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JunHe Special Situation Investment Legal Review: Legal approaches for foreign investors investing in defaulted bonds in China

2020.12.22 Catherine MIAO、LI, Yuming、LUO, Chong

 I. Overview of the bond market


The bond market of China  (for the purpose hereof, excluding regulations in the Hong Kong Special Administrative Region, Macau Special Administrative Region and Taiwan Region) consists of the stock exchange market, the interbank market and the over-the-counter market of commercial banks, among which the interbank market and the stock exchange market play the main roles. From the perspective of trading markets, the stock exchange market (Shanghai Stock Exchange and Shenzhen Stock Exchange, hereinafter referred to as “SSE” and “SZSE”) belongs to the floor trading market, while the interbank market and the over-the-counter market of commercial banks belong to the off-floor trading market. These bond markets are supervised and administered by the Ministry of Finance, the National Development and Reform Commission, the People's Bank of China (hereinafter referred to as “PBOC”), the China Banking and Insurance Regulatory Commission and the China Securities Regulatory Commission respectively (hereinafter referred to as “CSRC”) depending on the type of bonds issued. 


II. Legislative progress in relation to the transfer of defaulted bonds on maturity in China


i. The Interbank market


On 30 December 2019, PBOC promulgated the Announcement of the People's Bank of China [2019] No.24 — Announcement on Matters Relating to the Transfer of Defaulted Bonds on Maturity (hereinafter referred to as the “Announcement No. 24 2019”). This  stipulated that defaulted bonds on maturity shall be transferred through the trading platform on the interbank bond market and the bond depository and settlement institutions, and among other details, specifies the settlement method. 


In February 2020, the China Foreign Exchange Trade System and the National Interbank Funding Center (hereinafter referred to as  “CFETS”) promulgated the Rules on the Transfer of Defaulted Bonds on Maturity in the Interbank Market (hereinafter referred to as “Rules on the Transfer of Defaulted Bonds”); and on 27 August 2020, CFETS promulgated the Rules for the Implementation of Anonymous Bond Auctions (hereinafter referred to as the “Rules on Anonymous Auctions”), which further detailed the rules and requirements for the transfer of defaulted bonds on maturity in the interbank market. 


On 21 April 2020, the Beijing Financial Assets Exchange (hereinafter referred to as “BFAE”) promulgated the Operating Guidelines of the Beijing Financial Assets Exchange for the Transfer of Defaulted Bonds on Maturity in the Interbank Market (hereinafter referred to as  “CFAE Guidelines on the Transfer of Defaulted Bonds”). 


ii. The Stock Exchange Market


On 24 May 2019, SSE and the China Securities Depository and Clearing Co., Ltd. jointly issued the Notice on Matters Concerning the Provision of Transfer Settlement Services for Specific Bonds during the Listing Period on the  Main Board and the Notice on Matters Concerning the Provision of Transfer Settlement Services for Specific Non-publicly Offered Bonds during the Listing Period;SZSE and the China Securities Depository and Clearing Co., Ltd. jointly issued the Notice on Matters Concerning the Provision of Transfer Settlement Services for Specific Bonds during the Listing Period on the  Main Board and the Notice on Matters Concerning the Provision of Transfer Settlement Services for Specific Bonds during the Listing Period (collectively referred to as the “Notices on Matters Concerning the Transfer of Specific Bonds”), specifying the mechanisms for the transfer of specific bonds on the SSE and SZSE. The aforementioned specific bonds refer to the bonds for which the issuers fail to perform their repayment obligations as agreed, or are exposed to a greater payment risk, or bonds issued by the same issuers that have defaulted on other bonds.


III. Approaches for foreign investors to invest in defaulted bonds in China


i. Interbank market access and transfer approaches


(1) Market access


Announcement No. 24 2019, the Rules for the Transfer of Defaulted Bonds, the Detailed Rules for Anonymous Auctions, the CFAE Guidelines on the Transfer of Defaulted Bonds and other relevant regulatory documents have not explicitly restricted foreign investors as transferees of defaulted bonds. Therefore, we understand that foreign investors may, subject to the existing provisions on bond investment by foreign investors, invest in the interbank bond market through the current available approaches  (see the table below) and participate in the transaction of defaulted bonds in the interbank market. 


The methods by which foreign investors may invest in the interbank bond market in China include:

  • Bond Connect Mode: these are the institutional arrangements whereby mainland and overseas investors trade bonds that are tradable and transferrable on the bond markets in Chinese mainland and Hong Kong by virtue of the connection between and among the infrastructure institutions on the two bond markets. The Bond Connect Mode adopts the market maker mode and a multi-tier custody mode, enabling foreign investors to participate in interbank bond market transactions without changing their business practices. 

  • Direct Investment Mode: this is the mechanism whereby foreign investors satisfying the criteria stipulated in the People's Bank of China Announcement [2016] No. 3 may engage in spot bonds transactions and other transactions as approved by the PBOC in the interbank bond market. However, foreign investors shall entrust qualified interbank market settlement agents to carry out the trading and settlement operations. 

  • Qualified Foreign Institutional Investor Mode (QFII/RQFII): is the mechanism whereby foreign investors are approved by the CSRC to invest in domestic securities and futures using foreign funds. Such qualified foreign investors shall entrust qualified domestic institutions as custodians to manage their assets. 

 


Bond Connect Mode

Qualified Foreign   Institutional Investor Mode (QFII/RQFII)

Direct Investment   Mode

Qualification requirements

(1) commercial banks, insurance companies,   securities companies, fund management companies and other asset management   organizations, as well as other various types of financial institutions which meet certain requirements and are   incorporated overseas in accordance with the law; and

 (2) investment products issued by the   aforesaid financial institutions to customers pursuant to the law;

 (3) pension funds, charitable funds,   donation funds and other mid-to-long-term institutional investors recognized   by the PBOC; and

 (4) foreign central banks, international   financial organisations and sovereign wealth funds.

Upon approval by the   CSRC, foreign fund management companies, commercial banks, insurance   companies, securities companies, futures companies, trust companies, government   investment agencies, sovereign funds, pension funds, charity funds, donation   funds, international organisations and other organizations recognized and   satisfying the requirements of CSRC.

(1) commercial banks, insurance companies, securities companies, fund management   companies and other asset management organizations, as well as various other types   of financial institutions which meet certain requirements and are   incorporated overseas in accordance with the law; and

 (2) investment products issued by the aforesaid   financial institutions in accordance with the laws and regulations;

 (3) pension funds, charitable funds,   donation funds and other mid-to-long-term institutional investors recognized   by the PBOC.

Scope of bond investments

The allowed type of   bond transaction is spot bonds transactions, while the types of bonds   tradable shall be all types of bonds tradable and transferable on the   interbank bond market, including treasury bonds, local government bonds,   central bank bonds, financial bonds, corporate credit bonds, interbank   certificates of deposit, asset backed securities, etc.

With respect to the interbank   market, includes products tradable on the interbank bond market and bonds,   interest rates, foreign exchange derivatives, which the qualified foreign investors   are allowed to invest in by the PBOC.

Spot bonds and other   transactions approved by the PBOC.   These types of bonds include treasury bonds, local government bonds, central   bank bonds, financial bonds, corporate credit bonds, interbank certificates   of deposit, asset backed securities, standardized notes  and other bonds tradable and transferable   on the interbank bond market.

Relevant formalities

Qualified foreign   investors shall apply to the PBOC Shanghai Head Office for filing.   Overseas investors may complete filing formalities through CFETS or any other institutions recognized   by the PBOC on their behalf.

Qualified foreign   investors shall obtain approval from the CSRC;


Qualified foreign   investors shall entrust qualified domestic institutions as custodians   to manage their assets.

Overseas   institutional investors shall entrust an interbank market settlement agent   capable of engaging in international settlement business to carry out trading   and settlement; and


Settlement agents   shall file with the PBOC Shanghai Head Office on behalf of foreign   institutional investors.


Under the above provisions, qualified foreign investors of financial institutions may invest in bonds in the interbank bond market through the aforementioned three approaches. Foreign investors of non-financial institutions are not allowed to invest in the domestic interbank bond market through the Bond Connect Mode and Direct Investment Mode, and the Qualified Foreign Institutional Investor Mode (QFII/RQFII) does not prohibit foreign non-financial investors. Therefore, it is theoretically possible that foreign investors of non-financial institutions may obtain approval to invest in the interbank bond market through the Qualified Foreign Institutional Investor Mode (QFII/RQFII). However, based on our market observations, we have yet to find any case of non-financial institutional investors being approved under this mode. Based on this, we understand that it is relatively difficult for foreign investors of non-financial institutions to enter into the interbank bond market in China.


(2) Transfer Approaches


Institutions which organize the transfer of defaulted bonds on maturity include CFETS and CFAE. CFAE organizes the mechanisms of transfer by agreements and anonymous bond auctions and CFAE organizes the dynamic quotation mechanism. 


Pursuant to the relevant provisions, we understand that foreign investors may participate in the investment of defaulted bonds in the interbank bond market through the following approaches:


  • Transfer by an agreement and anonymous auction mechanism of CFETS


    Pursuant to provisions of  Announcement No. 24 2019, the Rules on the Transfer of Defaulted Bonds and the Rules on Anonymous Auctions as well as other relevant regulations, defaulted bonds may be transferred by agreement or anonymous auction. Given that the aforesaid provisions do not impose additional qualification restrictions on transferees of defaulted bonds, foreign investors may, pursuant to the relevant rules, enter into the domestic interbank bond market through the aforesaid Bond Connect Mode, Qualified Foreign Institutional Investors (QFII/RQFII) Mode or the Interbank Bond Market Direct Investment Mode, and participate in the defaulted bonds transactions via transfer by agreement or anonymous auction organized by CFETS


    In terms of transaction processes, qualified investors of non-financial institutions shall participate in the transfer of defaulted bonds on maturity organized by CFETS through CFAE, while financial institutions and non-legal persons who are qualified institutional investors that participate in the transfer of defaulted bonds on maturity organized by CFAE, shall make quotations and conclude the transactions through CFETS. 3 


    It was reported that, in April 2020, Bond Connect Company Limited launched transfer services for defaulted bonds on maturity in cooperation with CFETS. In September 2020, Orient Securities, a domestic market maker carried out the first transfer transaction of defaulted bonds on maturity with Japanese investors through the Bond Connect Mode. 


  • The dynamic quotation mechanism of CFAE


    CFAE organizes the dynamic quotation mechanism for the transfer of defaulted bonds on maturity in the interbank market in accordance with Announcement No. 24 2019 and the CFAE Guidelines on the Transfer of Defaulted Bonds. The transferees shall be qualified institutional investors in the interbank bond market and have relevant internal supervision and risk management systems, be qualified for participating in the transfer of defaulted bonds on maturity by CFAE and have signed the relevant risk commitment letters.4  


    In terms of transaction processes, qualified investors of non-financial institutions shall make quotations directly to CFAE. Qualified investors of financial institutions and non-legal persons shall participate in the dynamic quotation of CFAE by submitting quotations to CFETS.5


    From a legal perspective, foreign institutional investors entering the interbank bond market through the aforesaid market access approaches may, in theory, participate in the CFAE dynamic quotation mechanism directly or through CFETS, but we are not aware of any case in practice. 


ii. The Stock Exchange Market — Specific bonds transfer mechanism


Defaulted bonds in the stock exchange market shall be transferred through the specific bond transfer mechanism of the SSE or SZSE. Pursuant to the Notices on Matters Concerning the Transfer of Specific Bonds, the specific bonds refer to (1) bonds of which the issuer fails to pay the principal and the interest (including sell-back, repayment by amortization, accelerated repayment, etc., the same applies below); (2)  bonds issued by the same issuer who fails to repay the principal and the interest of other bonds or debt financing instruments issued by it; and (3) other circumstances recognized by the stock exchange for the purpose of protecting the legitimate rights and interests of investors. Specific bonds shall be transferred pursuant to the above-mentioned rules. 


There are a number of special characteristics in terms of the transfer system of specific bonds. Take SSE as an example. The abbreviation of specific bonds are preceded by the word “H” while the bond code remains unchanged; the specific bonds are transferred on the SSE's comprehensive fixed-income securities electronic platform only; the transfer of specific bonds are quoted at full price and settled item by item in full price; and the transfer price of specific bonds are negotiated by investors at their discretion and are not subject to any price limit. 6 


The transferees of specific bonds shall be qualified institutional investors satisfying the requirements of the Measures for Administration of Suitability of Bond Market Investors issued by the SSE and the SZSE as well as other relevant regulations. Pursuant to the Measures for the Administration of Suitability of Bond Market Investors, foreign investors who are qualified foreign institutional investors (QFII) or RMB qualified foreign institutional investors (RQFII) satisfying the corresponding requirements including but not limited to net assets and financial assets may become transferees of specific bonds issued by the SSE and the SZSE. 


IV. Conclusions 


In conclusion, in terms of the interbank market, qualified foreign investors of financial institutions may enter the domestic interbank market through the Bond Connect Mode, Qualified Foreign Institutional Investors Mode  and Direct Investment Mode, and invest in defaulted bonds on maturity through the following approaches: (1) participate in the transfer by an agreement mechanism or anonymous auction mechanism organized by CFETS, or (2) participate in the CFAE dynamic quotation mechanism by submitting quotations to CFETS. At present, it is relatively difficult for foreign investors of non-financial institutions to obtain approval to invest in the interbank bond market in China.


In terms of the stock exchange market, foreign investors may enter the domestic stock exchange market through the Qualified Foreign Institutional Investor Mode (QFII/RQFII) and participate in the transaction of defaulted bonds through the specific bonds transfer mechanism in the SSE and the SZSE. 



1. Article 5 of the Rules of the National Interbank Funding Center on Transfer of Defaulted Bonds on Maturity in the Interbank Market (Zhong Hui Jiao Fa [2020] No. 39)

2. Article 1 of the Operating Guidelines of the Beijing Financial Assets Exchange on Transfer of Defaulted Bonds on Maturity in the Interbank Market

3. Article 3 of the Operating Guidelines of the Beijing Financial Assets Exchange on Transfer of Defaulted Bonds on Maturity in the Interbank Market

4. Replies by the SSE to journalists' questions on Promulgating and Implementing the Business Rules for Transfer of Specific Bonds. http://www.sse.com.cn/aboutus/mediacenter/hotandd/c/c_20190524_4824987.shtml

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