Next Steps for China’s Derivatives Market

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.

In recent years, Chinese authorities have made incremental progress in developing the country’s derivatives markets and removing barriers to international participation. In 2021, they took a major step forward with draft legislation that would recognize the enforceability of close-out netting. With this seismic development now within reach, it is time to consider what further steps will be needed to promote a safe, robust and efficient derivatives market in China.

Last week, ISDA published a major whitepaper that explores this very issue. As well as setting out how the derivatives market will contribute to China’s financial system, capital markets and economic growth, it gives an overview of different types of derivatives, their role in capital markets and the various types of participants. It also outlines a series of possible policy measures to further support the development of safe and efficient derivatives markets.

The paper is based on more than 50 interviews with a wide range of domestic and foreign market participants in China. We hope it will serve as a useful resource as Chinese authorities consider future policy steps. From strengthening risk governance and increasing the size and breadth of the market participant base to enhancing the regulatory framework, the paper identifies the developments that will help continue the journey towards a mature, liquid and well-functioning derivatives market.

But we should be in no doubt that the enforceability of close-out netting remains the top priority. The draft Futures and Derivatives law was introduced for second reading at the Standing Committee of the National People’s Congress in October. ISDA is working closely with Chinese authorities, market participants and other industry associations to clarify the draft provisions and ensure netting is fully recognized through this legislation.

ISDA has always been clear that recognizing netting enforceability is the most effective step any country can take to improve the safety and efficiency of its derivatives market. By allowing parties to reduce their obligations to a single net payment due from one party to another, netting mitigates credit risk, drastically reducing the potential for market disruption in the event of a default, while also increasing liquidity and credit capacity.

Over the past 35 years, we have helped ensure netting enforceability in multiple countries, but the prospect of achieving this in China so soon after India passed netting legislation in September 2020 represents massive progress. These are two of the fastest growing markets in the world, but the lack of legal certainty on netting has acted as a cap on the growth of their derivatives markets in the past.

Critical as netting is to mitigate credit risk and lower the barriers to entry, it does not represent the end of the journey. Having worked towards the recognition of netting for so long, it is important we identify what reforms and policy measures may come next, which is why we have developed the whitepaper. We have already discussed the findings and recommendations with policy-makers and market participants in China, and will hold an event on January 20 to further explore the key themes.

I am hugely encouraged by the progress we have seen in developing China’s derivatives market this year and am looking forward to using the paper as the basis for further work in 2022 and beyond.

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