China’s regulatory shake-up offers hope on close-out netting

A lack of clear laws on close-out netting has long been a bugbear for foreign banks active in China but the stage is now set for the derivatives technique to become reality, according to sources in the country.

The project has a new home: China Banking and Insurance Regulatory Commission, the result of a merger in March between banking and insurance regulators. CBIRC will write netting rules, with signoff from the People’s Bank of China (PBoC). The two organisations share the same senior official, Guo Shuqing, which should help coordination. Guo is seen as sympathetic to calls to make the technique enforceable, while his previous experience also means he has links to all the regulatory bodies involved in drafting the broader relevant law.  

“I think there’s more of a holistic view on regulation now. The hope is that this will be positive for netting and we can now push things forward,” says a Beijing-based source close to Chinese regulators’ discussions on netting.

“There has been friction between [the different regulators] as to who should be leading this, with different ideas on which approach to take, but things now seem to be coming together.”

Legal certainty that close-out netting works in China would allow a derivatives dealer outside of the country to collapse offsetting trades into a single net payment if its Chinese counterparty defaults. Without netting, the offshore firm may face a claim for its gross exposure. Also, collateral posted into the jurisdiction might not be properly segregated, meaning it could be considered part of the defaulted firm’s estate and dragged into onshore bankruptcy proceedings.

Because of such benefits, banks have to hold capital only against their net exposure, rather than gross, for trades with counterparties in countries where lawyers say close-out netting is enforceable.

The technique can also speed up the development of local derivatives markets as it encourages more participation, according to the International Swaps and Derivatives Association.

The PBoC understand why close-out netting is important… There shouldn’t be any concern that legislative power is to be given to some guy that is new to the issue

Simon Zhang, Linklaters

The outlook for close-out netting in China was hazy in the months that followed the regulatory merger, as the CBIRC and the central bank discussed the split of responsibilities between them. But the division of labour is now clearer, say the Beijing-based source and two other sources close to the regulators.   

If the central bank agrees with the CBIRC’s draft netting rules, it will include them in the regulation on resolving commercial banks, which is currently in the works. This is the surest way to make close-out netting enforceable in China, the sources say.

The two bodies are unlikely to diverge far on the issue as CBIRC chief Guo is also the deputy governor of the PBoC. Earlier in his career, he headed the China Securities Regulatory Commission – whose powers extend to non-bank derivatives users – as well as the State Administration of Foreign Exchange. Both of these are contributing to the development of the bank bankruptcy rules.

“The PBoC understand why close-out netting is important,” says Simon Zhang, a derivatives lawyer at Linklaters in Hong Kong, adding the central bank has been “aware of the issue from the start”. “There shouldn’t be any concern that legislative power is to be given to some guy that is new to the issue.”

New energy

A draft text of the law on resolving commercial banks had been prepared but further work was stalled by the uncertainty that followed the regulatory reorganisation, says one of the sources, who is based in Asia.

Patrick Phua, a partner at law firm Ashurst in Beijing, believes the law could be finalised sooner now that the new, more streamlined regulatory system is in place.

“There could be new energy now to revive the process,” he says. “I think all the regulators are supportive [of netting] – in their public statements that is quite clear.” But he sounds a note of caution, suggesting that implementation could hit hurdles.

Similarly, one industry source says the regulatory reorganisation “definitely seems like the fastest way to get the wheels turning again” on close-out netting and bank resolution rules.

There are signs a broader push for close-out netting in China has been accelerating.

In December 2017, the UK announced the creation of a UK-China Netting Working Group led by the Chinese regulator in charge of banking at the time and China Banking Association, along with Asia Securities Industry and Financial Markets Association, and Isda. The aim was to “strengthen information sharing to promote the study [of] China’s close-out netting rules”, the announcement said.

The three sources say the working group met at the end of September to discuss how to move forward, adding that senior officials from the CBIRC and the PBoC and a judge from China’s Supreme Court were present.

Netting will also be discussed between CIBRC and Bank of England officials at a UK-China summit in London in December, according to a source at an Asian clearing house.

The enforceability of close-out netting in China is of crucial importance to UK banking giants HSBC and Standard Chartered.

A particular problem in China is not just that netting may not be enforceable in bankruptcy proceedings, but that the existing law is too vague for banks to know for sure it won’t be. For European Union banks, having this certainty would lead to the second-best prize: margin savings. The EU’s rules requiring margining of non-cleared trades effectively exempt transactions with counterparties in non-netting jurisdictions.

The confusion was brought to the fore when Ashurst started providing its bank clients with legal opinions stating that close-out netting does not work in China, enabling them to reap the collateral savings. Other law firms said they had refused to offer such non-netting opinions, arguing that the EU rules required too high a standard of certainty.

Editing by Olesya Dmitracova