China’s recently passed Futures and Derivatives Law (FDL) has been warmly received by market participants, who welcomed the confirmation of close-out netting under the new rules.

Its lack was an uncertainty that the Chinese derivatives industry had been grappling with for many years.

“Before the FDL, China was one of the few major economies that did not expressly recognise close-out netting, and it wasn’t entirely clear whether it would be enforced during bankruptcy proceedings according to the terms of the derivatives master agreement,” said Jing Gu, head of legal for APAC at ISDA. “Some parties said that close-out netting would be upheld in Chinese courts, while others were less certain that it would be enforced with a sufficiently high degree of legal certainty.”

The FDL has now removed these uncertainties, and has expressly provided that where derivatives are documented under a master agreement, a party can close out and net according to the terms of the agreement upon the occurrence of an agreed event. Close-out netting shall not be stayed, invalidated or revoked due to the commencement of bankruptcy proceedings with respect to a party to the transaction.

The derivatives industry and ISDA have spent more than a decade to try and resolve the uncertainty around close-out netting in China, according to sources.

“The FDL sets out, at a legislative level, the concepts of single agreements and protection of close-out netting from challenges under bankruptcy law, which have never been this clear before under Chinese law,” said Terry Yang, partner at Clifford Chance. “This is a watershed moment and the single most important development in China’s derivatives market.”

For Chin-Chong Liew, partner at Linklaters, the recognition of close-out netting will be an absolute game-changer for the onshore derivatives market. “To date, the development of the onshore OTC derivatives market is hamstrung by the legal uncertainty on close-out netting enforceability,” he said. “The volume of OTC derivatives will pick up drastically and foreign financial institutions will be able to enjoy the benefits of close-out netting, such as favourable regulatory capital treatment when trading with PRC counterparties. Chinese financial institutions will also become active players in the international market and join global clearinghouses as clearing members.”

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While the previous draft of the law required that an industry master agreement template be filed with the Chinese regulator before being protected during bankruptcy proceedings, this will also change under FDL.

“This proposal has raised some questions, such as whether a bank’s bespoke agreements be protected, by whom the industry agreement template should be filed, and how should the filing be carried out,” said Gu. “In the final version of the FDL, compliance with the regulatory filing requirement is no longer stated to be a pre-requisite for legal protection for single agreements and close-out netting.”

According to Gu, the law is beneficial to both foreign and Chinese banks. Foreign banks dealing with Chinese entities can calculate their credit risk exposure on a net rather than gross basis once they turn on their netting, for instance. Meanwhile, this should lead to cost reductions for PRC banks, as those trading with counterparties from a netting jurisdiction can get regulatory capital relief.

“The law brings down transaction costs for Chinese entities, as they can benefit from enhanced efficiency in using regulatory capital from foreign banks,” said Gu. “In addition, they will not be required to post margins on a gross basis under the global margin framework for non-cleared derivatives.”

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Next steps

ISDA is now planning to commission a netting opinion on China. For foreign banks, this means they will need to perform internal reviews to decide whether or not they should switch on netting for their Chinese counterparts once ISDA publishes its opinion.

With FDL set to become effective from August 1, international banks have little time left to ensure that their derivative agreements are aligned with close-out netting provisions.

“In addition to the ISDA master agreement, market participants will also need updated advice on other onshore agreements in China, such as the NAFMII [National Association of Financial Market Institution Investors] master agreement and SAC [Securities Association of China] master agreement, in light of the new law,” said Clifford Chance’s Yang.

While repo transactions are not expressly covered by FDL, the reasoning used to support close-out netting is also applicable to them, which means further discussion can be expected on documents such as the global master repurchase agreement.

“Given that a number of jurisdictions, including the UK and the EU, rely on the concept of equivalence for cross-border recognition and regulatory deference, having the relevant equivalence assessments in place from overseas regulators would facilitate cross-border trading with PRC counterparties and the ability for foreign entities to join Chinese clearinghouses,” said Liew.

Overseas market participants were also relying on exemptions from having to exchange regulatory margins when trading with PRC counterparties on the basis that these were based in a non-netting jurisdiction. “These foreign market participants will have to start assessing the regulatory margin requirements when trading with PRC counterparties when the country becomes a clean netting jurisdiction,” said Liew.

While foreign jurisdictions involved with Chinese counterparties have not provided for a transitional period regarding initial margin requirements, FDL’s implementation date could mean that phase one-to-five dealers will need to implement initial margin arrangements with PRC counterparties from August 1 while phase six dealers will have to do so by September 1.

“Market participants would be well-advised to contact their supervisors in advance to ascertain the regulatory expectations on this front,” said Liew.

According to Yang, PRC regulators and large banks have been trying to push towards onshore cash and bonds for collateral posting. “More measures can be expected around the application and operational infrastructure to implement the exchange of collateral, for instance, using the China Central Depository & Clearing (CCDC) bond depository systems for PRC bonds as collateral onshore,” he said.

TieCheng Yang, partner at Han Kun Law Offices added: “In addition to the CCDC, the Shanghai Clearing House (SCH) will need to update its systems to improve cross-border connectivity, so that investors who do not invest in the Chinese bond market and don’t have onshore renminbi bond accounts are able to accept the pledging of renminbi-denominated bonds.”