On 26 April 2021, the 28th meeting of the Standing Committee of the National People’s Congress, China’s top legislature (“NPC”) deliberated for the first time the “Futures Law of the People’s Republic of China (Draft)” (“Draft Futures Law”). On 22 October 2021, the revised draft of the Futures Law, renamed as “Futures and Derivatives Law of the People’s Republic of China” (“Draft FDL”) was submitted to the NPC for a second reading and public consultation. The Draft FDL proposes a significant number of changes to the first draft. We believe the changes cater for further flexibility and inclusive nature of the law to support the further development of futures and derivatives trading in China. The consultation period for the Draft FDL will end on 21 November 2021.
You may access our previous articles (in Chinese only) on the (first reading) Draft Futures Law below:
- 未来已来——试评《中华人民共和国期货法（草案）》（Series 1: OTC derivatives）
- “未来”与“选择”——试评《中华人民共和国期货法（草案）》（Series 2: Exchange-traded derivatives）
- 连接未来——试评《中华人民共和国期货法（草案）》（Series 3: Cross-border application）
This article highlights the key implications of the Draft FDL on over-the-counter (OTC) derivatives and market’s expectations on the critical outstanding points.
Legislative recognition of “Single Agreement” and “Close-out Netting”
As addressed in our earlier articles, the legal enforceability of the “Single Agreement” and “Close-out Netting” mechanisms, in particular during PRC bankruptcy proceedings against a PRC counterparty, is the fundamental and critical pillar underpinning the healthy development of the OTC derivatives market. The Draft FDL introduces a national legal framework for statutory recognition of “Close-out Netting” in China and has therefore attracted extensive market attention from both onshore and offshore market players.
Articles 33 and 35 of the Draft FDL recognize the legal certainty and enforceability of the “Single Agreement” and “Close-out Netting” mechanisms respectively, and clarify that such statutory “safe-harbor” shall prevail over certain mandatory provisions under the PRC Bankruptcy Law. Compared with the Draft Futures Law released at the first reading in April 2021, changes to articles 33 and 35 of the Draft FDL are minimal – it demonstrates the PRC legislature’s determination and continued efforts to retain these “safe-harbor” provisions to offer necessary comfort for the market as to the enforceability of “Close-out Netting” in China.
We greatly appreciate the legislature’s due considerations of the market’s earlier comments to the Draft Futures Law in revising the netting provisions applicable to central clearing (both with respect to OTC derivatives and exchange-traded derivatives). In the first reading draft of the Futures Law, all references to “bankruptcy proceedings” in provisions relating to central clearing of OTC derivatives trades were previously limited to investors and market intermediaries only. In the Draft FDL, these provisions have been revised to afford statutory protection of centrally cleared OTC derivative trades over the commencement of any bankruptcy proceeding with respect to any party to the relevant transaction.
Article 37 of the Draft FDL now reads as “[netting] shall not be stayed, invalidated or revoked due to the commencement of any bankruptcy proceeding with respect to any party to the transaction in accordance with the law.”
This change not only addresses the market’s concerns regarding an administrator’s stay power, but also supports the “safe-harbor” regime in the bankruptcy proceedings to cover a much broader range of parties (including central counterparties).
Filing Requirement as pre-condition to statutory “safe-harbor”
The filing pre-requisite element in the first reading of the Draft Futures Law is retained in the Draft FDL. Article 33 (Single Agreement) and article 35 (Close-out Netting) of the Draft FDL apply to, and benefit, only those master agreements and transactions entered into in compliance with article 32 of the Draft FDL.
Article 32 of the Draft FDL provides that “In organising OTC derivatives trading, the templates of the relevant master agreement and other model documents shall be filed with the departments authorised by the State Council or the futures regulatory body of the State Council” (“Filing Requirement”).
Imposing the Filing Requirement as a pre-condition to statutory recognition of the “Single Agreement” and “Close-out Netting” mechanisms does not reflect the prevailing practice in global OTC market, nor is it representative of an international regulatory approach for recognition of “Close-out Netting”. The legislature’s rationale underlying the Filing Requirement may arise from regulatory concerns on the untested nature of a statutory “safe-harbor” for the “Single Agreement” and “Close-out Netting” mechanisms in PRC bankruptcy proceedings.
The Filing Requirement for standard documents widely used for OTC derivatives may therefore be perceived as a means to impose regulatory overlay against potential market abuse of the new “safe-harbor” regime and assist PRC courts (especially those hearing bankruptcy cases) implement this regime in a safer and controlled framework.
Clarifications on the implementation details of and filing logistics for the Filing Requirement as contemplated under article 32 (such as what and how industry master agreement(s) should be filed) are necessary. The market observes that the previous Draft Futures Law had assigned the filing responsibility to “industry associations and the organisers of OTC derivatives”. The latest drafting of article 32 of the Draft FDL has removed the reference to “industry associations”, leading to a significant degree of uncertainty in the market as to the practical implications of the Filing Requirement, in particular, as to whether industry associations (such as ISDA) are able to complete and satisfy the Filing Requirement for industry standard agreement templates to enjoy the statutory “safe harbor” for “Close-out Netting” under article 35.
Some market participants are concerned that the deletion of “industry associations” poses obstacles for the filing of industry master agreements (such as ISDA, NAFMII and SAC Master Agreements) by industry associations. Questions include: Can industry associations file their master agreement templates? Can financial institutions file their mini-master templates? Will cross-border OTC transactions be covered by a master agreement which template has been duly filed? Can institutions that carry out OTC derivatives trading file an industry master agreement? Pending the legislature’s further clarification or future promulgation of the regulators’ implementation rules for the FDL, we believe that a narrow construction of article 32 does not seem to align with the legislative purpose of, and the market’s expectation regarding, the FDL because:
most OTC derivative transactions in the onshore and cross-border market are documented under standard master agreement templates published by industry associations, including the ISDA Master Agreement, NAFMII Master Agreement and SAC Master Agreement. The industry bodies that publish these standard agreements (including ISDA, NAFMII, SAC, AMAC or CFA) do not “organise” OTC derivative transactions; and
trading venues (such as China Foreign Exchange Trading System or “CFETS”) that organise OTC derivative transactions in China do not formulate their own master agreement templates or mandate the use of their designated master agreement templates. In fact, the CFETS has accepted 2009 NAFMII Master Agreements and ISDA Master Agreements as part of the application materials submitted by candidates and foreign participants since 2009 and 2020 respectively.
If the deletion of “industry associations” in article 32 were interpreted to prohibit the filing of industry master agreements by “industry associations”, the vast majority of OTC derivative transactions would not benefit from the protection under article 33 (Single Agreement) and article 35 (Close-out Netting) – this would significantly defeat the legislative intent of Section 3 (OTC Derivatives) of Chapter II.
In addition, the confinement of the Filing Requirement to onshore transactions and documents only (thereby excluding cross-border transactions) would inevitably lead to an unreasonable and negative impact on the development of China’s OTC derivatives market. In light of the internationalisation of China’s financial markets, a PRC counterparty would inevitably have outstanding onshore and cross-border transactions – it would be a difficult situation (and arguably create unfair consequences) if close-out netting for only onshore transactions are enforced but not for cross-border transactions when both are documented under standard industry master agreements adopting the same three pillar principles that underpin Close-out Netting.
We hope the legislature and regulators can consider the above feedback from market participants by clarifying the applicability of the Filing Requirement to the use of master agreements published by domestic and international industry associations in cross-border scenarios, as well as bespoke mini-master agreements designed by individual financial institutions which adopt the key three pillar principles that underpin Close-out Netting.
Notwithstanding the removal of “industry associations” from article 32, considering the Chinese government’s continued efforts to promote internationalisation of Chinese derivatives market, the current drafting of article 32 does not preclude the filing of the standard master agreement templates (developed by industry associations) by trading venues or other participants in derivatives trading.
Scope of credit support methods
Article 34 of the Draft FDL has streamlined its drafting relating to performance assurance arrangements for OTC derivatives transactions.
As noted in our previous articles, “transfer-style performance assurance” commonly used in the OTC derivative market is fundamentally different from, and should not be re-characterised as, “assignment security” recently established by the PRC judicial system pursuant to the PRC Civil Code (effective since January 2021). Hence, “transfer-style performance assurance” does not have a “security function”, nor should it constitute a subsidiary contract underlying a master agreement (because the transactions under a “transfer-style performance assurance” constitute a transaction as contemplated under the relevant master agreement).如我们在之前文章中指出，场外衍生品市场上常用的“转让式履约保障”与中国司法新近确立的“让与担保”具有显著差别，不能混为一谈。“转让式履约保障”既不宜被解读为“具有担保功能”，也并非“合同”（而是构成主协议项下一项交易）。
We welcome the legislature’s considerations of these issues and note that article 34 in the Draft FDL is drafted in sufficiently broad terms to capture all types of credit support methods without imposing any unnecessary qualifications such as “contracts with security functions” for performance assurance arrangements for OTC derivatives transactions. The streamlined drafting of article 34 may also mitigate the risk that “transfer-style performance assurance” would be re-characterised as “assignment security” under PRC law, leaving room for courts to interpret and recognise the enforceability of a “transfer-style performance assurance” pursuant to the “Single Agreement” and “Close-out Netting” mechanisms contemplated under article 33 and article 35.
Enhancement of the Draft FDL to cater for cross-border scenarios
The PRC legislature is required to take into consideration the market-friendliness, the rule of law and the internationalisation when formulating a new law. Article 2 of the Draft FDL expressly provides that it covers (i) futures and OTC derivatives transactions and related activities conducted within the territory of the People’s Republic of China and (ii) futures and OTC derivatives transactions and related activities conducted outside the territory of the People’s Republic of China where such transactions or activities have disturbed the domestic market order or damaged the legitimate interests of onshore trading participants. The drafting of article 2 of the Draft FDL is substantially similar to the Draft Futures Law at the first reading. It is worth noting that similar drafting (conferring extraterritorial jurisdiction to the Chinese regulators) has been adopted in article 2 of the PRC Securities Law (2019 amendment) which came into effect in Mach 2020.
We recommend the legislature to include an express provision for Section 3 (OTC Derivatives) of Chapter II of the FDL to apply to cross-border and offshore scenarios where a PRC counterparty is involved because OTC derivatives differ significantly from futures trading and securities trading, where the latter is organised by onshore trading venues. The OTC derivative market is de-centralised. It is often difficult to categorise with absolute certainty whether a cross-border OTC transaction between an onshore entity and an offshore counterparty “occurs” onshore or offshore.
We hope the legislature can clarify the extra-territorial application of the FDL to cross-border OTC derivative transactions involving a PRC counterparty in either article 2 or Section 3 (OTC Derivatives) of Chapter II of the Draft FDL – this is particularly important as market participants will need to rely on the statutory “safe-harbor” (Single Agreement plus Close-out Netting) for all OTC derivatives transactions (whether onshore or offshore) in PRC bankruptcy proceedings to reduce their overall transaction costs, mitigate systemic risks and secure financial stability of the market.
In the absence of a clear application of the FDL to cross-border scenarios, offshore counterparties may not be able to confirm that their cross-border OTC derivative transactions involving PRC counterparties will benefit from the “safe-harbor” protection under articles 33 and 35 – they may therefore not be able to treat PRC counterparties as “clean netting” counterparties , which may continue to pose adverse impact on efficiency of OTC derivative transactions for PRC counterparties, and continuation of higher transaction costs and lower international participation and bargaining power. These will be detrimental to the healthy development of China’s derivative market.
The Draft FDL represents a significant milestone by the PRC legislature to provide a robust legal framework to regulate the PRC OTC derivatives market. We encourage market players to submit their comments for clarifications and improvement to the FDL. With joint market efforts, we look forward to the market’s common goal for a “clean” netting legal framework ahead for China’s derivatives market.
King & Wood Mallesons is working closely with international industry associations and their members on their comments to recommend important amendments to the Draft FDL, and will continue to provide the market with updates on to the development of the futures and OTC derivatives market in the PRC