A robust derivatives market

In its push to strengthen its financial system and capital markets, China has turned its sights towards expanding the derivatives market and regulating it better.

The most visible recent step in this direction was the release of a draft Futures and Derivatives Law, which was given a second reading at the standing committee of the National People’s Congress in October 2021.

Along with the new regulations, the China Securities Regulatory Commission has taken steps to attract more foreign capital and open its derivatives market to international investors. Since November 2021, qualified foreign institutional investors and renminbi-qualified foreign institutional investors have been allowed to participate in commodity futures, options and stock market index options.

Small market, huge potential

China’s capital market is large but the derivatives market remains relatively small, according to the International Swaps and Derivatives Association (ISDA). There are relatively few options for over the counter (OTC) derivatives and few asset classes.

Average daily turnover of China’s OTC derivatives market between 2013 and 2019 accounted for about 1% of the global total, according to the ISDA. Japan, whose GDP is smaller than China’s, accounted for 3.3% in 2019.

Still, China’s exchange-traded derivatives market has developed quickly. In a December 2021 white paper, the ISDA noted that commodity derivatives were the main products traded on exchanges in 2019, when they accounted for 72% of the total US$44 trillion traded, followed by equity derivatives at 24% and interest rate derivatives at 5%.

‘The less developed derivatives market is because short selling is not encouraged in China, and also the Chinese stock market has set a limit for drops and rises [of stock prices],’ says Chong Tai Leung, an associate professor at the department of economics at the Chinese University of Hong Kong.

Derivatives have traditionally been used, among other things, to hedge against losses, but that has not played out as clearly in China.

‘People found opportunities in the market. The tools deviated from the original intentions for some people,’ says Chong.

Investor protection

The new regulations might help attract investors that have held back up to now because of ‘the lack of a legislative framework for the futures market, as well as perceived uncertainty around the enforceability of close-out netting and collateral arrangements for over-the-counter derivatives’, says Chin-Chong Liew, a capital markets partner at international law firm Linklaters.

The Futures and Derivatives Law addresses some of these concerns by defining derivatives transactions, clarifying how the subject of a transaction should be organised, and recognising close-out netting.

The effort to strengthen the framework for the derivatives market is comprehensive and covers futures trading, clearing, and the effective supervision of exchanges, clearing houses, trading and clearing members as well as investors, says Liew. What’s more, the FDL provides protection for the enforceability of close-out netting and collateral arrangements, he adds.

Significant step

Although still pending approval from the NPC standing committee, the Futures and Derivatives Law represents the first piece of legislation to regulate OTC derivatives transactions. As such, it represents a significant step forward in providing a comprehensive legal framework for futures markets within mainland China.

‘There is a chapter on OTC derivatives which expressly recognises the enforceability of close-out netting, and the law will dramatically reduce credit risk, lower costs for Chinese firms and remove a major barrier to international participation in Chinese derivatives markets,’ says Jing Gu, head of legal for Asia Pacific at the ISDA.

Close-out netting makes it possible to determine the net obligations of a counterparty in a derivatives transaction that has defaulted and is the ‘single most important risk mitigation tool’ for derivatives markets, Gu explains.

‘It results in drastically lower credit exposures between counterparties,’ she says.

Regulatory concerns

A key aim of the new law is to address the regulatory concerns of both domestic and foreign investors. Foreign investors have long been concerned about the recognition of close-out netting because it aligns with international transaction standards in global markets, according to the China Banking and Insurance Regulatory Commission.

Many banks currently measure their credit exposures on a gross, rather than net, basis when trading with Chinese financial institutions, Gu points out. The recognition of close-out netting should increase the efficiency of using credit lines, reduce costs, and ultimately ‘pave the way to deeper liquidity and greater efficiency in China’s capital markets’.

As the market continues to grow, the ISDA expects that the new legislation will help give the market a significant shot in the arm.

‘With the Futures and Derivatives Law, we expect there will be a big bang in the futures industry and international players will finally switch on netting – the trading tap with their Chinese counterparts,’ Liew says. ‘With this structural change, we will see greater acceptability of Chinese participation at overseas exchanges and clearing houses.’

Liew anticipates that more measures will be introduced to ensure the market is better aligned with international standards. ‘We also expect a recovery and resolution regime to be introduced, which will provide further stability and protection to the onshore financial systems,’ he says.