The 2009 China Inter-bank Market Financial Derivative Transactions Master Agreement

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1 Hot topic. March 2009 The 2009 China Inter-bank Market Financial Derivative Transactions Master Agreement 1. Background On 16 March 2009, the National Association of Financial Market Institutional Investors ( NAFMII ) published the 2009 version of the China Inter-bank Market Financial Derivative Transactions Master Agreement documentation (the 2009 NAFMII Agreement ). This 2009 NAFMII Agreement is to replace both the previous version which was published by NAFMII in 2007 (the 2007 NAFMII Agreement ) as well as the National Interbank Foreign Exchange Market RMB-FX Exchange Derivatives Master Agreement (the CFETS Agreement ) released by China Foreign Exchange Trading System ( CFETS ) in The 2009 NAFMII Agreement will govern Financial Derivative Transactions entered into between NAFMII members, which will include foreign currency related derivatives that used to be subject to the CFETS Agreement as well as Renminbi derivative transactions that were previously governed by 2007 NAFMII Agreement. The huge significance of the 2009 NAFMII Agreement is that it satisfies the derivative industry s call for one set of documentation applying to various types of domestic Financial Derivative Transactions conducted on different markets, and achieves a merger of the 2007 NAFMII Agreement and the CFETS Agreement. 2. Documentation structure The 2009 NAFMII Agreement consists of five documents as follows: the China Inter-bank Market Financial Derivative Transactions Master Agreement (2009 version) (the Master Agreement ), that governs the legal and credit relationship between the parties and sets up the framework pursuant to which the parties will enter into Financial Derivative Transactions in China; the Supplement to the China Inter-bank Market Financial Derivative Transactions Master Agreement (2009 version) (the Supplement ), under which parties can make the elections required under the Master Agreement or agree to additional tailor-made provisions; the China Inter-bank Market Financial Derivative Transactions Pledge Performance Assurance Document (2009 version) (the Pledge Document ), a stand-alone collateral agreement that uses the pledge approach for the taking of collateral; the China Inter-bank Market Financial Derivative Transactions Title Transfer Performance Assurance Document (2009 version) (the Title Transfer Document ), under which collateral is provided on a title transfer basis; and the China Inter-bank Market Financial Derivative Transactions Definition Document (2009 version) (the Product Definitions ). 1

2 For each specific derivative transaction, the contracting parties will enter into a transaction confirmation, which is referred to as a Transaction Agreement under the 2009 NAFMII Agreement. The transaction confirmation can be generated from a trading system, or signed by the contracting parties on a bilateral basis, or by way of exchange of documents. The NAFMII Master Agreement, the Supplement, and all the Transaction Agreements will, together, constitute a single agreement between the parties in respect of their Financial Derivative Transactions. Capitalised terms in this bulletin, if not otherwise defined here, shall have the meanings specified in the 2009 NAFMII Agreement. 3. Master Agreement The structure and main features of the 2009 NAFMII Agreement are based on the 2007 NAFMII Agreement, but it has also incorporated certain important features of the CFETS Agreement. The main differences between the 2009 NAFMII Agreement and previous master agreements are highlighted below. The Master Agreement will govern Financial Derivative Transactions that are entered into by the parties after they have bilaterally executed the Master Agreement. The term Financial Derivative Transaction is defined in the Master Agreement to be financial derivative transactions (i.e., overthe-counter derivatives) entered into between the parties on a bilateral basis, which includes, but is not limited to, derivative transactions in relation to interest rate, currency, bonds, credit or gold, that are either required by the laws of the People s Republic of China ( PRC ) to be governed by the 2009 NAFMII Agreement or mutually agreed by parties to be governed by the 2009 NAFMII Agreement. Compared to the 2007 NAFMII Agreement which did not give any freedom to the parties to agree on the scope of the Financial Derivative Transactions (which applied mandatorily to the parties), the 2009 NAFMII Agreement seems to give contracting parties more flexibility in determining whether or not to apply the Master Agreement to certain types of derivative transactions. However, it should be noted that the PBOC Announcement (as described in section 6 below) also prescribes that all the Financial Derivative Transactions between inter-bank market participants must be governed by the 2009 NAFMII Agreement. Furthermore, Financial Derivative Transactions is defined under the PBOC Announcement to mean those concluded between the parties on a one-on-one basis, including, but not limited to, interest rate, currency, bonds, credit, and gold derivative transactions. For these transactions, the application of the 2009 NAFMII Agreement is mandatory rather than being subject to the parties mutual agreement (as provided under the Master Agreement). It is not wholly clear whether commodity derivatives and equity derivatives, which are not expressly enumerated in the PBOC Announcement, are excluded from the scope of mandatory application; the PBOC Announcement does not provide a clear explanation for the meaning of inter-bank market participants either. These issues will have to be further clarified by the People s Bank of China ( PBOC ) in due course. Upon an early termination, an Early Termination Payment Amount is payable by one party to the other. This comprises the net sum of the fair market value of Terminated Transactions and any unpaid amount(s) (being payments which are due and payable but remain unpaid prior to the 2

3 Early Termination Date). Under the 2009 NAFMII Agreement, parties now have a choice of two valuation measures: parties can elect to calculate the fair market value of Terminated Transactions either on the basis of replacement transactions (in line with the Close-out Amount calculation under the ISDA 2002 Master Agreement) or market quotations obtained from Reference Market-makers ( in line with the Market Quotation method under the 1992 ISDA Master Agreement). The 2009 NAFMII Agreement introduces the concept of Specified Entities. This is partly because after the publication of the 2007 NAFMII Agreement, many foreign banks converted their Chinese branches into subsidiary banks, incorporated under PRC law and separate from their offshore parent banks. When evaluating the creditworthiness of a foreign subsidiary bank, it is desirable to take into account the financial situation of its parent institution, which the 2009 NAFMII Agreement enables the parties to do so by designating its parent institution as a Specified Entity. The method of notification has been expanded to include delivery by notarisation, delivery by public announcement, and delivery by serving the notice at the premises of the recipient. If the recipient refuses to sign the delivery receipt of a notice that is sent by personal delivery or courier service, the sender may use the foregoing new methods to make an effective delivery. As pointed out above, the purpose of publishing the 2009 NAFMII Agreement is to present a uniform agreement for transactions which up until now are governed by both the CFETS Agreement and the 2007 NAFMII Agreement; therefore, the 2009 NAFMII Agreement has retained many principal features of the previous agreements. The 2009 NAFMII Agreement contains important concepts for derivative transactions such as single agreement, flawed asset, and close-out netting, and most of the provisions governing Events of Default and the Termination Events remain unchanged. In keeping with its nature as an important document intended to set the standard for domestic derivative transactions in China, the Master Agreement emphasises its domestic nature by providing that it is governed by PRC law and parties should resolve their disputes by resorting to domestic PRC dispute resolution methods only. As with the previous agreements, there are certain provisions in the Master Agreement that are mandatory and cannot be amended by the parties. These provisions include the use of Renminbi as termination currency if the transaction currency includes Renminbi, conducting litigation or arbitration in China, the requirement of filing the executed NAFMII Master Agreement and Supplement with NAFMII, and so on. 4. The Performance Assurance Documents Unlike the 2007 NAFMII Agreement, where there was only one performance assurance document and parties should specify whether they elected to apply the pledge arrangement or adopt the title transfer approach, this time NAFMII has published two forms of Performance Assurance Document, namely the Pledge Document and the Title Transfer Document. Under PRC laws, a security agreement (such as a pledge agreement) is ancillary to the underlying contract. Hence, the Pledge Document and the Master Agreement hence are two different contracts, with the 3

4 Pledge Document being an ancillary contract to the Master Agreement. In comparison, the Title Transfer Document constitutes a Transaction Agreement under the Master Agreement (therefore being part of the single agreement of the 2009 NAFMII Agreement). Both documents envisage a bilateral mark-to-market provision of collateral, with the delivery amount and return amount calculated very much in the same way as under the ISDA credit support documents. Eligible collateral includes cash (in Renminbi or foreign currency) and bonds which are issued in China and in registered form, or other types of assets the parties may agree amongst each other. Third party guarantees may also be used as the Performance Assurance Documents but NAFMII will not issue any template for the guarantee. Pledge Arrangement The use of pledge for securing the performance under a Master Agreement still has certain limitations under PRC law. Enforcing a pledge of treasury bonds either requires the co-operation of the pledgor, or the pledgee has to obtain a court judgment or arbitration award, which could be a fairly lengthy process. Pledge of cash requires the appropriation of cash by depositing the cash into a special bank account, and a mark-to-market collateral arrangement may not be enforceable because it does not satisfy the appropriation requirement. Title Transfer Arrangement There is still a residual concern that such an arrangement may be subject to a re-characterisation risk; namely, since it has an economic effect similar to a pledge arrangement, a title transfer arrangement may be held to be an invalid pledge for failure to comply with relevant requirements under the PRC Security Law and the PRC Property Law. However, such risk may be considered not material as this is not the first time that PBOC has officially endorsed the title transfer arrangement, and it is believed that a PRC regulator would have consulted the PRC courts beforehand and have come to some general consensus before endorsing or employing a new legal concept. It is possible that some Chinese banks are still reluctant to adopt title transfer arrangement as the method to provide collateral because they are comparatively more familiar with the pledge approach. There may also be concerns that since an outright transfer of title has occurred when the collateral is provided, if the transferee later becomes bankrupt (an increasingly common concern amongst Chinese banks nowadays in light of the recent credit crunch in the international financial markets), the transferor may not be able to claw back the collateral property and will only have a claim against the bankrupt transferee in respect of the return of equivalent collateral assets as an unsecured creditor. 4

5 5. Product Definitions The Product Definitions will apply to specific types of transactions between the parties under the Master Agreement. The parties can incorporate the appropriate product definitions by making the appropriate references in the applicable transaction confirmation. To a large extent, the Product Definitions retain the same provisions as the product definitions under the 2007 NAFMII Agreement. This may be because the focus of the 2009 NAFMII Agreement was to realise the merger of the 2007 NAFMII Agreement and the CFETS Agreement, rather than an overhaul of all of the components of the 2007 NAFMII Agreement. It is possible that in light of the product development in the domestic derivatives market, NAFMII may be considering the expansion and improvement of the Product Definitions in the future. A main change in the Product Definitions is that clearer guidance will be given to the reference rate for interest rate derivative transactions, including the Renminbi one-year term deposit rate, the SHIBOR (i.e., Shanghai Interbank Offered Rate), and the repurchase basis rate. In addition, a new definition of interest rate period convention is added to be used in situations where the interest rate period is expressed in units of months. 6. Transition Period and Method of Execution On the same day when the 2009 NAFMII Agreement was published, the PBOC released a public announcement (dated 11 March 2009, the PBOC Announcement ) setting out guidance in relation to the mode of migration from existing agreements to the 2009 NAFMII Agreement, and the choice of documentation during the transition period. According to the PBOC Announcement, there will be a transition period of up to six months from the date of the publication of the 2009 NAFMII Agreement, during which the market participants can examine the 2009 NAFMII Agreement and carry out negotiations with their potential counterparties with an aim to execute the NAFMII Master Agreement and the Supplement on a bilateral basis. Once the two parties have executed the NAFMII Master Agreement, the 2009 NAFMII Agreement will apply to new Financial Derivative Transactions entered into between them. At the end of the transition period, the 2007 NAFMII Agreement and the CFETS Agreement will no longer be used for the new Financial Derivative Transactions, and all new Financial Derivative Transactions will be subject to the 2009 NAFMII Agreement. It is of great significance to note that, unlike the 2007 NAFMII Agreement, the 2009 NAFMII Agreement is to be entered into by parties on a bilateral basis rather than a multilateral (or protocol) basis. Furthermore, if two parties intend to enter into Financial Derivative Transactions with each other but have not yet agreed on all the credit terms that should be set out in the Supplement, it is possible for them to sign the Master Agreement first, and conduct negotiations on the Supplement; in the mean time they can document the derivative trades by adding credit terms into specific Transaction Agreement (i.e., a long form confirmation approach). We understand that NAFMII does not prohibit this approach as this may encourage NAFMII members 5

6 to sign the Master Agreement before they reach an agreement on every aspect of their contractual relationships. 7. Concluding remarks The publication of the 2009 NAFMII Agreement is a significant step forward in terms of the development of a unified single master derivatives agreement documentation for derivative transactions in China. It will also help NAFMII to further strengthen its status in the Chinese financial markets by moving one step closer toward becoming a major platform for Chinese financial institutions to conduct Financial Derivative Transactions. In addition, because PRC law requires banks and their customers to use the 2009 NAFMII Agreement to document Renminbi derivative transactions, the 2009 NAFMII Agreement could potentially also become a market standard derivatives agreement for the mass market of end-users, and could potentially be of far greater impact than the previous master agreements, which were either limited exclusively to CFETS market, or predominantly used only by financial institutions. One point to note is that the trading rules and operation procedures of CFETS still remain valid, and shall continue to apply to RMB foreign exchange derivative transactions conducted on CFETS market. The replacement of the CFETS Agreement by the newly issued 2009 NAFMII Agreement relates only to the documentation, and does not affect the foreign exchange trading platform of CFETS and the supervision thereof by SAFE. There is no doubt that NAFMII will to a large extent influence the future development of the Chinese derivatives market, yet the regulatory roles assumed by the PBOC and SAFE cannot be overlooked. The interaction among these three institutions will be closely watched by the domestic derivatives industry. 6

7 Contacts Linklaters is a member of the NAFMII working group responsible for the drafting of the 2009 NAFMII Agreement, and is also the only international law firm that has been invited by NAFMII to participate in the drafting of both the 2007 NAFMII Agreement and the 2009 NAFMII Agreement. If you would like to discuss any of the issues raised in this article, please contact: Hong Kong chin-chong.liew@linklaters.com i-ping.soong@linklaters.com simon.zhang@linklaters.com chris.zhao@linklaters.com Shanghai jian.fang@linklaters.com wendy.kao@linklaters.com Beijing celia.lam@linklaters.com yuan.cheng@linklaters.com ext ext Singapore kevin.wong@linklaters.com jeanne.ong@linklaters.com For more news from Linklaters in Asia visit This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts at Linklaters, or contact the editors. Linklaters All Rights reserved. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com Linklaters in Asia practices through Linklaters LLP, its affiliated firms and other entities carrying on business under or including the name Linklaters or under joint venture or collaboration arrangements in association with Linklaters LLP. In Asia these include Linklaters Hong Kong, Gaikokuho Kyodo-Jigyo Horitsu Jimusho Linklaters in Tokyo, Linklaters Allen & Gledhill Pte Ltd in Singapore and Linklaters (Thailand) Ltd. Linklaters converted to Linklaters LLP on 1 May References in this document to Linklaters for the period following 1 May 2007 accordingly refer to Linklaters LLP and, where relevant, its affiliated firms and entities around the world. Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC The term partner in relation to Linklaters LLP is used to refer to a member of the LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the nonmembers who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on Please refer to for important information on our regulatory position. A