FIA hosted a webinar on 22 June exploring the recently passed China’s Futures and Derivatives Law (FDL), a significant milestone in the opening up of the Chinese futures markets. Legal experts at Linklaters and Zhao Sheng provided a regulatory overview of China’s futures markets and addressed key questions on clearing, licensing, and extra-territorial implications of the FDL, among other topics related to the law. The following is an excerpt from the webinar.
Tze Min Yeo, FIA's Vice President, Legal and Policy, Asia-Pacific: There have been futures exchanges and futures companies operating in China since the 1990s. What is the significance of the Futures and Derivatives Law?
Chin-Chong Liew, Partner, Linklaters: The Futures and Derivatives Law is truly historic because for the first time in mainland China there is specific legislation for the futures and derivatives market. It provides a comprehensive legal and regulatory framework for the operation of the futures market in China covering a wide range of areas including trading, clearing, settlement, licensing, and the supervision of all participants – the exchanges, clearing houses, clearing members, and investors – as well as market misconduct, cross border trading and overseas futures in which Chinese investors invest. It will support the healthy development of China’s futures market.
From a clearing lawyer’s perspective, it facilitates compliance with the all-important Principles for Financial Market Infrastructures [PFMI]. With the Futures and Derivatives Law, there is now a high level of certainty in the futures market, whether for settlement, finality, closeout, netting, and collateral, since the FDL will prevail over bankruptcy law.
Tze Min Yeo: One of the core principles of the PFMI is settlement finality, recognized as an important building block for risk-management systems. In other jurisdictions, there is the so-called “market contract” concept, which protects the finality of settlement and payments. The China futures market did not have this finality protection previously. How does FDL achieve settlement finality?
Simon Zhang, Counsel, Linklaters: The FDL provides statutory support for settlement finality for the first time. Article 43 recognizes futures margin payment and settlement payment. As long as these are in accordance with exchange rules, the result is final. The China Futures Law goes further to say that even if a settlement party goes into a bankruptcy proceeding, these results are still final and will not be revoked, suspended, or stayed. So, for this, we do have important recognition of the settlement finality under the China Futures Law.
Tze Min Yeo: The PFMI also states that the enforceability of the netting arrangement should have a sound and transparent legal basis. A key aspect of that is the enforceability by the CCP of close-out netting/liquidation provisions against a defaulting clearing member, particularly when that clearing member has become insolvent. Does the FDL afford such protection?
Chin-Chong Liew: Yes, indeed, there is protection for default enforcement purposes in the FDL. This is slightly different from settlement finality because we are talking about finality protection where a party, the clearing member, has defaulted. The law expressly provides that in the default of a clearing participant, the CCP can liquidate and close out the position and then apply margins to satisfy its claims. The CCP can also use the guarantee fund or other resources in accordance with the rules.
Tze Min Yeo: How is collateral provided in the Chinese futures market? Are both cash margin and securities margin allowed? Is there legal protection for the investors under the FDL if the CCP or clearing member defaults?
Ying Zhou, Counsel, Zhao Sheng: Both cash and securities can be posted as collateral in the Chinese futures market and both cash and securities will be provided by way of security interest rather than title transfer. The ownership of this collateral will still belong to the collateral provider and will not form part of the bankruptcy estate of either the clearing member or the CCP.
In addition, the FDL requires margin to be segregated from the own assets of the clearing member and the CCP and cannot be used for purposes other than the prescribed statutory purpose. One point to note is that the FDL does not require margin collateral of a client of a clearing member to be segregated from the collateral of other clients of the same clearing member. It is technically a commingled client account, but in practice China adopts a so-called closed-loop supervision mechanism, so there are protections from both a legal and operations perspective.
Tze Min Yeo: Looking at this from the end-investors perspective – does client clearing in the China futures market fall within the category of principal model or agency model?
Chin-Chong Liew: The FDL does not say anything about the client clearing model. In Europe, client clearing is based on the principal model, and in the US, it is the FCM model, the agency model, but there is no legal characterization under Chinese law on what sort of model it is. From our perspective, a key consideration is whether there is a back-to-back transaction between the clearing member and the client. If there is, then it is a principal model. If there isn't and it is a transaction between the client and the CCP, that is more an agency model.
There is some confusion when it comes to China because in Chinese law they talk about back-to-back settlement, which is settlement between a client and clearing member and between the clearing member and the CCP and some people mistake that to be a back-to-back transaction. We believe that China's model, even though it isn’t defined under its law, is more akin to an agency model.
Tze Min Yeo: Let’s also look at how services can be provided to China persons to facilitate them accessing offshore futures markets. For instance, for entities that operate a futures brokerage business outside of China, would they be subject to any licensing or approval requirements once the FDL becomes effective?
Also, we notice that offshore futures exchanges would need to obtain CSRC approval to provide “direct access” to Chinese investors. What does direct access mean?
Ying Zhou: The FDL is the first law in China that sets out a cross-border licensing regime, which allows overseas brokers and exchanges to obtain a license in China to provide services to Chinese persons on a cross-border basis in a compliant way. So, under this regime, if an overseas broker provides services to an offshore person to facilitate their trading in offshore futures, then the overseas broker would need to be registered in China and be subject to the supervision of the CSRC. They also would need CSRC approval to carry out any marketing or solicitation activities in China. That said, as the implementing rules have not been published yet, we are still waiting to see whether there might be any exceptions and what the registration process will look like.
In terms of direct access, the FDL does not define what direct access is, but generally speaking if an overseas exchange admits a Chinese person as a direct trading member, then that would count as direct access. If a Chinese person is a client of an overseas member and trades indirectly on an exchange through the member, that would not count as direct access, but many cases might fall into a grey area that haven't been explicitly provided for under the law.
For instance, if a Chinese client uses a member's ID to directly transmit orders for execution to the exchange without using the member's infrastructure, that arguably is more likely to fall within the direct access category, subject of course to any further clarification that may be included in the implementing regulation that the CSRC may publish in the future.
Tze Min Yeo: Turning to extra-territorial implications, what does publication of the FDL mean for Chinese CCPs – does this help in their recognition as Qualifying CCPs?
Chin-Chong Liew: With the publication of the FDL, the question is whether Chinese CCPs would now be recognized as a QCCP outside China, in overseas jurisdictions like the US, the EU, or Hong Kong for instance. To this end, the FDL is particularly important because it facilitates compliance with the PFMI principles. We believe that a Chinese CCP could be a QCCP in Hong Kong. Likewise, similar analysis will need to be carried out using relevant US rules.
Rules in the EU are slightly more complicated because it's a two-stage analysis: First China as a jurisdiction needs to be recognized as equivalent by the European Commission. We understand that the Commission is considering whether China is an equivalent jurisdiction. If it is found to be equivalent, the Chinese CCP must then apply to ESMA to become a designated third country CCP.
Watch the webinar for more insights on China’s Futures and Derivatives Law.
