2022.05.06 XIE, Qing (Natasha)、 ZHU, Jiayin、 ZHANG, Chi、 LI, Hanwen
Last year was remarkable for the Chinese futures and derivatives markets. It only took twelve months for the formal promulgation of the Futures and Derivatives Law since it was released for consultation. This was surprisingly fast and boosted market confidence in further improvements to the legislation of futures and derivatives. On April 20, 2022, the Standing Committee of the 13th National People's Congress adopted the Futures and Derivatives Law of the People's Republic of China in its 34th session, which will come into force on August 1, 2022. By comparing the Futures and Derivatives Law (the “Law” or the “Futures Law”) with the Futures and Derivatives Law (Second Draft)(“Second Draft”), we highlight some of the key points below that domestic and foreign futures market investors are most concerned with.
The Futures Law provides the definition of futures trading and derivatives trading. Futures trading is “a trading activity with futures contracts or standardized options contracts as the trading subject.” According to the definition, futures trading is trading of either standardized futures contracts or standardized options contracts that are listed and traded on a futures exchange , meaning that “futures trading” is equivalent to the "exchange-traded futures"(which is commonly known in practice); derivatives trading is “a trading activity with swap contracts, forward contracts, non-standardized options contracts, or a combination of the foregoing as the trading subject”, which is equivalent to "over-the-counter derivatives trading (‘OTC derivatives trading’)” as commonly used in practice. Compared with the Second Draft, the Law slightly amends the definition of "derivatives trading" , making it more precise. Based on this, we believe that some swap contracts and forward contracts, though standardized in certain aspects, should fall within the concept of "derivatives" under the Law. The Law sets out the definition of swap contracts and forward contracts, pointing out that they are both "financial contracts". On the one hand, it sets out the difference between derivatives trading and civil transactions by highlighting the financial nature of swap contracts and forward contracts; on the other hand, it should also be noted that the contractual nature of these reveals that derivatives trading is still based on contract relationship, while this kind of contract/agreement has the hallmark of “current formulating but future performance.”
The Law also states that the futures regulatory authority of the State Council (i.e., the China Securities Regulatory Commission, the “CSRC”) shall implement centralized and unified supervision and administration on the national futures markets (i.e., the futures trading markets) pursuant to the law. But if the State Council makes provisions for interest rate and exchange rate futures products otherwise, such provisions shall prevail. The Law further provides that the futures regulatory authority of the State Council or the authorized departments of the State Council shall supervise and administer the derivatives market based on their division of functions. It can be inferred that the Futures Law does not change the current regulatory framework that separates the regulatory authorities by the varieties of the underlying assets and the different market participants. Instead, it proposes high-level programmatic legislation, under the principles and framework of which, competent regulatory authorities may, based on the varieties of the underlying assets and the different market participants, regulate their own market according to their statutory duties.
The Futures Law codifies the current rules for futures trading, settlement and delivery, as well as some other existing China-specific practices (such as real-name account systems and trader suitability management systems) and sets out the framework at a statute level.
According to the Administrative Regulation on Futures Trading, futures companies shall open a separate account and set up a separate trading code for each client: mingling clients’ codes is prohibited (this requirement is known as “One Client, One Code”). “One Client, One Code” is in effect the requirement for a “real-name account.” To strengthen the administration of futures accounts, the Futures Law explicitly requires that futures trading shall be conducted under a real-name account system, requiring each trader to open an account in their own name. Additionally, as drawn from the relevant provisions in the Securities Law (amended in 2019), the Futures Law stipulates that any entity or individual shall not lend its proprietary futures accounts to others, nor borrow others’ futures accounts to engage in futures trading. Any entity or individual who is in violation of such provisions shall bear the liability consistent with that in the Securities Law (amended in 2019), i.e., shall be ordered to rectify the matter and be issued a warning, and it may be fined up to RMB 500,000.
The Futures Law categorizes futures traders into ordinary traders and professional traders, of which the qualification standards for professional traders shall otherwise be formulated by the futures regulatory authority of the State Council. We expect that such qualification standards for ordinary traders and professional traders may be drawn from the relevant criteria for determining ordinary investors and professional investors stipulated in the Administrative Measures for Suitability of Securities and Futures Investors issued by the CSRC in 2020.
In addition, under Article 52 of the Futures Law, legal persons and unincorporated organizations engaging in futures trading shall establish an internal control policy and a risk control policy that adapt to the type, scale, and purpose of the contracts they trade. Currently, domestic and overseas investors are required to submit their risk management policies, internal control policies and other relevant policies in respect to the management of futures trading before trading listed contracts on the Shanghai International Energy Exchange Co., Ltd.. However, it remains to be seen whether such practical requirements will be applied to all futures exchanges.
Consistent with the Securities Law (amended in 2019), the Futures Law stipulates that program trading conducted through the automatic generation and delivery of trading orders by computer programming shall comply with the provisions prescribed by the futures regulatory authority of the State Council, shall be reported to the futures trading venues and shall not impact the system security or the normal trading order of the futures trading venues. Article 129 of the Futures Law sets out the legal liabilities for an entity or individual who adopts program trading that impacts the system security or the normal trading order of a futures trading venue: they shall be ordered to rectify the matter and fined not less than RMB 500,000 but not more than RMB 5,000,000. However, the Law remains silent on the legal liabilities for failure to report program trading to the futures trading venues. We note that each futures exchange has already put program trading under its regulation and required reporting of program trading for a while. Following issuance of the Futures Law, futures exchanges may put in place more details on program trading in its business rules such as the legal liabilities for a failure to report program trading.
De facto control relationship filing is a unique system only required in futures trading, which can be seen in the relevant rules of each futures exchange. For the first time, the Futures Law establishes such system at a statute level, requiring traders to make a filing of de facto control relationship with the futures operation institutions or the futures trading venues in accordance with the regulations provided by the futures regulatory authority of the State Council. However, the Futures Law does not clarify the definition of a de facto control relationship and the corresponding legal liabilities for violating such filing obligation. It remains to be seen whether the CSRC will formulate specific administrative measures for the de facto control relationship filing in futures trading.
Pursuant to the Administrative Regulations on Futures Trading, traders may post cash or other negotiable securities with a stable value and high liquidity such as standard warehouse receipts and treasury bonds as the margin for settlement of futures trading and to guarantee the performance of contracts. The Futures Law broadens the scope of eligible margins to cash, treasury bonds, stocks, fund units, standard warehouse receipts and other negotiable securities with high liquidity, as well as other assets stipulated by the CSRC. Use of negotiable securities as margins may be carried out by means of pledge or any other performance assurance method pursuant to laws.
The ownership rights to margins and the protection of margins in a bankruptcy proceeding are key concerns for both foreign and domestic institutional participants. Unlike the Administrative Regulations on Futures Trading, which stipulates that the margins collected by futures exchanges from members shall belong to members, and those collected by futures companies from clients shall belong to clients, the Futures Law specifies requirements for “segregation” and “proper use”, which is consistent with the requirements in the Administrative Regulations on Futures Trading and the Administrative Measures for Supervision on Futures Company, i.e., the margins and premiums collected by the futures clearing house and the settlement participant shall be kept separately from its own funds, deposited in a special account, and managed separately in accordance with the regulations of the futures regulatory authority of the State Council. Misappropriation of such margins or premiums shall be prohibited.
Furthermore, the Law remains silent on the protection of margins and relevant assets in a bankruptcy proceeding. In our view, unless otherwise stipulated by the CSRC, the relevant provisions in the current Administrative Measures for Supervision on Futures Company shall still apply; that is, a client’s assets shall not be treated as assets or properties of a futures company if the futures company enters into bankruptcy or liquidation proceedings. The Law further provides that margins, premiums, settlement guarantee funds, risk reserve funds and other such assets collected and withdrawn by the futures clearing house pursuant to its business rules shall be preferentially applied for settlement and delivery and shall not be sealed up, frozen, retained or forcibly enforced. Pursuant to this provision, funds deposited by traders in the futures margin depository institution, once collected or withdrawn by the futures clearing house as margins or premiums, shall be used only for settlement and delivery for futures trading. No person shall misappropriate such margins or premiums intended for guaranteeing the performance of contracts and delivery before the completion of settlement and delivery.
The Futures Law, for the first time at a statute level, recognizes the futures clearing house as a central counterparty (that is, a common counterparty to all settlement participants), and it carries out net settlement as well as providing assurance for the centralized performance of futures trading. Futures clearing houses shall include futures trading venues with internal settlement departments, independent futures clearing houses, and securities clearing houses that engage in the settlement and delivery business of futures trading related to securities business with approval by the futures regulatory authority of the State Council. Until now, the CSRC has approved five futures exchanges as “qualified central counterparties.” In addition to the futures exchanges with internal settlement departments, the Law leaves room at a statute level for the CSRC to approve the establishment of independent futures clearing houses in the future.
Moreover, in line with the Securities Law (amended in 2019), the Futures Law explicitly confirms the rule for settlement finality, that is, the outcome of a futures transaction conducted pursuant to the business rules formulated by the futures venues shall not be varied, and settlement and delivery conducted pursuant to laws shall not be stayed, invalidated or rescinded as a result of the commencement of bankruptcy proceedings on the side of either party to the settlement. By this provision, the Law recognizes that all futures transactions take place at futures exchanges, as a qualified central counterparty, may be settled and arrange for the delivery of cash and contracts on a net basis, and the settlement results shall be final and cannot be invalidated or rescinded by an administrator in accordance with the Bankruptcy Law of the People’s Republic of China (“Bankruptcy Law”).
China is urged to further strengthen regulations on derivatives trading given many of the global financial crisis or events that have occurred in recent years have been associated with financial derivatives trading. The Futures Law provides a whole section in “Chapter II Futures Trading and Derivatives Trading” that specifically regulates derivatives trading. It establishes some basic systems for derivatives trading, such as a single master agreement, close-out netting, and a reporting database, by reference to the established practice in mature markets and it authorizes the State Council to formulate detailed administrative measures, thereby providing a legal basis for the development of the derivatives markets.
A prominent development lies in Article 31 of the Law, which is new and explicitly provides that “where financial institutions carry out derivatives trading business, they shall obtain approval or authorization pursuant to laws, fulfill the trader suitability management obligations, and comply with the relevant regulations of the State”. It echoes the relevant provisions of the Guiding Opinions on Promoting the Regulation of Derivatives Business (Draft for Comment) (“Guiding Opinions”) issued by the People’s Bank of China (“PBOC”) in December 2021, reiterating that financial institutions shall not carry out derivatives business without approval. By reading Article 31 together with the Guiding Opinions, we understand that it in fact denies the legal feasibility for non-financial institutions to initiate financial derivatives trading business proactively. In other words, in any financial derivatives trading, non-financial institutions can only be a party to accept, rather than offer, derivatives products and services.
In addition, Article 31 sets trader suitability management as a financial institutions’ statutory obligation at a statute level. This is not the first time that legislators have imposed suitability management obligations on financial institutions that carry out derivatives businesses. Indeed, Article 7 and Article 8 of the Guiding Opinions already specified that financial institutions that conduct OTC derivatives businesses shall fulfill the suitability management obligations to investors. By a literal reading of Article 31 of the Law, this intends to extend the application scope of suitability management obligations to all types of derivatives businesses, rather than only restricting them to OTC derivatives businesses. It is noteworthy that the Guiding Opinions clarify that suitability management obligations should focus on verifying an investor’s qualifications and the trading purposes (i.e., whether it is for non-hedging purposes), while Article 13 provides no more detail on the suitability management obligations. In the context of dispute resolution, if referring to the relevant provisions under the Summary of the National Courts’ Work Concerning Civil and Commercial Trials (“Summary”) in respect of the suitability obligations of financial service providers, the seller shall bear the burden of proof that it has performed the suitability obligations; that is, it has to demonstrate, for example, that it has established a risk assessment and corresponding management system for its financial products, it has tested the consumers' risk perception, risk appetite, and risk tolerance level, and it has notified the consumers of the investment return and the major risk factors of its products or services. However, in the case of derivatives transactions, especially when both parties are financial institutions, it remains uncertain as to whether each party shall perform the trader suitability management obligations to its counterparty. These issues may have a significant impact in practice and need to be addressed in later implementation rules.
The Law explicitly recognizes the legal effect of close-out netting conducted pursuant to laws, and specifies that the close-out netting shall not be stayed, invalidated, or rescinded in the event of the bankruptcy of any party in the transaction; therefore, the close-out netting would not be subject to the restrictions on the statutory set-off rights stipulated by the Bankruptcy Law, nor would the bankruptcy administrator having cherry-picking rights restrict the close-out netting even in the case of the debtor's bankruptcy. Similarly, the Law further clarifies that the close-out netting can also be applied to the centralized settlement of derivatives trading pursuant to laws, and such centralized settlement of derivatives trading shall not be stayed, invalidated, or rescinded in the event of a settlement participant’s bankruptcy. So far, close-out netting has been recognized and protected at a statute level in China. We hope that the relevant regulatory departments may take this opportunity to engage in bilateral and multilateral dialogues, and encourage the international community to recognize China as a jurisdiction of close-out netting as soon as possible..
It should be noted that in a Q&A of the Circular on Issues Concerning the Rules for the Measurement of Default Risk Assets of Counterparties in Derivatives Trading (No. 124  of the General Office of the CBIRC), the China Banking and Insurance Regulatory Commission (“CBIRC”) released a sign that it would actively advance the legislative process and further promote the clarification and improvement of the close-out netting mechanism as well as the regulatory authorities’ power to stay the counterparty's exercise of early termination rights in the legislations of the Commercial Bank Law, the Banking Regulation and Supervision Law, the Futures and Derivatives Law, the Enterprise Bankruptcy Law and other laws. According to the Financial Stability Law (Draft for Comment) that was recently issued by the PBOC , the financial regulatory authority of the State Council does have the power to temporarily stay the close-out netting of qualified financial transactions (which we believe should include derivatives transactions) in certain circumstances. This will undoubtedly impact the legal certainty of the enforceability of the close-out netting for derivatives transactions. The lengthy stay period or the loose requirements/criteria for the approval of taking such measures would give rise to great uncertainty on the protection of the lawful interests of the counterparties in derivatives transactions. For these reasons, we suggest the regulators have thorough discussions and clarify the relevant resolution measures in the Financial Stability Law before it is finalized and promulgated, and pay close attention to its potential impact on the enforceability of the close-out netting for derivatives transactions.
The Law retains the filing requirement in the Second Draft in respect of the scope of filing, requiring only the model master agreement adopted in the derivatives trading rather than all agreements executed for each specific derivatives transaction to be filed for record. It stipulates that both the “departments authorized by the State Council” and the “futures regulatory authorities of the State Council” shall be responsible for accepting the filing, which runs parallel with the legislative technique of the terminologies used in the Securities Law (amended in 2019), and to some extent addresses the issue of how master agreements issued by international industry associations would be filed with the regulatory departments in China.
The Law remains silent on the party responsible for the filing. However, since the Law no longer mentions “venues that organize the derivatives trading” (as provided in the Second Draft) as the only party responsible for filing, we believe that, in addition to venues that organize the derivatives trading, other market participants that engage in derivatives businesses or industry associations may also file the model master agreements on their own. Additionally, as we expected, the specific practical issues about the filing of master agreements were still not addressed in this Law. The procedures for filing and other details would be otherwise provided by the department authorized by the State Council or the futures regulatory authority of the State Council, as explicitly stipulated in this Law. Given the signals in the Law for respecting derivatives market practices, we believe that the current filing requirements will not be a barrier for the further application of widely used model master agreements issued by PRC industry associations and international industry associations.
In addition, the Law removes the provisions in the Second Draft that the filing of master agreements should be a premise for recognizing the legal effect of the single agreement and close-out netting, which to a great extent disassociates the filing requirement from the enforceability of the single agreement and close-out netting. Based on such changes and in consideration of the legal basis of the filing requirement, we believe that the filing requirement is mainly for the purpose of administrative supervision and may not intended to affect the legal effect of the contractual arrangement such as close-out netting. However, this view remains to be further tested by judicial practice.
This Law also retains the performance assurance methods in the Second Draft, i.e., “pledge or any other performance assurance methods may be provided for derivatives trading pursuant to laws,” emitting a positive sign that the legislator will recognize other performance assurance methods other than pledges that are lawfully entered into by parties of derivatives trading. Taking the “title transfer collateral arrangement” (a widely adopted method in the global financial derivatives markets and a commonly seen method of credit enhancement for derivatives transactions) as an example, because the Law does not explicitly provide for the “title transfer collateral arrangement,” leaving it uncertain about how the nature of “title transfer collateral arrangement” would be determined at a statute level. Additionally, there is no clear recognition under the Law that the close-out netting mechanism will also apply to specific trading under the “title transfer collateral arrangement” together with all multiple derivative transactions under a single agreement. These issues require clarification or guidance in future judicial practice.
Consistent with the Securities Law (amended in 2019), Article 2 of the Law stipulates that “Futures trading, derivatives trading and related activities taking place outside the territory of the People's Republic of China that disrupt domestic market order and impair the legitimate rights and interests of domestic traders, shall be handled and investigated for legal liability in accordance with this Futures and Derivatives Law.”
Until now, foreign investors may engage in domestic futures trading and derivative trading mainly via the following channels:
(1) A foreign investor with a Qualified Foreign Institutional Investors (QFII) license or RMB Qualified Foreign Institutional Investors (RQFII) license (the QFI Scheme) is allowed to trade permissible listed futures and options contracts;
(2) A foreign investor who satisfies the requirements for access to the China Interbank Bond Market (CIBM Direct) (including QFI) is allowed to trade bond-type, interest rate-type and foreign exchange-type derivatives;
(3) Trading specific domestic-listed futures contracts;
(4) Setting up a wholly foreign-owned entity (WFOE) or joint venture in mainland China to trade domestic futures contracts or options contracts with their legitimate RMB income;
(5) Trading foreign structured investment products or OTC derivatives products that link to domestic underlying assets such as futures contracts, options contracts and others.
Such foreign structured investment products or OTC derivatives products (for example, Total Return Swap (TRS)), which are usually tailor-made by foreign investment banks or foreign brokers for their institutional clients, enable foreign investors to gain economic exposure to domestic underlying assets indirectly without inconvenience or high costs to pursue the relevant cross-border qualifications (such as QFI). We are inclined to believe that, although current Chinese laws and regulations do not explicitly prohibit or restrict such OTC derivatives trading, the legality and compliance of such arrangements may be questionable for breach of the look-through regulatory principle pertained to in the Futures Law, and further, if the trading subjects are domestic futures or standardized options contracts, they may also be in breach of the real-name account system established under the Futures Law.
For the first time, the Law puts forward general provisions for the cross-border futures businesses at a statute level:
(1) Overseas Futures Trading Venues: The Law requires overseas futures trading venues that provide domestic entities or individuals with direct access services to their trading systems to register with the futures regulatory authority of the State Council and be subject to supervision and administration by the futures regulatory authority of the State Council, unless otherwise stipulated by the futures regulatory authority of the State Council. In addition, futures contracts, options contracts and derivatives contracts listed on overseas futures trading venues and settled according to the prices of contracts listed on domestic futures trading venues shall comply with the provisions stipulated by the futures regulatory authority of the State Council.
(2) Overseas Futures Trading: Where domestic entities or individuals engage in overseas futures trading (we believe this should be subject to approval or permission of the relevant regulatory authorities), they shall entrust a domestic futures operation institution that is qualified for overseas futures brokerage business, to conduct the relevant overseas futures trading, unless otherwise stipulated by the State Council. Where a domestic futures operation institution entrusts an overseas futures operation institution to conduct overseas futures trading, the overseas futures operation institution shall make an application for registration with the futures regulatory authority of the State Council and be subject to supervision and administration by the futures regulatory authority of the State Council, unless otherwise stipulated by the futures regulatory authority of the State Council.
(3) Marketing and Relevant Activities: For the first time, Article 122 of the Futures Law makes stipulations for overseas institutions engaging in the marketing, promotion and solicitation activities within the territory of the PRC as well as the legal liabilities for violations. First, overseas institutions shall obtain approval from the futures regulatory authority of the State Council and shall be subject to the relevant provisions of the Futures Law if they engage in marketing, promotion or solicitation activities within the territory of the PRC. Second, domestic institutions shall also obtain approval from the futures regulatory authority of the State Council if they conduct marketing, promotion or solicitation activities within the territory of the PRC for any overseas institutions. Third, no entity or individual shall engage in marketing, promotion or solicitation activities in violation of the foregoing provisions. Currently there is no such approval attainable to overseas institutions and they are in fact restricted from engaging in any marketing, promotion or solicitation activities within the territory of the PRC, directly or indirectly through domestic institutions or individuals. Where any entity or individual, in violation of this rule, engages in marketing, promotion or soliciting activities within the territory of the People’s Republic of China, the regulatory authority, in accordance with the Law, may order it to rectify the matter, issue a warning, confiscate its illegal gains, and fine it not less than one time but not more than ten times the amount of the illegal gains; if there is no illegal gain or the illegal gain is less than 500,000 RMB, a fine not less than 500,000 RMB but not more than 5,000,000 RMB may be issued. The person directly in charge and other persons directly responsible shall be issued a warning and fined not less than 100,000 RMB but not more than 1,000,000 RMB.
(4) Cross-Border Regulatory Cooperation: The futures regulatory authority of the State Council may establish a cooperative mechanism for supervision and administration with overseas futures regulatory authorities to implement cross-border supervision and administration, and carry out cross-border investigations and evidence collection, while an overseas futures regulatory authority is prohibited from directly carrying out law enforcement activities such as investigation and evidence collection within the territory of China. It should be noted that the Second Draft once provided that “without permission of the futures regulatory authority of the State Council and the relevant departments of the State Council, no entity or individual shall provide documents and materials relating to futures business activities to any overseas party” . The Law further clarifies the scope of prohibition by amending it from “any overseas party” to “any overseas regulatory authority,” thereby onshore entities or personnel are not prohibited from engaging in normal communications with overseas party such as providing certain documents and materials relating to its daily operations of futures trading to its parent company or related parties overseas.
The promulgation of the Futures Law is undoubtedly key to establishing the futures and derivative legal systems of China and marks a new era for the Chinese futures and derivatives markets, which we believe will have profound implications to the whole industry. We will continue to monitor the situation and keep our clients apprised of its implementation rules and the latest developments in market and law enforcement practices.