On 20 April 2022, the Standing Committee of the National People's Congress, the top legislature of the People's Republic of China ("China"), adopted a new law on futures and derivatives trading, titled the Futures and Derivatives Law of the People's Republic of China (in Chinese <中华人民共和国期货和衍生品法>) (the "FDL").
The FDL, which will take effect on 1 August 2022, is the first Law（in Chinese, 法律）at a national legislative level regulating futures and derivatives in China since trading in these markets commenced more than three decades ago. As such, the enactment of the FDL marks a new era for the futures and derivatives markets in China. Some of the key developments are summarised below.
Even prior to the FDL, the regulation of China's futures and derivatives markets has been continuously strengthened over the decades. With the Administrative Regulations on Futures Trading (in Chinese《期货交易管理条例》), for example, as the core legislation for futures trading, the regulators and exchanges developed comprehensive rules and regulations to regulate and guide the futures markets. However, there remained some perceived shortcomings. Noticeably, for example, in the Chinese legislative hierarchy, those rules and regulations all rank lower than a Law and, as a result, the principle of legal supremacy limits the scope of such rules and regulations and may create ambiguities/disputes as a result of conflicts with other laws.
In response to the market's desire for greater certainty and to address the above issues, China's top legislature has been working on the new Law which is intended not only to clarify fundamental rules for futures and derivatives trading from a legal perspective but also establish a legal framework and market structure for the healthy development of the futures and derivative markets. The first draft and second draft of the FDL were published for consultation, respectively, in April 2021 and October 2021.
The long-awaited final version of the FDL, which was renamed from the Futures Law to the Futures and Derivatives Law, clearly identifies itself as the fundamental Law in China for Futures as well as OTC derivative products. According to the China Securities Regulatory Commission (the CSRC), the new law provides "a strong legal guarantee for building a standardized, transparent, open, dynamic and resilient capital market and has a very important and far-reaching significance."
One of the key provisions of the FDL, in respect of derivatives documented under a master agreement, is the express recognition of the enforceability of close-out netting provisions. This is achieved through a combination of Article 32 (which specifies that the master agreement, together with all supplementary agreements and confirmations with respect to specific transactions, constitutes a single legally binding agreement) and Article 35 (which provides that the close-out netting provisions of the master agreement shall not be stayed, invalidated or revoked due to the commencement of bankruptcy proceedings with respect to a party to the transaction). It is expected, therefore, that China will become a clean netting jurisdiction once the FDL comes into effect on 1 August 2022. This development has been widely welcomed by market participants.
One practical point to note is that the FDL requires that the template master agreement must be filed with the relevant Chinese authorities. Significantly, however, the final version of the FDL (unlike earlier drafts) seems to have no longer prescribed compliance with this filing requirement as a pre-condition for the enforceability of close-out netting. It remains to be tested whether, in practice, the enforceability of close-out netting would still be based upon such filing requirement.
International market participants that have existing derivatives master agreements (such as an ISDA Master Agreement) in place with on-shore counterparties in China may have included bespoke provisions (including switching on automatic termination provisions) aimed at mitigating the risk of a bankruptcy administrator of a Chinese company cherry-picking whether to perform or unilaterally terminate its obligations with respect to individual transactions under a master agreement. In light of the new statutory recognition of close-out netting under the FDL, any such provisions may no longer be required in the future.
Another of the consequences of China recognising the enforceability of close-out netting is that China may no longer be considered a “non-netting jurisdiction” for the purposes of certain exemptions in the regulatory uncleared margin rules (UMR) in various jurisdictions. As a result, in-scope entities who have been relying on these exemptions will need to re-assess whether they will be required to exchange variation margin and initial margin with their counterparties in China.
On a separate but related note, Article 36 of the FDL provides for the establishment of trade repositories for derivatives reporting. Detailed rules for reporting are to be prescribed by the relevant regulators in due course.
The FDL reaffirms various market manipulation prevention mechanisms and investor protection mechanisms (some of which are unique to the Chinese markets.
The futures trading margin system in China follows the "pay first, trade later" principle. That is, before each transaction, a sufficient margin must be paid in advance to open a position for the corresponding futures contract, where no overdraft is allowed. Under the current mark-to-market settlement system, orders can be placed only if margin has been pre-paid, whereas settlement of margin is required each time a new futures position has been opened and when the corresponding value of the futures contract has decreased. The FDL reaffirms the margin system that is currently adopted by the market and, by stipulations that require margin collection to conform to the rules promogulated by CSRC, delegates to the CSRC the right to decide on the specifics of the margin regime.
All accounts are subject to the "real-name system" and "penetrating supervision". Regulators and exchanges can "look through" futures brokers (who are clearing members) and verify the contract positions and funds in the end investor's account. As a result, no nominee account would be allowed. In this regard, it is noteworthy that the FDL only stipulates regulatory principles for accounts with actual control relationships, which are not as detailed as the concept of "persons acting in concert" stipulated under China's Securities Law. This leaves CSRC and the futures exchanges room to further clarify and improve the current definitions and concepts imposed by the FDL. The FDL also prohibits futures trading participants lending their own futures accounts or borrowing other people's futures accounts to participate in futures trading.
The FDL also sets out rules concerning insider trading, market manipulation and other illegal actions that intend to disrupt the futures markets. The FDL adopts in principle the relevant provisions in the Administrative Regulations on Futures Trading, fleshes out key concepts such as what constitutes inside information and whom should be considered as insiders and lists more examples of illegal market manipulations measures. Wider investigative powers are also granted to the regulator and exchanges to ensure that they are better equipped to pursue any such illegal actions.
The regulators and exchanges have long recognized the increasingly important role of programmatic trading in the futures markets and they have taken measures to tackle the potential market volatilities which may ensue, which include various pre-filing requests and market surveillance measures. However, the market lacks unification on the measures taken as well as clear legal consequences for any adverse effects caused by programmatic trading, which the FDL intends to address. The FDL defines programmatic trading as trading conducted through automatic generation or issuance of trading instructions by computer programs and requires the investors to 1）comply with regulatory provisions complied by the CSRC； 2）file a report to the futures exchange；3）ensure that the transaction shall not affect the security of the futures exchange system or the normal trading order. Additionally, the FDL provides that if the adoption of programmatic trading has adverse effects on the system security of futures trading exchanges or the order of normal trading, the regulators may order the investor to rectify its behaviors and be subject to a fine ranging from RMB500,000 to RMB5 million simultaneously. Further, the directly accountable person(s)-in-charge and other directly accountable personnel may also be subject to a warning and a fine ranging from RMB100,000 to RMB1 million.
Nonetheless, many questions concerning programmatic trading have been left unanswered. For instance, what information is required to be filed? What types of (and in respect of high frequency trading, how fast will) transactions be considered as having "adversely affected the system security of futures trading exchanges or the order of normal trading"? With the top legislation laying out the groundwork, we may anticipate further and more detailed departmental or exchange level guidance being provided soon.
As evidenced by the recent reforming of China's qualified foreign investor ("QFI") regime, the opening of selected futures products to overseas investors and offshore brokers, and the admission of offshore investors to the domestic interbank derivatives markets, the Chinese futures and derivative markets are steadily becoming more and more internationalised. At the same time, Chinese traders and brokers have also become more active in global futures markets. Corresponding to these trends, the FDL imposes new obligations on both regulators and market participants, which include, among others, those summarised below.
First, it is stipulated that CSRC shall establish a cross-border regulatory cooperation mechanism with overseas regulatory authorities to carry out cross-border supervision and administration. Secondly, procedural requirements are to be provided for the provision of services by overseas futures exchange and futures operating institutions to domestic parties as well as the prohibition of unauthorized marketing of their services. Thirdly, the FDL is expressed to have extraterritorial effect. This means that potential legal liability may arise under the FDL in respect of futures and derivatives trading and related activities which are conducted outside the territory of China but which disrupt the domestic market order and harm the legitimate rights and interests of onshore trading participants. In addition, to address national concerns over information/data security, the FDL stipulates that market participants in China may not provide documents or materials related to their futures business activities to overseas regulatory agencies without authorization from Chinese regulators.
In summary, the significant legal certainty and robust regulatory framework provided by the FDL sets the stage for the continued growth and development of China's futures and derivative markets, which will be welcomed by both domestic and international investors1.