China open door

The newly introduced Futures and Derivatives Law brings the country’s financial services market in line with international standards, welcoming foreign financing. James King reports.

The liberalisation of China’s capital market is progressing quickly, as the country’s lawmakers enact reforms to bring the domestic financial rulebook in line with international standards. The latest addition to this package of regulatory and legislative updates is the introduction of the Futures and Derivatives Law (FDL) at the start of August.

Regarded by many analysts as a game-changing moment for China’s capital market, the FDL is expected to reduce costs for investors while opening up Beijing’s securities markets to higher levels of foreign investment. 

“Essentially, the new law shows China’s readiness to institute a system and a regulatory model for China's financial services market that are linked to internationally accepted standards,” says Sylvia Leung, banking and finance associate in Mayer Brown’s Hong Kong office. 

In particular, the FDL creates a robust regulatory framework for the trading, settlement and clearing of futures and derivatives, while simultaneously strengthening investor protections through higher legal guarantees. As such, China’s derivatives market is expected to enjoy a period of strong growth over the coming months and years, as both domestic and foreign market participants adjust their risk appetites to the improved regulatory environment. 

“Going forward, it is not unreasonable to expect the size of [China’s] derivatives market to increase rapidly and significantly, at least in the medium to long term,” says Vincent Sum, banking and finance partner at Mayer Brown. 

Welcome news for investors

For market participants, the FDL’s strongest benefit stems from the enforceability of close-out netting provisions for over-the-counter (OTC) derivatives. Close-out netting refers to an internationally recognised mechanism that governs payouts in cases where a counterparty to a derivative contract defaults. Before the FDL was enacted, market participants enjoyed few protections in the event of a counterparty default, meaning that credit risk, among other problems, was high. 

This is very favourable to international investors from a risk management perspective

Sylvia Leung

To implement close-out netting, the FDL expressly carves out traditional bankruptcy proceedings from the general operations of the derivatives market. Through this explicit distinction, the new law has changed the risk calculation for a broad range of investors. “This is very favourable to international investors from a risk management perspective, as their exposure to Chinese counterparties’ credit risks could be significantly reduced. This practice has other obvious benefits too, such as lower transactional and compliance costs, including margins determined on a net basis,” says Ms Leung.

Compliance burden

A further outcome of enforcing new close-out netting rules is that China will no longer be deemed a “non-netting” jurisdiction, according to international regulatory guidelines. As such, Chinese capital market entities will be obliged to meet margin requirements in any OTC derivatives transaction, meaning they will have to post collateral as part of any agreement.

The immediate implications of this change will present both Chinese firms, and entities engaging with China’s derivatives market, with sizable operational challenges. “In the short term, market participants would need to revisit their derivatives documentation to determine what needs to be done in order to comply with the various margin rules that would affect existing trades,” says Mr Sum.

Milestone measures

These changes, which feature among many other improvements delivered by the FDL, will play an important role in developing China’s derivatives market. In 2021, the country accounted for only about 1% of global derivatives market turnover, according to data published by the Bank for International Settlements. As such, the FDL is expected to not only strengthen financial system stability by enhancing investment standards and investor protections, but also to deepen economic growth and development in China over the coming years. 

“Having an internationally accepted practice will attract international participants to more actively trade with Chinese counterparties, and will equally encourage Chinese investment houses to become a real player in the international derivatives markets. This will promote the growth of the Chinese OTC derivatives market,” says Ms Leung. “On a macro level, this will fuel the further opening up of China’s capital markets.”

For its part, the International Swaps and Derivatives Association (ISDA) recognised the enforceability of close-out netting in China in a dedicated legal opinion published on August 1. Scott O’Malia, ISDA’s chief executive, noted that the FDL was a “historic milestone” in the development of China’s derivatives market and that it would offer “firms the certainty they need” when engaging with counterparties in the country.

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