Law on Derivatives in China Is “Groundbreaking”

A new rule in China, which goes into effect on Monday, will bring the country’s payout criteria in line with those of other major markets where the same mechanism is used to determine payouts if a derivative counterparty defaults. Recognition of so-called close-out netting reduces the cost of trading by reducing the money required to safeguard against credit risks..

According to Bloomberg Intelligence, the change comes after years of financial industry lobbying and will eliminate a significant roadblock to overseas involvement. Amidst considerable adjustment, however, the new approach offers the promise of revolutionizing cross-border business in an economy that is still largely isolated from the global economy.”

A Hong Kong-based lawyer, Chin-Chong Liew, called it “definitely a gamechanger” and added that it will help the Chinese over-the-counter sector flourish. You’ll be able to interact with Chinese counterparties, but you’ll be able to enter China and become a real stakeholder in the marketplace. China’s places of worship can also become more involved in the global community.”

According to a 2021 study by the International Swaps and Derivatives Association, OTC derivatives trading in China accounted for less than 1% of worldwide turnover in 2019.

Net obligations of the defaulted counterparty to a derivatives transaction can be determined via close-out netting. There are already more than 80 countries that have legally adopted the method, which typically involves exemptions from bankruptcy rules. To avoid greater transaction costs and margin on a gross basis, financial institutions must use cash received from counterparties to offset their liabilities without close-out netting.

The second-largest economy’s adoption of ISDA has grown in recent years, but India was the noticeable exception until it was recognized by ISDA two years ago. China has not experienced any major bankruptcy involving derivative claims comparable to Lehman Brothers, therefore Linklater’s Liew said the change was not previously seen as a top priority.

According to Jenny Cosco, the London Stock Exchange Group’s global head of government relations and regulatory strategy, the lack of clarity about netting enforceability has put Chinese banks at a disadvantage.

If you can net, you have more money at your disposal, Hong Kong-based Cosco stated. As a critical building component for capital markets development, “it is the single most essential tool to mitigate credit risk connected with derivatives transactions.”

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The new rule, according to China Securities Regulatory Commission head Yi Huiman in an interview with state-run media Xinhua, “completed the legal framework” for cross-border futures trading.

According to the country’s official five-year plan, which covers the period through 2025, China has vowed to establish an institutional framework and a regulatory model linked to international laws as part of its efforts to pursue a so-called high-quality opening up.

Even though China’s economy is one of the world’s largest, the country’s trading environment is still in its infancy. Government bond futures are still unavailable for trading from outside the country, although currency derivatives are open to licensed foreign institutions and central banks. Investors from outside will be able to trade onshore interest-rate swaps through Hong Kong in six months, according to a PBOC announcement from July.

The new derivative standard is not a cure-all, to be sure.

According to Andrew Tong, senior portfolio manager for China A-shares quant strategies at Invesco, China’s financial regulatory bodies will need to revise current rules and market participants may need to take a wait-and-see approach on how CSRC and their international counterparts will cooperate on cross-border supervision and administration.

A six-month transition period for Chinese derivative counterparties that may unexpectedly be subject to initial margin regulations has been proposed by UK regulators.

However, many may ask for additional time, given that system upgrade and legal documents are not instantaneous operations,” stated Neil Murphy, triResolve business manager at OSTTRA. There is a possibility of bottlenecks and delays due to the fact that numerous organizations are attempting to establish documents with the same set of counterparties at the same time.

However, risk managers and traders alike will embrace the long-term benefits of close-out netting, which could inspire foreign banks to review their China plans, according to Murphy..

More than 20 years of labor have culminated in China’s enforcement of close-out netting, according to Jing Gu, Head of Legal for Asia-Pacific at ISDA. Derivatives market growth and development will be facilitated by this move, which we applaud Chinese authorities for doing.

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