Close-out Netting Enforceability and China’s Financial Market Opening-Up
January 15, 2020, Singapore
Scott O’Malia, Chief Executive, ISDA
Good morning. I’d like to extend a warm welcome to all of you, and thank you for coming.
I would like to thank our very distinguished keynote speakers – Ms. Guan Li of the Supreme People’s Court, Ms. Cai Jiangting of the China Banking and Insurance Regulatory Commission and Professor Ba Shusong of HKEx. We are honored to have you join us here today.
I would also like to take this opportunity to thank our partners, ASIFMA and HKEx, for helping us to put on this event, and Barclays for hosting us.
This is an opportune moment to discuss Chinese market reforms and the importance of a predictable and robust legal framework, including enforceable close-out netting rules. The progress China has made to liberalize its market and currency has been unmistakable, and foreign investors are participating more actively in the country’s economic growth. China is also now an energetic player in the global economy, thanks to projects such as the Belt and Road Initiative and the Asian Infrastructure Investment Bank.
With regulators making this push toward greater openness, we now need to consider the infrastructure and legal framework that is required to support further growth and liberalization. In particular, the legal enforceability of close-out netting will be critical in the next stage of this journey.
In my remarks today, I will highlight three areas where China is taking important steps to expand participation and facilitate global access to liquidity in its cash and derivatives markets. First, I will explore China’s market reforms. Then, I will highlight the important progress that has been made on enforceable close-out netting. Finally, I will touch on the development of a resolution regime for systemically important financial institutions in China.
ISDA and other trade associations are very supportive of China’s reforms to open up the financial sector, internationalize the RMB, improve financial stability and develop a safer and more cost-effective banking system.
We believe a transparent and predictable legal framework is crucial for China to implement these reforms successfully. According to an ISDA survey of Asia-Pacific derivatives market participants that we published last year, the growth and development of financial centers depends on the depth and breadth of financial market infrastructure, a sound legal and regulatory framework, and netting certainty.
We agree with that. In fact, we think close-out netting is the single most important risk-mitigation tool in derivatives markets and other markets like repo. By allowing parties to combine their obligations into a single payment, netting mitigates the credit risk associated with derivatives, repo and other transactions and promotes financial stability. It also encourages active participation by both foreign and domestic participants, supporting more liquid and efficient capital markets.
The importance of netting has been recognized at the highest level by global regulatory bodies. For example, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions have developed capital and margin rules that provide clear advantages for firms in jurisdictions where netting is legally enforceable.
To ensure the safety and soundness of these markets, along with the best risk management and cost efficiencies, we must now work together to ensure the recognition of netting.
The progress China has made on liberalization and market reform in recent years has been very encouraging. China’s bond market is now the world’s second largest. It is already the largest in terms of green bond issuance. Reflecting the importance of this sector, Chinese government and policy bank bonds were included in the Bloomberg Barclays Global Aggregate Bond Index last year, with other indices set to follow suit, which will likely encourage more foreign investment flows.
Last September, we saw increased access to the domestic market, following a decision to scrap investment quota limits on stocks, bonds and other securities via the qualified foreign institutional investor (QFI) and RMB qualified foreign institutional investor (RQFI) schemes. Along with the Stock Connect and Bond Connect initiatives, which allow foreign investors to trade Chinese securities electronically via Hong Kong, there are now more avenues for overseas participants to access China’s financial markets than ever before – which means significant potential for further growth.
As China’s debt market continues to grow, so too will the demand for derivatives as a means of managing and hedging risk exposures. Derivatives are an important risk management tool, used by both foreign and domestic institutions to hedge foreign exchange risk and interest rate exposures and to lock in financing costs. We hope China will further increase the accessibility of hedging instruments for both domestic and foreign institutional investors, as well as harmonize derivatives trading rules so they are the same irrespective of the platform or program investors use to access China’s markets.
Demand for triparty repo transactions in the interbank bond market will also likely increase, as bond market participants look to manage the risk associated with short-term financing. With initial margin rules set to be implemented for smaller firms this year and in 2021, there will be increased demand to access Chinese government bonds as collateral for derivatives transactions.
As firms are able to access a greater diversity of cash and hedging tools, exposures to Chinese counterparties will increase. It is important to have legal certainty on how a default will be handled, and whether firms will be exposed on a gross or a net basis. Similarly, if RMB-denominated products become eligible as initial and variation margin, we must have certainty around these assets as well.
Enforceable Close-out Netting
There are currently no specific provisions addressing close-out netting in the Enterprise Bankruptcy Law and no clear judicial recognition of the concept. This lack of legal certainty acts as a brake on the development of a vibrant and liquid capital markets ecosystem.
This actually affects Chinese financial institutions the most – they face higher capital and transaction costs and a reduced pool of international counterparties to trade with. Importantly, they would also be required to post margin on a gross basis under the global margin framework for non-cleared derivatives, requiring those entities located in jurisdictions without netting to pay significantly more to hedge their risk. Ultimately, it creates an unnecessary build-up of credit risk in the financial system.
Nonetheless, there have been some developments on close-out netting. In a 2017 response to the National People’s Congress, the CBIRC expressed its view that the Enterprise Bankruptcy Law does not conflict with close-out netting in principle. While the CBIRC statement doesn’t represent a legal change that would confirm the enforceability of close-out netting, the comment is very positive.
A UK-China Netting Working Group was subsequently established to consider the issue, led by the CBIRC and China Banking Association and involving ISDA and ASIFMA. This group has helped to increase information sharing on the subject, and has made significant advances in exploring the enforceability of close-out netting in China.
The CBIRC has also been working with the Legislative Affairs Commission of the Standing Committee of the National People’s Congress, the Supreme People’s Court and other policy-makers in China to clarify the position of netting enforceability under the Enterprise Bankruptcy Law in respect of CBIRC-regulated entities. We would encourage the CBIRC to conduct a public consultation on the proposed solution so market participants have an opportunity to provide feedback and assess the impact in light of external legal opinions and internal risk management guidelines.
In addition to this CBIRC-led effort, we believe the proposed bank resolution rules provide an opportunity to deliver greater certainty for a critical part of the market – trades involving systemically important financial institutions. The process by which China will handle resolution of these firms is critically important.
China is currently working to develop a resolution regime for its systemically important financial institutions, which will help mitigate the financial stability risks associated with the failure of a large financial institution. We are very supportive of a strong, internationally consistent resolution regime for financial institutions that is aligned with the principles set out by the Financial Stability Board, and we commend the PBOC, the CBIRC and the CSRC for their work in this area.
As Chinese authorities develop these critical rules, it is imperative that close-out netting and financial collateral arrangements are safeguarded in resolution proceedings, in line with FSB recommendations. Towards the end of last year, ISDA, ASIFMA and ICMA jointly wrote a letter to the PBOC, CBIRC and CSRC, in which we set out some proposals for consideration.
For instance, we think it’s important that any stay on the creditors’ termination rights imposed by a resolution authority should comply with the safeguards set out in the FSB Key Attributes. If the resolution is unsuccessful, a public announcement should be made before regulatory consent is given to start bankruptcy proceedings, and there should be sufficient time for counterparties to close out and net their outstanding transactions outside of bankruptcy proceedings.
Finally, it is important to make clear that close-out netting and enforcement of related collateral arrangements would not subsequently be made void under the Enterprise Bankruptcy Law if a systemically important entity is put into bankruptcy proceedings once a resolution fails.
Ultimately, we would like to see greater clarity on close-out netting enforceability across the entire market. The most effective solution is to develop comprehensive legislation to provide netting certainty for all types of Chinese counterparties.
Over the past 30 years, ISDA has worked with authorities all around the world to support the drafting of netting legislation. So far, we have published netting opinions on more than 70 countries, and we have developed an ISDA Model Netting Act, which provides a template for jurisdictions considering close-out netting legislation. The ISDA Model Netting Act can be a valuable guide for Chinese legislators and policy-makers and educators on the basic principles that should underlie a comprehensive statutory regime for close-out netting.
We strongly believe that certainty on close-out netting will create the foundations necessary for strong, safe and efficient derivatives and repo markets. This in turn will lead to a robust and vibrant ecosystem for capital markets funding and hedging.
We recognize that the liberalization of China’s financial markets is a long journey and the enforceability of close-out netting is one of many market developments that are being considered. That’s why events like these that bring together market participants and official-sector institutions are so important in raising awareness, promoting education on key topics and moving forward together.
Thank you again to ASIFMA and HKEx for partnering with us on this event, and to Barclays for hosting. Thank you to our distinguished guests, and thank you all for coming. I hope you enjoy the conference and find it useful.
I’d like to finish by playing a short video that explains the benefits of close-out netting.