A Netting Milestone in China

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

For the past 35 years, ISDA has consistently advocated for the enforceability of close-out netting as an indispensable foundation for safe and efficient derivatives markets. Every country that recognizes netting in its domestic legislation represents a positive step forward, but the draft legislation that has been tabled in China is a seminal milestone.

On April 29, the Standing Committee of the National People’s Congress of China published a draft Futures Law for public consultation. Among its provisions, the draft bill appears to explicitly recognize netting enforceability in over-the-counter (OTC) derivatives, which would enable counterparties to close out transactions and calculate a net amount payable in the event of a default. It also expressly states that close-out netting cannot be invalidated or revoked because a party has entered bankruptcy proceedings.

It would be impossible to overstate the significance of this legislation for China’s derivatives market. Netting is the single most important credit risk mitigant, allowing counterparties to reduce their obligations into a single net payment due from one party to another – minimizing market disruption in the event of a default. Managing credit risk on a net rather than a gross basis also increases liquidity and credit capacity.

As China continues to liberalize its financial markets, recognition of netting would remove a major barrier to international participation, supporting the development of liquid and efficient capital markets. Enforceability of close-out netting is typically recognized as risk reducing when it comes to setting regulatory capital requirements, while firms can exchange collateral on a net basis under the global margin framework for non-cleared derivatives. This creates more favorable conditions to attract greater international participation in domestic derivatives markets. It also means financial institutions have more capacity to provide liquidity and extend credit to local economies.

The progress in China comes hot on the heels of another fast-growing market. In September 2020, India passed the Bilateral Netting of Qualified Financial Contracts Act 2020, which ensures the enforceability of close-out netting. ISDA had worked closely with Indian authorities on this for nearly two decades, and the ISDA Model Netting Act provided a template for the legislation that eventually passed. ISDA’s Indian netting opinion has subsequently been updated to reflect the changes introduced by the legislation.

To see progress on such a critical issue in both China and India in rapid succession represents a major breakthrough in ISDA’s ambition to promote and support the recognition of netting around the world. As in India, China’s draft legislation comes after extensive dialogue between ISDA and Chinese authorities on the benefits of close-out netting. Important steps had been taken in recent years as the People’s Bank of China, the China Banking and Insurance Regulatory Commission and other agencies recognized the need to move forward.

Of course, we cannot declare success until the legislation passes and the enforceability of netting is confirmed. The Futures Law is a wide-ranging piece of legislation that sets out rules on futures trading, settlement and clearing, futures brokers and exchanges, as well as a regulatory framework for documentation, trading, reporting and clearing of OTC derivatives. The draft legislation is open for public consultation until May 28, and we will work with our members over the coming weeks to formulate our response.

If the legislation passes as we hope it will and enforceability of netting is confirmed, policy-makers and market participants will need to think about what further developments are needed to promote a mature and effective derivatives market in China. ISDA is developing a whitepaper that sets out how an efficient and vibrant derivatives market will contribute to China’s financial system and makes a series of policy recommendations. It has been a long journey to reach this point, and we are excited to embark on the next stage in collaboration with Chinese authorities.

This year’s ISDA Annual General Meeting with include a panel on China and progress on netting enforceability. Click here for more details.

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