant - it lays the much-needed legislative foundation for the expansion of international participation in the over-the-counter (OTC) derivatives market in China and for safer and more efficient cross-border transactions involving Chinese counterparties.
The FDL introduces a comprehensive framework for the operation and regulation of the derivatives market. Originally named as “Futures Law” and aimed predominately at futures trading and futures market, the law had “Derivatives” added to its title in the second draft, as it contains a number of concise, yet ground-breaking provisions on trading of other forms of derivatives products, both OTC and exchange-traded.
On 1 August 2022, an opinion commissioned by the International Swap and Derivatives Association (ISDA) was published by ISDA. The opinion confirms the enforceability of close-out netting in China with respect to 1992 and 2002 ISDA Master Agreements (China Netting Opinion).
Scope of the FDL
Apart from futures trading - which falls into a separate category under the FDL - Article 3 of the FDL defines “trading in derivatives” as trading activities in respect of swap contracts, forward contracts, non-standard options contracts and any combination of such contracts. It is notable that repurchase agreements and stock lending agreements are not mentioned, and therefore the view of the market participants is that such contracts are outside the scope of the FDL.
Recognition of single agreement concept and close-out netting
Article 32 of the FDL specifically confirms that where master agreement is adopted in derivatives trading, the master agreement, all supplementary agreements and any confirmations for specific transactions entered into by two parties thereunder shall constitute a complete and legally binding single agreement between such two parties.
In addition, Article 35 specifies that where derivatives are traded under the master agreement in accordance with law, upon the occurrence of any pre-agreed circumstance, transactions under such master agreement may be terminated pursuant to the agreement and the profits and losses of all transactions thereunder shall be calculated on a net basis. Such close-out netting shall not be stopped, invalidated or rescinded due to the bankruptcy proceedings of one party.
The combined effect of Article 32 and Article 35 provides much needed clarity and certainty on the conditions of recognition of single agreement concept and the enforceability of close-out netting mechanism. The final text of Article 32 and Article 35 is a welcome improvement from the wording in two previous drafts of FDL, where the legal protection offered by each provision was subject to the condition that the relevant master agreement be registered with the department authorised by the Chinese State Council.
Master Agreements containing provisions acknowledging single agreement and close-out netting have been used in derivatives trades in China or cross-border derivatives agreements with Chinese counterparty for many years. For example, other than ISDA Master Agreements, the NAFMII Master
Agreement1 and the SAC Master Agreement2 all specifically provide for close-out netting in settlement upon termination, although the enforceability of such clause in China was not without doubt prior to the FDL, especially with respect to its effectiveness during bankruptcy proceedings of a Chinese counterparty. The concern arises from the right of bankruptcy administrator to cherry pick performance or termination of certain specific transactions under PRC Enterprise Bankruptcy law (EBL), potentially undermining the operation of close-out netting. There were also concerns about potential stay of close-out netting while waiting for decision of bankruptcy administrator, as well as potential clawback risk. For these reasons, previous ISDA-commissioned netting opinion for China did not consider China as a “clean netting jurisdiction”. Such fundamental uncertainty is a significant barrier for safe and efficient cross-border derivatives transactions involving Chinese counterparties. Counterparties typically would choose to apply “Automatic Early Termination” under ISDA Master Agreement to trigger termination in advance of any bankruptcy event of the Chinese counterparty.
The Chinese financial regulators sought to confirm close-out netting via administrative measures in 2021. In November 2021, China Banking and Insurance Regulatory Commission (CBIRC) issued a regulatory circular (CBIRC Circular) amending its previous risk quantification rules for commercial banks with respect to their derivatives counterparty default risk. The amended rules acknowledge that where derivatives counterparties are regulated financial institutions in China, and where the derivatives transactions with such counterparties are based on the NAMFII Master Agreement, ISDA Master Agreement or any other master agreement recognised by CBIRC as eligible for close-out netting, then such commercial banks may calculate their risk exposure to such derivatives counterparties on a net basis.3 The change means that there is no longer the requirement for the relevant close-out netting agreement to be legally valid, supported by relevant legal opinion, in order for the commercial banks to calculate risk on a net basis.
In the Q&A accompanying the CBIRC Circular, CBIRC explained its interpretation, as well as that of the judiciary, of the enforceability of close-out netting, confirming that in their view, close-out netting would be upheld under the set-off principles under the PRC Contract Law and that the mandatory provisions of the EBL would not apply.4 Market participants have taken some comfort from the views expressed in the Q&A with respect to the position of Chinese banking institutions. However, in practice, since the draft FDL was already in circulation for comments, many have been expecting more certainty in primary legislation when the FDL is finalised.
Against this background, the express recognition of close-out netting in the FDL for in-scope derivative transactions under a master agreement, including the confirmation that it is not affected by bankruptcy proceedings of one counterparty in China, is widely welcome by international market participants. It provides legal certainty at the level of primary legislation and facilitates effective credit risk mitigation in derivatives transactions involving Chinese counterparties.
Registration of master agreement
The FDL still requires, under Article 33, that template of master agreement used for derivatives transactions covered by FDL be submitted for registration with the department authorised by the State Council or the futures regulatory agency of the State Council. As mentioned above, the final next of the law shows that such registration requirement is independent, and is not a pre-condition in order for the single agreement provision and close-out netting provision under Article 32 and Article 35 to apply. Detailed rules on how such registration would work and which party would have the obligation to file such registration are not yet clear. Based on the text of Article 33, it seems the registration requirement would be less onerous than some current practice in China, where signed master agreement needs to be registered, rather than just the template.
In relation to collateral posting, Article 34 of the FDL provides that performance guarantee may be legally provided for derivatives transactions in forms such as pledge etc. Collateral posted by way of title transfer is not specifically mentioned under Article 34, raising the question whether title transfer collateral is recognised by FDL, and crucially, whether such collateral would be allowed to be applied during close-out netting. Most market commentators are of the view that the reference to “pledge” under Article 34 is not meant to be exhaustive but only as an example. It does not preclude other form of credit support such as collateral by way of title transfer. Furthermore, collateral posted by title transfer method would not be subject to restrictions on enforcement typically imposed on assets subject to security interest in any event. The fact that credit support arrangements under 1995 ISDA Credit Support Annex (Transfer- English law) constitute a “Transaction” under the ISDA Master Agreement also means that the credit support arrangement would be part of the single agreement between the parties, and therefore such collateral should be included in the close-out netting calculation in accordance with Article 35 of the FDL.
Now that ISDA has issued the China Netting Opinion, all parties engaged in in-scope derivatives transactions involving Chinese counterparties should assess their respective regulatory obligations under non-cleared margin rules in their home countries. Certain exemptions from initial and variation margins requirements previous available when facing counterparties in “non-netting jurisdictions” may no longer be available with respect to Chinese counterparties from 1 August 2022. Phase 1-5 counterparties may be required to implement initial margin arrangements with Chinese counterparties immediately. For Phase 6 dealers, the deadline of 1 September 2022 is also fast approaching. Parties would be well-advised to work with their regulators to see whether any extension period may be available by way of transition. The UK Financial Conduct Authority and Prudential Regulatory Authority have published a consultation on proposals that would give Chinese counterparties an additional six months to comply with non-cleared margin rules.
Detailed implementing rules concerning several aspects the FDL are still pending, these include trade reporting and registration requirements. There may also be risk mitigation measures similar to those adopted by other G-20 countries, such as regulatory margin.
In addition, legislative developments in other areas of financial laws in China may impact on close-out netting provisions under the FDL. The draft revised PRC Commercial Banks Law and the draft PRC Financial Stability Law contain provisions dealing with procedures and process of resolution for banks. Temporary stays of close-out netting may be imposed under these laws as a result. It is hoped that the length of temporary stays required by these laws would be consistent with international practice based on the principles set out by the Financial Stability Board.
The FDL marks a significant milestone for the development of China’s derivatives market and its integration with the international market. The recognition of close-out netting has the potential to unlock the door to exponential growth in cross-border derivatives trading by Chinese counterparties as well as international participation in China’s derivatives market and capital market.