Close-out netting for OTC derivatives
As mentioned above, the provisions for OTC derivatives, importantly, include protection for close-out netting. Close-out netting is the right to terminate all outstanding transactions (and the various payment and delivery obligations agreed under them) and to determine a net amount owed by one party to the other, should a counterparty default - and is a key provision of trading agreements, such as those published by the National Association of Financial Market Institutional Investors and the Securities Association of China, and, internationally, the ISDA Master Agreement (published by the International Swaps and Derivatives Association). The ability to treat a trading relationship and all of the outstanding transactions on a net basis and as a single arrangement is at risk under bankruptcy laws if a defaulting counterparty’s general creditors (or the insolvency official representing them) can cherry-pick between those transactions that are profitable and those that are not. A moratorium on contractual enforcement rights at the commencement of insolvency proceedings can also expose counterparties to contracts with ongoing payments to the same cherry-picking risk. ISDA (for example) promotes netting legislation to create a safe-harbour for derivative transactions from bankruptcy laws and similar provisions such as bank resolution regimes.
Chapter 3 of the Futures Law will protect the netting of eligible OTC and other derivative transactions under recognized close-out netting agreements from the provisions of Chinese bankruptcy laws. Articles 34 and 35 allows a master agreement to be registered by official trade associations with the authorities, so that all transactions under it will form part of a single agreement. For registered agreements, a PRC bankruptcy administrator will only be able to adopt or terminate the transactions under the agreement as a whole. In addition, Article 37 says that the net settlement of transactions following termination under a registered form of master agreement will not be invalidated by the commencement of bankruptcy. As well as the details of any registration regime, the scope of these provisions also depends on Article 3 which defines “other derivatives” as including contracts with performance obligations on a future date where the value fluctuates by reference to an underlying asset, index, marketable security or other financial product. This seems to cover a broad range of OTC derivatives, including swaps, forwards and options relating to a wide range of financial and other risks – subject to clarifying and updating the range of products as markets evolve. It is important that any netting agreement conforms to the specified requirements; but it will also be important that the legislation allows any agreement which includes some excluded transactions, or other arrangements, to continue to be effective for those parts of the agreement that are in-scope.
As well as the draft Futures Law, a number of commentators have previously argued that existing precedents in China also support a special regime for netting derivatives. These included Appendix 6 of the “Measures for Administration of Capital of Commercial Banks (Trial Implementation)” of the China Banking and Insurance Regulatory Commission and the Supreme People’s Court’s “Notice on the Relevant Issues Concerning Case Filing and Acceptance of the Bankruptcy Case on procedural issues relating to filing and the acceptance of bankruptcy petitions” published in 2016. The Futures Law will reinforce these and help to define their scope. It will also impact draft changes to the resolution regime in the Commercial Bank Law recently proposed by the People’s Bank of China in October 2020. Powers for regulators to make partial property transfers in relation to the business of a failing bank should only apply to the net amount, if close-out netting for derivative transactions is to be protected.
Collateral Arrangements in derivatives markets
In addition to netting, another important risk mitigant for derivatives is collateral. The Basel Committee on Banking Supervision and the International Organization of Securities Commissions, require counterparties to uncleared OTC derivative transactions to provide collateral. Certain types of security need to be registered in China in order to be enforceable. Offshore security may also require registration with SAFE, the regulatory authority for foreign exchange transactions. Where relevant, these procedures can be difficult and slow. Enforcement can be delayed by a stay imposed in restructuring proceedings and by requirements for court supervision and/or an auction of the relevant assets, or permissions needed to remit the proceeds of enforcement offshore. These apply to creditors generally, but certainty about the extent to which these issues affect collateral arrangements for derivatives markets (and relevant exemptions) will be critical to counterparties which need to comply with the BCBS/IOSCO rules.
Collateral arrangements in derivatives markets also have a unique feature, the requirement for variation margin, which complicates the legal analysis. The BCBS/IOSCO rules require daily transfers between the parties so that the amount of collateral is equal to the value of the transactions as determined from time to time (the “mark-to-market”). Larger market participants are also required to calculate and make regular transfers of initial margin between themselves. Initial margin provides protection for the potential change in the mark-to-market of transactions over the period between a default and enforcement and is also a variable amount. In order to facilitate these transfers, only certain types of asset are normally used for these arrangements: cash and securities. For variation margin, derivatives markets often adopt the approach also used in many jurisdictions for repo and securities lending transactions, and transfer ownership of these amounts outright. The recipient agrees to redeliver a fungible asset of the same type and amount at a later date, and can set this off against the exposure if there is a default. On the other hand, regulators require initial margin to be segregated, and this needs a security interest to segregate the assets and protect the interests of the grantor.
These ongoing transfers create a number of issues. Title transfer collateral gives some of the economic benefits of security without all of the consequences. It is important that it is not recharacterised as security, since in that case it will often be invalid. Given the reliance on set-off, it is also important that title transfer collateral arrangements will be eligible for close-out netting under the Futures Law. The legal issues for transfers for both title transfer and security interests also include bankruptcy zero hour rules and voidable antecedent transactions. Under the PRC Enterprise Bankruptcy Act, there is a cut-off for payments by an insolvent debtor from the time the court accepts the bankruptcy petition: subsequent transfers may be set aside. Prior transfers may also be voidable under certain rules. The suspect period for fraudulent conveyances and preferential payments during the run up to the proceedings are one year and six months respectively. Fraudulent conveyances may include the early settlement of a debt and the grant of security. Similar issues exist in many jurisdictions but have often resulted in legislation. Marking to market also means that any collateral needs to be realized quickly on enforcement of any security interest, so that counterparties are not under collateralised: the value of both the transactions and the collateral can be volatile.
A focus of industry responses to the consultation draft of the Futures Law has therefore been the impact on collateral arrangements. Article 36 of the Futures Law states that market participants may use guarantees, pledges and other arrangements with the features of real and personal security to support OTC derivatives transactions. This will require that transfers cannot be set aside under existing laws - for example, if made to comply with an enforceable pre-existing contractual obligation, or if made offshore. Arguably this should be stated in Article 36. Alternatively, Article 40 gives the State Council the discretion to make additional rules for other derivatives, so long as it acts in accordance with the principles in the Futures Law itself. Article 39 also states that safeguards for the property rights and finality of securities settlement will be introduced for cleared derivatives on the same basis as for futures under Article 46. Given their similarities, the safeguards that Articles 39 and 46 of the Futures law provide for cleared and exchange-traded derivatives, would, benefit OTC derivatives (and indeed other markets such as repos). Responses to the consultation have therefore requested that the final form of the Futures Law will expressly include protections for collateral for OTC derivatives, including title transfer collateral arrangements. If not, Article 40 could be used to introduce some protections at supervisory level.
Also relevant, a new PRC Civil Code came into force on 1st January 2021, which covers security interests. The Code is supplemented by a notice in the form of an Interpretation of the Supreme People’s Court (the SPC) that also has force of law. This also includes a number of reforms. Traditionally security under PRC law is limited to pledges, mortgages and liens. For security interests, the legal issues relating to top-up collateral include the application (particularly the timing) of security interests to future property. The priority of claims against an asset for various purposes are often determined in favour of the first in time. A secured creditor may not be protected against intervening claims, and the security may also be vulnerable to suspect periods, if the security interest only attaches when the collateral is transferred, rather than when first agreed. Article 440(6) of the PRC Civil Code now also allows a pledge of both existing and future receivables - provided these are identifiable at the time of enforcement. In tandem with this, the SPC Interpretation also recognizes security over a fluctuating balance in a bank account: something that had previously been considered a conceptual problem. The SPC Interpretation should therefore benefit security interest arrangements requiring transfers of cash collateral. Hopefully the same is true for a fluctuating balance of investment securities.
Prudential recognition requirements for banks
The reforms being introduced under Futures Law should alter the way in which European and UK financial institutions treat their exposures to Chinese counterparties. Under Article 296 the European Capital Requirements Regulation (Regulation (EU) 575/2013), a European credit institution can calculate counterparty exposures arising from derivative transactions on a net basis for capital purposes if close-out netting is enforceable against that counterparty. The credit institution must have a contractual netting agreement with its counterparty (based on a template (and core netting provisions) filed with the ECB – although in this case registration does not affect enforceability). It must also have reasoned opinions from external legal advisers confirming the enforceability of those agreements. Recognition of netting by a credit institution also affects requirements for credit institutions to collect and provide collateral for OTC derivatives.
In addition, under Regulatory Technical Standards (Commission Delegated Regulation (EU) No 2016/2251) published by the European Supervisory Authorities (the “RTS”) collateral is required as one of the risk mitigation requirements for non-cleared derivatives. In line with the BCBS/IOSCO requirements, the RTS states that a credit institution must put in place variation and (for the bigger banks) initial margin arrangements to protect against exposures on OTC derivatives that are not managed through a derivatives clearing house. However, the RTS includes an exemption for counterparties where netting and collateral arrangements cannot be enforced and/or if posted collateral (in the hands of a counterparty) cannot be segregated. Again, this must be confirmed by legal opinions. In that case, institutions must agree collateral arrangements on a gross basis, or may be exempt from agreeing any collateral arrangements if an enforceable gross collateral arrangement is not possible, provided that the aggregate amount of all exposures benefitting from the exemption is less than 2.5% of the overall portfolio.
So far, European credit institutions have generally taken the view that the exemption applies when dealing with Chinese counterparties. If, instead, netting and collateral arrangements can be enforced as the RTS requires, then the general requirements for variation and initial margin will apply. In principle, this analysis ought to be determined for both onshore and offshore collateral. A foreign bank posting collateral should be able to segregate cash and securities offshore without interference from Chinese law. However, an analysis of offshore arrangements will still involve some elements of Chinese law when collecting collateral from a Chinese counterparty. A relationship trading derivatives is unlikely to exist in isolation from other commercial dealings. A secured creditor will need comfort that any enforcement offshore will not result in other (secured or unsecured) domestic claims being stayed or reduced, or the creditor subject to some other sanction, during onshore proceedings. Equally, offshore counterparties need to be sure that PRC FX regulations will not limit cross-border transfers or that there are sufficient assets offshore to satisfy payments and deliveries under the collateral arrangements. For collateral arrangements using Hong Kong law, a recent (May 2021) co-operation agreement between the authorities in the PRC and Hong Kong on assistance in cross-jurisdiction bankruptcy proceedings should help. There are more substantive choice of law rules which apply in both jurisdictions for securities held in the Hong Kong Stock Exchange’s bond connect and stock connect services, but requirements for securities settlement based on delivery versus payment will limit the relevance of this to security interests for those securities for the time-being.
In summary the draft Futures Law is a welcome development. It is part of a number of recent initiatives to improve the legal framework for financial markets in China, and is consistent with reforms that have been adopted by major financial centres globally after 2009. In particular, the new Civil Code also contains important provisions relating to collateral arrangements. European credit institutions must assess these reforms and determine the enforceability of netting and collateral for purposes of their own prudential regulation. Any decision is the responsibility of each institution individually, and will depend on a matrix of factors, including the provisions of each relevant agreement. The relevant legal issues, particularly those affecting secured credit, are also broader than just the derivative markets. The analysis by each credit institution of collateral arrangements for the derivatives markets must be consistent with its other businesses in China, Hong Kong and with Chinese clients and counterparties onshore and offshore.