China’s Futures and Derivatives Law (FDL), which takes effect today, marks a historic moment for the country’s over-the-counter derivatives market. By enshrining the enforceability of close-out netting in law, the FDL removes a significant barrier to the development of a well-functioning derivatives market, paving the way to greater domestic and international participation and more effective risk management.
By allowing counterparties to reduce their obligations to a single net payment, close-out netting drastically reduces credit risk in the event of a default. As in other jurisdictions where similar legislation has been passed, netting enforceability will lead to greater efficiencies, deepening liquidity and increasing credit capacity. This helps to create vibrant and robust local derivatives markets, enabling effective risk management and supporting economic growth.
ISDA has worked towards this goal for many years and has collaborated closely with Chinese authorities and market participants to make the case for netting. Following the passage of the law in April, we commissioned King & Wood Mallesons to develop a netting opinion, which has also been published today. This will give firms the certainty they need on netting enforceability to trade with onshore Chinese counterparties.
While implementation of the FDL and publication of the ISDA netting opinion are landmark developments, there are some knock-on implications. There is now just one month to go until the September 1 deadline for the final phase of margin requirements for non-cleared derivatives. This was always set to be the most challenging phase, sweeping in the largest number of market participants yet. As the threshold for compliance falls to an average aggregate notional amount of non-cleared derivatives of just €8 billion, we expect more than 775 counterparties to come into scope next month.
As it stands, margin rules in the EU, UK and several other countries provide exemptions from posting margin for trades with firms in non-netting jurisdictions. Now that China has a clean netting opinion, this exemption is likely to fall away and non-cleared derivatives transactions with in-scope Chinese entities may become subject to the requirements. This poses significant operational challenges, as firms will need to negotiate new documentation, establish custodial relationships, and put in place systems and processes for calculating and exchanging margin. This will take time – particularly as hundreds of other entities across the globe are all rushing to meet the September 1 phase-six deadline.
In response, ISDA has written to regulators asking for a transition period to give firms the time they need to put the necessary arrangements in place. The UK Prudential Regulation Authority and Financial Conduct Authority were first out of the blocks, issuing proposals on July 12 to allow a six-month transition period for firms that come into scope of the margin rules for the first time, where the rules would otherwise apply immediately. In cases where a netting exemption falls away, this transition period would begin once a firm has concluded its own legal review to confirm that netting is enforceable.
We very much welcome the intent behind the proposed transition, and we’re currently evaluating whether six months will be sufficient, given the current lack of infrastructure for exchanging margin in China. We hope regulators in other jurisdictions will follow suit by introducing their own proposals for relief.
In the meantime, with netting now achieved, attention is already turning to what policy measures may be needed to further develop China’s onshore derivatives market. A recent ISDA whitepaper provides a helpful blueprint, with 18 recommendations across four key areas – risk governance, market structure, counterparty and market risk management and regulatory framework. Following the success of the FDL, we look forward to working with policymakers and market participants on these key issues in the years ahead.
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