The passage of China’s Futures and Derivatives Law (FDL) is arguably the most significant legal development in Asian derivatives markets over the past two decades. The FDL will make China a ‘clean netting jurisdiction’, thus marking an exciting new chapter in the development of derivatives markets in the world’s second largest economy. This article explores some key takeaways from the FDL for OTC derivatives.
What is the FDL and why is it important?
The FDL is a significant legal milestone because, for the first time in China’s modern history, the legal enforceability of close-out netting will be expressly recognized at a national legislative level. The FDL takes effect on 1 August 2022.
Close-out netting basically involves terminating individual derivatives transactions documented under a master agreement and reducing them to a single net amount due from one party to the other. It is a very important mechanism for the reduction of counterparty credit risks associated with derivatives transactions, and close-out netting enforceability is critical for safe and efficient derivatives markets.
The enactment of the FDL means the People’s Republic of China (“China”) will become a clean netting jurisdiction, meaning that reputable legal counsel in China will be able to issue an industry legal opinion (called a “clean netting opinion”) concluding that close-out netting is legally enforceable in China before and during bankruptcy proceedings involving a Chinese entity. Significantly, this conclusion will not depend on the parties to the relevant master agreement switching on automatic early termination (“AET”), which is a mechanism under which derivatives transactions will automatically terminate immediately before certain bankruptcy events occur.
Based on the clean netting opinion, financial institutions will measure their credit and risk exposures to Chinese derivatives counterparties on a net (as opposed to gross) basis for a wide range of risk management, quantitative and regulatory purposes, including for the purposes of calculating their regulatory capital ratios and other regulatory metrics. Measuring derivatives exposures on a net basis can significantly reduce transaction and regulatory costs, thereby promoting the further growth and development of China’s derivatives markets.
How does the FDL recognize and protect close-out netting? What about the Filing Requirement?
Two key provisions of the FDL recognize and protect the legal enforceability of close-out netting – Article 32 and Article 35.
In the final version of the FDL, Article 32 provides that where derivatives trading is effected using a master agreement, that master agreement, its schedules and the derivatives transactions under it constitute a legally binding single agreement. This statutory recognition of the single agreement concept is designed to prevent a bankruptcy official from ‘cherry picking’ individual derivatives transactions under a master agreement.
In the final version of the FDL, Article 35 provides that, where derivatives trading is effected “in accordance with law” using a master agreement (in Chinese: “依法采用主协议方式从事衍生品交易”) close-out netting shall not be stayed, invalidated or revoked because one of the parties has entered into Chinese bankruptcy proceedings.
Those closely following the development of the FDL are aware that, in the previous draft of the FDL, the legal protection for the close-out netting and single agreement concepts conferred by Articles 32 and 35 was expressly made conditional upon the template master agreement (such as the pre-printed version of the ISDA Master Agreement) being filed with Chinese financial regulators (“Filing Requirement”).
While the Filing Requirement has been retained (albeit in modified form) in the final version of the FDL, compliance with the Filing Requirement is no longer stated to be a pre-requisite for the legal protections under Articles 32 and 35 to apply. Rather, Article 33 of the final version of the FDL simply refers to the master agreement described in Article 32 (i.e., the master agreement used to effect derivatives trading), and states that a template of such master agreement should be filed in accordance with rules promulgated by the relevant Chinese regulator. We understand that these changes in the final version of the FDL are intended to clarify that legal protections conferred by Articles 32 and 35 of the FDL are not conditional upon satisfaction of the Filing Requirement. This is a significant change in the final version of the FDL and will be welcomed by the market.
What about legal protection for collateral arrangements?
Article 34 of the FDL provides for statutory recognition of the ability to collateralize derivatives transactions by methods such as creating pledges. This wording covers the exchange of initial margin (“IM”) under applicable regulatory margin rules, because IM is usually subject to a security interest in favor of the collateral taker. However, Article 34 does not expressly refer to title transfer collateral arrangements, which are commonly used in connection with the exchange of variation margin (“VM”) under applicable regulatory margin rules. Despite the absence of any express reference to title transfer collateral arrangements in the FDL, we believe that such arrangements, when used to provide credit support for derivatives transactions, are legally valid and enforceable in China.
How does China becoming a clean netting jurisdiction impact regulatory margin documentation?
Currently, under the regulatory margin rules in certain jurisdictions, a regulated financial institution may be exempt from the requirement to exchange VM or IM with a counterparty that is based in a non-netting jurisdiction. With China becoming a clean netting jurisdiction, international financial institutions should carefully re-assess their regulatory margin arrangements with their Chinese counterparties. We have been working closely with our financial institution clients to get ready to negotiate and enter into margin documentation with their major international counterparties in anticipation of the FDL. Our bilingual FAQs on regulatory margin requirements and legal documentation issues is available here.
For completeness, we note that China has not yet implemented any regulatory margin requirements for OTC derivatives. However, a consultation paper published by Chinese financial regulators last year proposed, in principle, that margin be posted for OTC derivatives.
What else is covered in the FDL besides legal recognition of close-out netting and collateral arrangements?
The FDL has over 150 articles and covers a broad range of topics relating to both futures and OTC derivatives. These topics include licensing and authorization, conduct of business, central clearing, trade reporting, regulatory cooperation, insider trading and other market misconduct, trading venues as well as the trading and listing of futures contracts.
On the topic of licensing and authorization, compared to previous drafts, the final version of the FDL introduces a new Article 31. New Article 31 provides that financial institutions conducting derivatives trading business must obtain approval in accordance with the law and comply with trader/counterparty suitability management obligations as well as relevant Chinese supervisory and regulatory requirements. These approvals could include, in the case of Chinese commercial banks, derivative licenses granted by the China Banking and Insurance Regulatory Commission (“CBIRC”), and in the case of Chinese securities firms, no-objection letters from the China Securities Regulatory Commission (“CSRC”) or filing records with the Securities Association of China (“SAC”).
What’s in store in the post-FDL world?
The significant legal certainty that the FDL provides for close-out netting and collateral enforceability opens up an exciting new era for the growth, development and further opening-up of China’s derivatives markets in particular, and its financial sector in general.
China’s status as a clean netting jurisdiction will encourage more domestic and international end-users and financial institutions to turn to China’s derivatives market to hedge and manage all types of risks. The size of China’s derivatives market is not yet commensurate with China’s status as the world’s second largest economy. But the FDL has the potential to change all that over time.
Derivatives and related financial products will play a greater role in supporting China’s real economy, including China’s five-year plan and development goals. For example, as Chinese companies expand their international activities and as foreign companies increase their business dealings with their Chinese counterparts, they will look to more sophisticated FX and related hedging solutions offered by China’s derivatives markets. Domestic and international investors will also increasingly look to credit derivatives to manage credit risks associated with Chinese issuers, which is important to support the healthy growth and internationalization of China’s bond markets, especially now when there is a growing need to mitigate such credit risks. The development of carbon emissions derivatives and other ESG-related derivatives will also have an important role to play in helping China meet its climate and other social objectives. As more Chinese entities exchange VM and IM with their international counterparties, we may also see greater use of RMB-denominated assets as collateral, thereby promoting the internationalization of the Chinese currency.