China’s ‘Gamechanger’ derivatives law is the latest bid to open up the market

(Bloomberg) – A regulatory breakthrough is expected to lower costs for investors trading OTC derivatives in China, the latest step in opening up the country’s capital markets to foreign investors.

A Chinese law that comes into effect on Monday enforces a mechanism used around the world to determine payouts in the event of a derivative counterparty defaulting, bringing standards there in line with those used in other major markets. This recognition of so-called close-out netting is seen as reducing the cost of transactions by reducing the funds that should be set aside to protect against credit risk.

The development, which follows decades of lobbying by the financial industry, will remove a major barrier to international participation, according to Bloomberg Intelligence. While there will be adjustments as market participants adopt the new system, it promises to eventually revolutionize cross-border trade in an economy that still remains significantly cut off from international markets.

“It’s absolutely a game changer,” said Chin-Chong Liew, Linklaters Hong Kong partner, adding that it will fuel the growth of the Chinese over-the-counter market. “International houses will not only be able to deal with Chinese counterparties, but go to China and be a real player, a market maker. Chinese houses can also be more active internationally.

China’s OTC derivatives trade accounted for only about 1% of global turnover in 2019, compared to 3.3% for Japan, according to a 2021 report by the International Swaps and Derivatives Association.

Close-out netting is a method of determining the net obligations of a defaulting counterparty to a derivative transaction. The International Swaps and Derivatives Association recognizes more than 80 jurisdictions that formally rely on the mechanism, which often requires waivers of bankruptcy laws. Without close-out netting, financial institutions face higher transaction costs and must provide margin on a gross basis, which means they cannot use the cash they may receive from counterparties to offset their debts.

While its use has grown in recent years, with the ISDA recognizing India two years ago, the world’s second-largest economy was the most notable exception. There have been no massive bankruptcies involving derivative claims similar to Lehman Brothers in China, so it was not previously seen as a high-priority reform, Linklater’s Liew said.

This lack of clarity on the applicability of netting has put Chinese banks at a disadvantage, according to Jenny Cosco, global head of government relations and regulatory strategy at the London Stock Exchange Group.

“If you can win, you have more money at stake,” Hong Kong-based Cosco said. “It’s the single most important mechanism for reducing the credit risk associated with derivative contracts, so it’s really a key part of the development of capital markets.”

The revised law filled a missing part of the legal system for cross-border futures trading, Yi Huiman, chairman of the China Securities Regulatory Commission, said in an interview with state media Xinhua.

It is also part of China’s efforts to pursue so-called high-quality opening up, a term used in the official five-year plan covering the period to 2025, during which China pledged to build an institutional system. and a regulatory model that is linked to international rules.

Despite the size of its economy on the world stage, China has a relatively underdeveloped business environment that has not yet fully opened up to foreign investors. Its currency derivatives market is only accessible to foreign banks or licensed central banks, while its government bond futures are still closed to trading from abroad. The PBOC announced earlier this month that international investors will be allowed to trade the onshore interest rate swap market through Hong Kong in six months.

Of course, the new derived standard is not a panacea. Market participants may need to take a wait-and-see approach on how the CSRC and their international counterparts will cooperate on cross-border supervision and administration, according to Andrew Tong, senior portfolio manager for China A-share quantitative strategies. at Invesco.

In the meantime, UK regulators have proposed a six-month transition period for Chinese derivative counterparties that could suddenly fall under initial margin rules.

“While not wishing to appear ungrateful, many may wish for more time, given that system change and legal documentation are far from overnight processes,” said Neil Murphy, commercial director of triResolve at OSTTRA. “The challenge is complicated by the fact that many companies will try to establish documentation with the same set of counterparties simultaneously, which will risk bottlenecks and delays.”

Nonetheless, Murphy agrees that risk managers and traders will appreciate the long-term benefits of close-out netting, which could encourage foreign banks to re-evaluate their strategies in China.

“Enforceable termination-netting in China is the culmination of more than 20 years of work,” said Jing Gu, chief legal officer for Asia-Pacific at ISDA. “We commend the Chinese authorities for taking this step, which will open the door to the development and growth of the derivatives market.”

©2022 Bloomberg LP

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