China’s new Futures and Derivatives Law is set to push the country’s large but still developing market to align with international practice, with requirements on cross-border trade bringing in fresh compliance pressures. Luna Jin reports
Unlike the history of futures trading in the West, born spontaneously in the free market and in existence for more than a century, it was not until 32 years ago that the Zhengzhou wholesale grain market witnessed the first futures trading in China. This was a market created entirely by the central government, from scratch.
Since then, along with the gradual unshackling of economic policies and ideologies, the Chinese futures and derivatives market has expanded at a rapid pace. According to the latest data released by the China Futures Association, China has traded 7.51 billion lots of futures in 2021, accounting for 12% of the total volume of the global market.
However, compared to developed economies, China’s vast market, originally set up to price commodities, still has a long way to go, and the longstanding absence of dedicated high-level legislation has hindered foreign investors.
After years of preparation, the Futures and Derivatives Law, the first fundamental law for China’s futures and derivatives markets, was finally passed by the National People’s Congress on 20 April, and will come into force on 1 August.
The new law consists of 13 chapters and 155 articles, which circumspectly regulate the trading of futures and derivatives in terms of market participants, trading practices, clearing and settlement, cross-border trading and regulatory collaboration, among other areas.
The law directly addresses the longstanding concern on whether netting under Chinese bankruptcy proceedings is legally protected for domestic and foreign entities, while clarifying the performance protection mechanism for derivatives transactions.
As part of the series of efforts to update China’s legal framework for financial markets in recent years, the new law provides a comprehensive clarification of trading rules and regulatory attitudes, which opens up huge development opportunities for the industry. It will prompt international industry associations to update China’s jurisdictional status under key provisions, and will fundamentally change the way foreign credit institutions deal with risks associated with Chinese counterparties’ risks.
As James Guo, a senior partner at AllBright Law Offices in Shanghai, says: “After the implementation of the Futures and Derivatives Law, the legal framework of the futures market, with the new law as the core, will be established and become complete, and the legal hierarchy of China’s futures market will be greatly enhanced, which will have a far-reaching impact on promoting the internationalisation of China’s futures market.”
LEGAL PROTECTION ON CLOSE-OUT NETTING
As a leveraged and perilous investment behaviour, one of the greatest risks associated with futures and derivatives trading lies in the netting stage. When a default or termination occurs on one side of a transaction, the other side has the right to terminate all transactions under the master agreement and calculate a “netting amount” in an agreed manner, which is then transferred from the net payer to the net earner. This mechanism, which is designed to reduce the credit risk of the counterparty, is known as “close-out netting”.
However, previously, the smooth progression of the netting process has always been under the threat of China’s bankruptcy law – once a counterparty entered into bankruptcy proceedings, which constituted a breach of the master agreement, its general creditors or bankruptcy administrators were entitled under Chinese bankruptcy law to choose at their own discretion to perform the transaction in their favour, or to apply to the court to suspend certain contracts by avoiding acts they considered to be detrimental to the debtor.
Although Chinese regulators have issued documents in recent years to support the enforceability of close-out netting, this regulatory attitude has not been established at the legislative level and, as a result, China has been considered a “non-netting jurisdiction” for a long time in the memoranda of various international industry associations such as the International Swaps and Derivatives Association (ISDA).
David Mu, a Shenzhen-based partner of King & Wood Mallesons, explains that the process of Chinese counsel issuing a clean netting opinion – i.e., arguing that the close-out netting mechanism is legally enforceable both before and after the commencement of bankruptcy proceedings involving Chinese entities – is a highly complex legal analysis involving not only the application of conflicting Chinese laws and regulations, but also how international practices and contractual agreements were actually treated in Chinese bankruptcy proceedings.
“Traditionally, the laws and regulations that can be applied to derivatives were lagging behind the times and generally of low rank, and there weren’t many exemplary Chinese bankruptcy cases where the close-out netting process of derivatives got tested,” says Mu. “Therefore, a rigorous legal analysis is difficult to achieve, and lawyers were always carefully seeking a balanced approach between regulatory support and market expectations amid the lack of substantive changes to the legal foundation.”
The new Futures and Derivatives Law, on the other hand, provides the first legislative recognition of a close-out netting regime:
Article 35. Where derivatives are traded under the master agreement in accordance with the law, if any circumstance agreed upon occurs, trading may be terminated as agreed upon in the agreement, and netting of all trading profits and losses under the agreement shall be conducted.
Netting according to the provisions of the preceding paragraph shall not be suspended, invalidated or revoked in the event that either party to the transaction enters bankruptcy proceedings in accordance with the law.
Article 37. Where derivative trading is settled in a centralised manner by a clearing institution as a central counterparty approved by the department authorised by the State Council or the futures regulatory agency of the State Council, netting may be terminated in accordance with the law; and settlement property shall be first used for settlement and delivery, and shall not be placed under seal, frozen, impounded, or be subjected to enforcement; and shall not be used by anyone before the completion of settlement and delivery.
The new law also establishes a “single agreement” regime, whereby a breach by one party to a transaction of its obligations under any one document constitutes a breach of the entire agreement, thus preventing the bankruptcy administrators from selectively performing each specific transaction under the master agreement.
Article 32. If the master agreement is adopted in derivative trading, the master agreement, all supplementary agreements under the master agreement, and any agreements made by both parties to the transaction on all specific transactions, among others, shall together constitute a single integrated agreement between both parties to the transaction and be legally binding.
So, looking forward, the relationship between the basic regimes of derivatives transactions and Chinese bankruptcy procedures has been clarified at the legislative level, which will greatly affect the business operations of Chinese and foreign banks.
According to Mu, these changes will enable Chinese institutions (both financial and non-financial) to be treated as “netting counterparties” in cross-border derivatives transactions, thus achieving the same trading status as offshore financial institutions, more favourable regulatory treatment, more favourable capital treatment and lower cost burdens.
“The non-defaulting party will be able to exercise its early termination rights in a timely manner on the basis of a single agreement to prevent the expansion and deterioration of risk resulting from the continued performance of the transaction, and to reduce the impact of credit risk on the defaulting party and the overall financial markets in the event of bankruptcy by promptly reducing the exposure to multiple transactions to a smaller single net amount via the netting process,” he says.
Another major positive impact of the close-out netting mechanism is that efficiency in the use of institutional funds will be enhanced. Under the mechanism, the market exposures of multiple transactions on both sides of the trade can be aggregated. For financial institutions subject to capital adequacy and riskbased capital regulation, it can reduce risk exposures and riskbased capital provisions, and the related margin (especially variation margin) can be charged on a net basis, rather than the full amount on a line-by-line basis, thus improving the efficiency of capital utilisation by financial institutions.
“These changes will not only promote active trading of both domestic and cross-border derivatives in both directions for various institutions, but will also reduce the compliance burden and cost pressure on both sides of the transaction, guarantee a fairer and more equitable trading position, and create an institutional basis and legal environment for financial instruments [especially for hedging instruments] to support the real economy,” says Mu.
Frank Qu, a Shanghai-based senior partner of Dentons China, points out that the ISDA had already adjusted China to a “netting jurisdiction” in an updated memorandum the same month as the new law was issued. It is important to note that the Financial Stability Law (Draft for Public Comment), issued by China’s central bank on 6 April, provides that the financial authorities under the State Council may, in order to deal with financial risks, take measures including “suspending the close-out netting of eligible financial transactions”. The drafted exceptional provision will undoubtedly affect the legal certainty of the enforceability of close-out netting of derivatives transactions.
In addition, Qu suggests that commercial and investment banks will still need to attach great importance to the agreed terms relating to netting and early termination when conducting derivatives transactions after the new law comes into force, even though the use of these provisions is clear and unambiguous.
This is because, “in a number of past cases, disputes have easily arisen as to whether each transaction has been concluded, how the early termination payment is calculated, and the nature of the early termination and the breach”, he says.
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CROSS-BORDER REGULATION
With the long-arm jurisdictional statute for some of the provisions of the new law, and a cross-border regulatory co-operation mechanism established by the law, rules have been set for cross-border trading by domestic traders and domestic futures operators, as well as the conduct of foreign exchanges and foreign futures operators in providing services or marketing to the mainland China market, from both outbound and inbound aspects.
Qu says this is the first time that domestic traders can participate in offshore futures trading. However, according to the new law, they should choose to entrust a Chinese futures company qualified for offshore futures brokerage business, and then a domestic Chinese futures company will entrust an offshore futures operator to engage in offshore futures trading.
“It is a major boon for domestic Chinese futures companies, especially for those that have already obtained a licence to conduct offshore futures business,” he says.
Foreign futures brokers, meanwhile, will be able to either accept clients’ mandates to participate in Chinese futures trading in their host countries, or accept mandates from Chinese futures companies and Chinese clients to trade in the futures markets of their host countries. “But they should apply for registration with the China Securities Regulatory Commission [CSRC] and be subject to the supervision and management of the CSRC, otherwise they will likely face penalties from the Chinese regulator,” says Qu.
Overseas futures trading venues that plan to provide direct access to trading systems for domestic entities should also apply for registration with the Chinese regulating authorities. “This also shows a change from the traditional regulatory approach of regulating domestic investors through an ‘offshore futures business licence’ to a ‘registration system’ for offshore futures exchanges,” says Mu.
In response to the more diverse and open trading scenarios in the future, the new law also takes into account the cross-border factors. Offshore futures, options and derivatives that use domestic futures or options as the underlying or linked assets will need to comply with special regulations in the future. In the past, when foreign products were linked to domestic products such as stock index futures, only a relevant licensing agreement between the domestic and foreign exchanges was required.
In addition, foreign institutions wishing to engage in futures market marketing, promotion and solicitation activities within China should also obtain approval from the CSRC. However, the law currently only provides for cross-border marketing in principle, with the relevant clear engagement, approval procedures and requirements to be further refined.
“For offshore entities, their cross-border marketing guidelines need to be adjusted accordingly to mitigate the associated regulatory and reputational risks in advance,” suggests Mu.
Regulatory co-operation and assistance between domestic and foreign regulators will be carried out under the framework of the co-operation mechanism, or based on the principle of reciprocity. According to CSRC data, by the end of 2021, it had entered into cross-border regulatory co-operations with the securities or futures regulators of 67 countries and regions.
Mu explains that the principles of the new law are largely consistent with the cross-border data compliance principles of laws such as the Cybersecurity Law and the Data Security Law in terms of cross-border investigation, evidence gathering and information provision. As such, he suggests that domestic and foreign institutions should impose additional care when dealing with information disclosure provisions and confidentiality clauses.
SPECIALISED DISPUTE RESOLUTION
Zhang Hong, a partner of JunZeJun Law Offices in Beijing, summarises that typical disputes in the futures market mainly occur when the margin provided by the clients is insufficient, including overdraft trading when the margin is insufficient, notice of a margin call by the futures company to the clients, and forcible closing of positions when the clients fail to make a timely margin call or close the position on their own.
“Some of the controversies are not unrelated to the fact that the previous Futures Trading Regulations make it an obligation of futures companies to forcefully close out positions [when their clients fail to make timely margin calls or close out their own positions],” she says.
The new law has been amended to provide that when clients fail to make a timely margin call or close out a position on their own, the forced closure of the position will be carried out in accordance with the agreement between the clients and the futures company.
Zhang says that once the law comes into effect, the handling of the above-mentioned disputes will be more likely to be resolved in accordance with the agreement between the two parties to the transaction.
In contrast, while there aren’t as many disputes in the derivatives market, the types of disputes are broader, says Zhang. These disputes include various compliance issues in relation to derivatives transactions between financial institutions and their clients – for example, prior to the transactions, whether the financial institution has confirmed the existence of a genuine demand of the client to enter into the transaction, and whether the client has been adequately alerted to the risks – whether the financial institution has the right to terminate the relevant transaction early, or whether the calculation of the settlement amount in case of early termination is reasonable, etc.
Mu says that in the case of over-the-counter (OTC) derivatives transactions involving cross-border elements, common disputes also include jurisdictional disputes (such as recognition and enforcement of cross-border adjudication), issues of formation, validity and enforceability of derivatives contracts, issues of qualification of the parties to the transaction, disputes over mis-selling of derivatives, etc.
For such disputes, Zhang recommends arbitration as a means of resolution. She points out that as futures and derivatives is a highly specialised niche for legal professionals, it may be fairer and more efficient for someone with a relevant professional background to handle the relevant disputes. “Someone with a professional background may be able to understand the underlying transaction more accurately, and respect the agreement of the transaction and the true intention of the parties in the transaction,” she says.
In addition to seeking arbitration with dedicated arbitration centres, Mu also recommends going to the financial courts to resolve disputes, arguing that the two have a more market-accurate judgment on the nature of derivatives transactions, the definition of the rights and obligations of both parties, and the means to resolve disputes, and “can reduce the influence of local protection and other unfavourable factors”.
He says that derivatives have been developed in China for a relatively short period of time and are an integral part of the multi-level market, which is both innovative and specialised, and should be nurtured and cared for.
The Supreme People’s Court issued guidance towards all levels of courts in 2012, requiring that “when reviewing the validity and legality of innovative financial products, the people’s courts should follow the specificities, concepts and practices of relevant commercial transactions, and listen to the opinions of China’s financial regulators, and it is not appropriate to simply deny the legality of a transaction on the grounds that it is not clearly stipulated in laws and regulations”.
FUTURE PROSPECTS
Despite the limitations of the law, the various positive signals it sends will encourage more domestic and foreign companies and institutions to seek out the more sophisticated forex hedging solutions offered by the Chinese derivatives market, and to use credit derivatives more commonly to manage the risks associated with Chinese issuers in the bond market, as Chinese companies expand their international commercial activities and engage in more frequent commercial dealings with foreign companies.
Against the backdrop of China’s continued opening-up of its financial markets, derivatives will be the new asset class to be included in the mainland China-Hong Kong financial connectivity mechanism in six months’ time, following equities, bonds and exchange-traded funds.
The People’s Bank of China, the Securities and Futures Commission of Hong Kong, and the Hong Kong Monetary Authority recently issued a joint announcement that they would work together to develop “Swap Connect”, a new mutual access programme between Hong Kong and mainland China’s interbank interest rate swap markets. The new mechanism will be officially launched in early 2023.
Qu, of Dentons China, points out that foreign investors holding Chinese bonds inevitably have a need to manage interest rate volatility risk. “Important financial derivatives such as treasury bond futures and interest rate swaps naturally have advantages for hedging interest rate risk.”
Under the new regime, domestic and foreign investors will be able to participate in both financial derivatives markets through the institutional linkage between Hong Kong and mainland China. It will start with northbound trading, allowing foreign investors from Hong Kong and other countries and regions to participate in the mainland’s interbank derivatives market through an interconnected mechanism for trading, clearing and settlement.
As for the futures industry, Guo, of AllBright, thinks that the new Futures and Derivatives Law has reshaped the legal system of the futures market. He says it consolidates previous administrative regulations, ministerial rules and regulations, as well as the self-regulatory rules of futures associations and futures exchanges, while respecting the reality of the development of China’s futures industry, and summarising and absorbing the historical experience of previous futures regulation.
He also mentions that the new law has built a trader protection system and increased investor protection. “This provides more legal remedies and avenues to attract more foreign investors to participate in the Chinese futures market in the future, and boosts the confidence of market players,” says Guo.
“We look forward to the futures legislation further releasing the vitality of market players, streamlining administration and delegating power to lower levels so as to invigorate enterprises in the process of future amendments and improvements,” he adds.
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