China’s derivatives market will be built on the back of G20 reforms. OTC subject matter expert, Sol Steinberg explores.
When members of the Group of 20 (G20), met in Pittsburgh in 2009 in the wake of the global financial crisis, they committed to reforms that ushered in a more calculated approach to systemic risk in the financial industry, and along with it, a new market structure for Over-the-Counter (OTC) derivatives. Anchored by the principles of mandatory reporting of OTC derivatives transactions, mandatory clearing through central counterparties (CCPs) and mandatory trading on exchanges or electronic trading platforms, the new market G20 planned for the OTC derivatives space stressed transparency, risk controls, and improved protections against market abuses.
In some of the world’s most established OTC derivatives markets, those changes are well underway. In the U.S. OTC derivatives market, trade reporting and central clearing are well established, and trading of OTC swaps on US Swaps Execution Facilities (SEFs) is mandated for many instruments, with trade volumes on the facilities building slowly but steadily. Europe adopted the European Market Infrastructure Regulation (EMIR) and implemented trade reporting. Legislative frameworks are being finalized and adopted for rolling out central clearing and trading on automated platforms. Elsewhere, in markets like Singapore and Australia, similar progress is being made with reforms achieving milestones on the path to market transformation.
In line with this global commitment, Chinese regulators have proposed a similar regulatory regime. In China, where interest rate swaps, credit default swaps and many of the instruments that make up global OTC derivatives markets have not been traditional tools of finance, the commitment of the Chinese regulators to the post-financial crisis system of reforms means China is essentially building an OTC derivatives market without the shackles of legacy systems. China’s commitment to global financial reform will essentially give one of the world’s largest economies a swaps market designed from the ground up for transparency, regulatory oversight and management of systemic risk.
Central Clearing
Beginning in 2014 with mandatory clearing by the Shanghai Clearing House of new RMB interest rate swaps with tenors of no more than five years, China is building central clearing into the foundation of a its interest rate swaps market. Central clearing has been an early success of OTC swaps market reform, with some SEFs in the US reporting that a few non-US clients have chosen to trade on SEFs while not required to do so because of the benefits central clearing offers in controlling counterparty risk.
Through Shanghai Clearing House, China was the fifth country in Asia to begin OTC clearing after Australia, Hong Kong, Singapore and Japan. On its inaugural data of operations, Shanghai Clearing House cleared 59 interest rate swaps between 15 financial institutions worth a total notion amount of 5 billion yuan, equivalent to $827 million.
On July 1, clearing of Chinese yuan interest rate swaps became mandatory onshore in China for dealers and clients. Thirty-five direct clearing members were admitted prior to launch but some banks did not make the cut prior to the launch of mandatory trading of yuan interest rates swaps. Of the foreign firms that were not on board, some hesitated to join because of compliance rules and others were rejected by Shanghai Clearing House for various reasons. Authorized institutions, licensed corporations and other Chinese persons who are counterparty to a clearing-eligible transaction are required to clear through a CCP if both entities have a clearing threshold and are not exempted from clearing obligations.
Trade reporting and confidentiality
China has moved aggressively on other G20 goals as well. In China, only one trade repository should be designated for the purposes of the mandatory reporting obligation. The reporting obligation for Chinese persons will remain unchanged, i.e. their reportable transactions will have to be reported if their positions exceed a specified threshold (reporting threshold), which will be assessed based on the total amount of gross positions held. For licensed corporations, and local authorized institutions, the reporting obligation will apply if they are counterparty to the transaction or the transaction has a Chinese nexus. For foreign authorized institutions, the reporting obligation will not apply if its Chinese branch is neither involved as a counterparty to, nor as an originator or executor of, the reportable transaction, or its Chinese branch is the originator or executor of the transaction, but the reportable transaction does not have a Chinese nexus. A T+2 reporting schedule will provide market participants some leeway to ensure they can meet reporting obligations.
Reporting to global trade repositories will not suffice for the purposes of any mandatory reporting obligation under Chinese law. Chinese law prohibits the disclosure of state secrets and there is some lack of clarity as to the definition of state secrets. In fact, there are already reports that some US firms located in China have stopped trading with each other in China because of concern that reporting their trades to US trade repositories, as would be required by two US firms, would be a violation of Chinese privacy law. Due to concern that the mandatory reporting obligation may compel market players to breach confidentiality obligations under overseas laws, Chinese regulators will try to build in a degree of flexibility into regime to avoid this.
Forthcoming: mandatory trading and oversight clarifications and adjustments
As of April 2014 three jurisdictions – China, Indonesia and the US – reported having regulations requiring organized platform trading. That said, mandatory trading will not be imposed at the outset, but will be phased in at a later date. Once mandatory trading on designated facilities is in place, fines will be imposed for breaches of mandatory trading obligations that will be comparable to those of other major jurisdictions around the world.
Legislation will seek to clarify when failures to comply with trading, as well as clearing and reporting obligations should be penalized and when they may be excused. Chinese regulators should be able to take disciplinary action against parties that breach their obligation and regulators are also proposing a civil penalty regime whereby civil or administrative fines might be imposed for compliance breaches.
Margin and capital requirements will be proposed and Chinese regulators intend to impose higher capital and margin requirements for non-cleared OTC derivatives transactions.
As the market continues to progress, Chinese regulators will continue to revise the regulatory authority role in capturing and monitoring the activities of dealers and advisors as well as capturing the activities of clearing agents. Regulators will also have to work to clarify regulations as they relate to portfolios of OTC derivatives.
Finally, regulators will devote special emphasis to identifying, registering and regulating systemically important players. Chinese regulators intend to have a high degree of oversight with respect to systemically important players including a registry of names and positions that should be kept with regulators.
