On 17 February 2023, China’s central bank, the People’s Bank of China (“PBOC”), published the much-awaited Swap Connect proposed rules. This article provides a high-level overview of the Swap Connect proposed rules and their key takeaways. The public consultation for the Swap Connect proposed rules will end on 4 March 2023.
1. Background
Swap Connect is an arrangement for domestic (Mainland Chinese) and offshore market participants to access the financial derivatives markets in Mainland China* and Hong Kong* through mutual connections established between the financial market infrastructure institutions (“FMIs”) in both places. Initially, Swap Connect will be open for “Northbound Trading” only, allowing market participants from Hong Kong and other foreign jurisdictions (“offshore market participants”) to participate in the Mainland interbank financial derivatives market in respect of derivatives trading, clearing and settlement.
The initial high-level framework for Swap Connect was first announced by the PBOC, the Hong Kong Securities and Futures Commission (“SFC”) and the Hong Kong Monetary Authority (“HKMA”) in a joint statement issued on 4 July 2022. The joint statement anticipated that Swap Connect will be officially launched after six months.
The latest release of the PBOC’s Swap Connect proposed rules (entitled the “Interim Administrative Measures for the Interconnection and Cooperation in the Interest Rate Swap Markets between Mainland China and Hong Kong (Consultation Draft)”[1]) is very much welcomed by the market. The Swap Connect proposed rules currently focus on Northbound Trading. Further details of Southbound Trading, which allows Mainland market participants to participate in Hong Kong’s derivatives market through mutual access between FMIs in both places, will be addressed at a later stage.
The publication of the Swap Connect proposed rules marks an important milestone and signals the imminent launch of Northbound Trading this year. We expect that the Swap Connect proposed rules, together with the corresponding trading, clearing and settlement rules to be published in the near future by the relevant Swap Connect trading platforms such as the China Foreign Exchange Trade System (National Interbank Funding Center) (“CFETS”) and Swap Connect clearing institutions such as the Shanghai Clearing House (“SCH”) and OTC Clearing Hong Kong Limited (“OTC Clearing”), will form the key pillars of the Swap Connect Northbound Trading regulatory framework.
2. Key takeaways from the Swap Connect proposed rules
After it was announced in July 2022, market participants have been eagerly awaiting important details about Swap Connect. The Swap Connect proposed rules helpfully clarify the following key aspects of the Swap Connect Northbound Trading arrangement.
a) Types of derivatives products covered: RMB IRS
The Swap Connect proposed rules clarify that, initially, Northbound Trading will be available for RMB interest rate swaps in the Mainland interbank derivatives markets where the quotation, trading and settlement currency of such swaps are in RMB (“RMB IRS”).
By way of background, at the end of 2021, foreign investors held approximately RMB 4 trillion of the onshore RMB-denominated bonds market, representing a market share of nearly 3.5%. Foreign investors holding onshore RMB bonds have a significant demand for derivatives-based hedging and risk management solutions. Allowing offshore market participants to trade in onshore RMB IRS through Northbound Trading is expected to promote the further opening-up of the Mainland financial markets in response to growing market demand.
b) Access conditions for domestic and offshore market participants
The Swap Connect proposed rules set out the access conditions for both domestic and offshore market participants that are looking to engage in Northbound Trading. Domestic market participants of Northbound Trading must be Mainland financial institution legal persons that have strong pricing, quotation and risk management capabilities, a good international reputation as well as adequate business systems and professional personnel to support Northbound Trading. Each eligible domestic market participant must also execute a “Swap Connect quotation provider agreement” with a domestic electronic trading platform recognized by the PBOC (i.e., CFETS) (“domestic electronic trading platform”) to participate in Northbound Trading under Swap Connect.
Offshore market participants of Northbound Trading must be offshore institutional investors that “meet the requirements of the PBOC” (符合中国人民银行要求) and that have completed filings necessary to access the China interbank bond market (“CIBM”). In particular, we understand that the concept of “completed filings necessary to access the CIBM” captures the following key categories of offshore investors:
- Qualified Foreign Institutional Investors (“QFIIs”) and RMB Qualified Foreign Institutional Investors (“RQFIIs”);
- foreign central banks, multilateral financial institutions and sovereign wealth funds;
- offshore financial institutions (such as commercial banks, insurance companies, securities companies, fund/asset management companies) and investment products issued by offshore financial institutions to their customers;
- pension funds, charitable funds and endowment funds;
- other medium and long-term institutional investors recognized by the PBOC; and
- Northbound Bond Connect investors.
c) Swap Connect quota management system
The Swap Connect proposed rules provide that Northbound Trading will be subject to a quota management system, with the quota being adjusted from time to time based on prevailing market conditions. Specifics of the Northbound Trading quota management system will need to be further clarified by the relevant regulators and FMIs.
d) Swap Connect trading system
The Swap Connect proposed rules provide that a Northbound Trading transaction shall be concluded on a domestic electronic trading platform (i.e., CFETS), upon which the transaction shall be deemed to be completed and confirmed. According to the Swap Connect proposed rules, transfers of existing swaps shall also be carried out through the domestic electronic trading platforms. It remains to be seen whether this would allow offshore market participants to transfer existing swaps amongst themselves.
e) Swap Connect clearing and settlement arrangements
A key feature of the clearing and settlement arrangements for Northbound Trading is the interconnection established between domestic and offshore central derivatives clearing institutions (“Clearing Interconnection”). According to the Swap Connect proposed rules, the domestic clearing institution approved by the PBOC (i.e., SCH) and the overseas clearing institution approved by the SFC (i.e., OTC Clearing) shall jointly provide clearing and settlement services through the Clearing Connection to domestic and offshore market participants of Northbound Trading.
The Swap Connect proposed rules take into account the existing central clearing requirements for interest rate swaps in the Mainland interbank derivatives market, and provide that the domestic electronic trading platform shall send the results of transactions to be centrally cleared to the domestic and overseas clearing institutions for clearing and settlement. The overseas clearing institution (i.e., OTC Clearing) shall be responsible for funds settlement involving offshore market participants of Northbound Trading, while the domestic clearing institution (i.e., SCH) shall be responsible for funds settlement involving domestic market participants as well as cross-border funds settlement involving the overseas clearing institution.
In order to mitigate systemic risks, the domestic and overseas clearing institutions shall, among other things: (1) carry out central clearing in accordance with the Principles for Financial Market Infrastructures (“PFMI”); (2) jointly manage their risk exposures to each other; and (3) establish special risk reserve funds to address defaults by either one of them. Specifically, if either the domestic clearing institution or the overseas clearing institution defaults, the non-defaulting clearing institution shall apply reserve funds pursuant to applicable clearing rules and clearing agreements to undertake default management actions. Where the non-defaulting clearing institution has used its own reserve funds and those contributed by its clearing members, it can seek recovery from the defaulting clearing institution.
f) Cross-border payments and foreign exchange matters under Swap Connect
The Swap Connect proposed rules provide that cross-border payment of funds under Northbound Trading shall mainly be processed through China’s Cross-Border Interbank Payment System (“CIPS”).
Although Northbound Trading is initially limited to RMB IRS, the Swap Connect proposed rules allow offshore market participants to use either their RMB or foreign exchange funds to participate in trading and settlement under Swap Connect. Offshore market participants can convert their foreign exchange funds into RMB through “Hong Kong Settlement Banks”, a term which refers to RMB clearing banks in Hong Kong as well as overseas RMB business participating banks in Hong Kong that are approved to access China’s interbank foreign exchange market. Swap Connect appears to use the same Hong Kong Settlement Bank arrangement as Northbound Bond Connect, which means Northbound Bond Connect investors can enjoy the convenience using their existing Hong Kong Settlement Bank to convert their foreign exchange funds for the purposes of participating in Northbound Trading under Swap Connect.
g) Trade data reporting under Swap Connect
The Swap Connect proposed rules require domestic and offshore market participants to report data relating to their Swap Connect transactions to a trade data depository approved by the PBOC. This echoes the requirement in Article 36 of the PRC Futures and Derivatives Law to establish a trade data repository for the purposes of centrally collecting, preserving, analyzing and managing data relating to derivatives trading, and to disclose relevant information to the market in a timely manner in accordance with applicable regulations.
The Swap Connect proposed rules helpfully clarify that the domestic electronic trading platform used for Northbound Trading (i.e., CFETS) can report trade data on behalf of market participants and, if the domestic electronic trading platform is recognized by the PBOC as a trade data repository, then market participants do not need to separately submit their own reports.
3. Some remaining Swap Connect issues that should be clarified
a) Derivatives master agreement required for Northbound Trading
The Swap Connect proposed rules provide that, a domestic or offshore market participant of Northbound Trading shall enter into, with its counterparty, a master agreement or other agreement recognized by the PBOC. Under current market practice, to document their derivatives transactions, domestic and offshore market participants would typically choose to enter into either the ISDA Master Agreement (1992 or 2002 version) published by the International Swaps and Derivatives Association (“ISDA”) or the NAFMII Master Agreement (2009 version or 2022 cross-border version) published by China’s National Association of Financial Market Institutional Investors (“NAFMII”). For further information about the recently published NAFMII Master Agreement (2022 cross-border version), please refer to our earlier article here.
We further note that in the international derivatives market, parties may document a derivatives transaction using a long-form confirmation, which avoids the significant time and costs associated with negotiating a full schedule to the ISDA Master Agreement. The long-form confirmation works by deeming that the parties have entered into a standard form ISDA Master Agreement using contractual incorporation by reference, which would usually only need to expressly provide for elections relating to the governing law and dispute resolution arrangements (“Deemed Derivatives Master Agreement”). The derivatives transaction documented in the confirmation and the parties’ rights and obligations are governed by the terms of the Deemed Derivatives Master Agreement.
Some of the questions raised by market participants about the derivatives master agreement required for Northbound Trading under Swap Connect include: (1) can market participants choose to use either the NAFMII Master Agreement or the ISDA Master Agreement? and (2) can long-form confirmations be used to avoid the significant time and costs associated with negotiating a full schedule to the ISDA Master Agreement?
b) CDEA and other clearing agreements
According to the Swap Connect proposed rules, a transaction that has been rejected for central clearing by the domestic and overseas clearing institutions must be disposed of in accordance with the agreement reached between the parties on the domestic electronic trading platform before the transaction was concluded. We understand that when domestic and offshore market participants enter into transactions on the domestic electronic trading platform, they need to agree on the consequences of the transactions being rejected for central clearing.
By way of background, the FIA-ISDA Cleared Derivatives Execution Agreement (“CDEA”), jointly published by the Futures Industry Association (“FIA”) and ISDA, is a standard execution agreement for market participants looking to enter into derivatives that are intended to be centrally cleared outside of the United States. The CDEA documents the process for the submission, acceptance and/or rejection of derivatives transactions that were intended to be centrally cleared. The standard form CDEA includes fallback provisions which prescribe the consequences if a derivatives transaction intended to be cleared is rejected by the clearing house, namely:
- continuation of the rejected derivatives transaction as an uncleared bilateral trade if it is not subject to any mandatory clearing requirements; or
- the terminating party having the right, within an agreed period of time, to terminate the derivatives transaction which has been rejected for clearing and to determine the relevant early termination amount taking into account the then-prevailing market conditions.
The standard provisions in the CDEA may need to be adjusted to take into account the features of Swap Connect. At the initial stage of Swap Connect, the necessary regulatory approvals, accounts and other infrastructure might not be in place for participants to continue performing their obligations under the derivatives transaction as a bilateral uncleared trade (in the case of the first fallback option under the CDEA) or to effect cross-border payment of the early termination amount (in the case of the second fallback option under the CDEA). Therefore, market participants might wish to consider whether a derivatives transaction not accepted for clearing shall instead be cancelled at zero cost, as if the parties have never entered into the transaction in the first place – this is generally described as “zero cost cancellation”, which means that neither party will be required to pay any early termination amount to the other. We anticipate that the Annex to the CDEA can be amended to include zero cost cancellation as an additional fallback option under the CEDA.
It remains to be seen whether market participants must enter into a CDEA to participate in Swap Connect, and whether the arrangements among the domestic electronic trading platform, the domestic clearing institution and the overseas clearing institution will take into account the specific agreements made in the relevant CDEA.
c) What does “meeting the requirements of the PBOC” actually mean?
According to the Swap Connect proposed rules, offshore market participants of Northbound Trading must be offshore institutional investors that “meet the requirements of the PBOC” (符合中国人民银行要求) and that have completed filings necessary to access the CIBM. For offshore institutional investors that have already completed filings necessary to access the CIBM, a remaining question is whether they automatically "meet the requirements of the PBOC” or whether additional registration or vetting process will be required. As the Swap Connect proposed rules do not specify what the “requirements of the PBOC” are, there remains some uncertainty in this area. We expect that this point will be further clarified in subsequent rules and regulations to be announced by the relevant FMIs for Swap Connect.
Should you have any questions about Swap Connect, please feel free to contact our core team members below.
*For purposes of this article, “Hong Kong” means “Hong Kong Special Administrative Region of the People's Republic of China”, and any reference made to “Mainland China”, “onshore” or “PRC” shall be construed as excluding Hong Kong, Macau Special Administrative Region and Taiwan.
Reference
[1] The full title of the PBOC’s Swap Connect proposed rules in Chinese is “《内地与香港利率互换市场互联互通合作管理暂行办法（征求意见稿）》”, which can be accessed at: http://www.pbc.gov.cn/tiaofasi/144941/144979/3941920/4797472/index.html
