China Launches Credit Derivatives Market.

Transcription

1 8 November 2010 China Launches Credit Derivatives Market. Introduction After months of anticipation, the National Association of Financial Market Institutional Investors ( NAFMII ) published the Guidelines for Inter-bank Market Credit Risk Mitigation Instruments (Pilot Scheme) (the Guidelines ) on 29 Oct 2010 which paves the way for the launch of a credit derivative market onshore China. This is a major milestone in the China interbank 1 market and signifies the beginning of credit derivative products (which were blamed as a major cause of the global financial crisis) in the nascent derivatives market in China now the second largest economy in the world. Understandably, the products being introduced under the pilot scheme are relatively simple. At this stage only two types of products are allowed - one being credit risk mitigation contracts (effectively an OTC single name reference obligation only CDS) and the other being credit risk mitigation certificates (which are transferrable certificates giving holders the right to put reference obligations to the issuer). Key points in the Guidelines Types of instruments These are dubbed credit risk mitigation instruments in the Guidelines the term was carefully chosen to disassociate these products from the negative connotations surrounding CDS in the international markets. It is further provided that such credit risk mitigation instruments (the CRM Instruments ) comprise credit risk mitigation contracts ( CRM Contracts ), credit risk mitigation certificates ( CRM Certificates ) and other simple and basic credit risk management products. While leaving room for other types of products to be introduced later, at this stage only CRM Contracts and CRM Certificates are contemplated under the Guidelines. Contents Key points in the Guidelines... 1 Types of instruments... 1 CRM Contracts... 2 CRM Certificates... 3 Tiered market access qualifications... 4 Dealers... 4 Primary Dealers... 4 Non-Dealers... 4 Tiered market access 4 Risk management... 5 Documentation... 6 CRM Contracts... 6 CRM Certificates and NAFMII Master (Certificate version)... 6 Structure of Certificate Master... 7 Mode of execution... 7 Observations... 8 Conclusion... 9 Your contacts: Despite being called interbank market, it is instructive to note that participants of the China interbank market comprise financial institutions as well as corporates. While there are certain procedural requirements to be satisfied, corporates can generally have access to the China interbank market and currently make up the larger part of the interbank memberships. China Launches Credit Derivatives Market 1

2 CRM Contracts A CRM Contract is a contract under which the credit protection buyer pays a premium to the seller, and the seller provides credit risk protection in respect of the reference obligation. Although not expressly stated, it would seem that, under the Guidelines, settlement of a CRM Contract (whether by way of cash settlement, physical delivery or auction settlement) has to be by reference to the reference obligation. In terms of what obligations can be designated as the reference obligation, the Guidelines define reference obligations as bonds or other similar debts of the reference entity. To this end, bonds commonly traded in the interbank market, including financial bonds issued by financial institutions as well as corporate bonds and debt financing instruments 2 issued by corporates, would be included. In addition, although not expressly provided, it seems clear that loans would fall within the ambit of other similar debts and would qualify as a reference obligation. On the other hand, it is doubtful if other types of payment obligations such as trade receivables and swap obligations could qualify as reference obligations. Another point to note is that, although structured bonds (such as asset backed bonds in the interbank market) are debt instruments and can technically qualify as reference obligations, it is unlikely that they will be the reference obligations for any CRM Contracts. This would appear to be the case since a CRM Instrument should be a simple and basic risk management product; accordingly an instrument such as asset backed credit default swaps (or ABCDS) will be out of bound for the moment. As mentioned earlier, given the requirement of credit linkage to a reference obligation, CRM Contracts are akin to Ref Ob Only CDS traded on the international markets. However, it would be interesting to see whether any other permutations are acceptable to NAFMII and the interbank markets. For example, would parties be able to do CRM Contracts on reference obligations on a portfolio basis? Would it be acceptable to use other debt obligations (rather than the specified reference obligation) to settle a CRM Contract? Would nth-to-default credit derivative products be allowed? At this stage the answers to these questions would appear to be in the negative because only simple and basic products are allowed under the Guidelines. In terms of clearing, there is no mandatory central clearing requirement for CRM Contracts. This is understandable, given that the credit derivative market in China is in its infancy, and it remains to be seen whether there is any need for central clearing, and whether the terms of CRM Contracts will be standardised, which is a pre-requisite for central clearing. 2 For reasons outside the scope of this bulletin, the official name for some of the bonds issued by corporates at interbank markets is debt financing instrument ( 债务融资工具 ), instead of bonds ( 债券 ). China Launches Credit Derivatives Market 2

3 CRM Certificates To those familiar with credit derivatives, the term credit risk mitigation certificates is likely to connote a product under which the issuer buys protection from certificate holders. However, the term certificate is used differently under the Guidelines instead of buying protection, the issuer is selling protection to holders of CRM Certificates. In other words, a CRM Certificate is akin to a credit linked put warrant - where, upon the occurrence of a credit event, holders of CRM Certificates are entitled to put (or deliver) the reference obligations to the issuer against payment by the issuer of the relevant notional amounts. Credit linked put warrants are rare even in the international markets. So it may come as a surprise that such a product is being introduced to the China market at this very early stage of development. One possible explanation is that Chinese banks are currently not allowed to provide guarantees for corporate debts and therefore CRM Certificates provide an alternative route through which banks can sell credit protection and, subsequent to their issuances, this protection can be transferred to third parties together with the relevant reference obligations. 3 Given the exposure of holders of CRM Certificates to the credit risk of the issuer, the Guidelines contain detailed regulations on such products to ensure that only qualified entities are allowed to issue CRM Certificates. To this end, an issuer of CRM Certificates has to be either a Primary Dealer (see below for further details) or a Dealer that satisfies certain requirements and that is approved by NAFMII. Similar to corporate bonds issued at the interbank market, issuance of CRM Certificates is subject to the approval of an expert panel ( Expert Panel ) to be set up by NAFMII. It is expected that NAFMII will publish rules or guidelines regarding the detailed working procedures of the Panel, such as how members for a panel are to be selected from a pool of experts, where and when an expert is precluded from being selected as a panel member to avoid conflict of interest, how panel members may be protected from potential liabilities and so forth. In terms of the scope of review by the Expert Panel, the Guidelines provide that the Panel will not make any substantive assessment in terms of the investment value or risk of the CRM Certificates under review. The Guidelines do not expressly state the basis on which the Expert Panel will decide whether to accept or reject an application. Presumably the Panel will conduct diligence on whether an applicant has the requisite capacity to issue the Certificate, and whether the documents are in compliance with the requirements imposed by NAFMII. It is also likely that an application may be rejected on the ground that a position limit has been or would be breached if the Certificate in question were allowed to be issued. Upon receipt of the approval from the Expert Panel, the relevant issuer is required to publish the offering documents on NAFMII s website within 10 3 Banks can sell protection through CRM Contracts but given its bilateral nature, CRM Contracts cannot be easily transferred with the underlying bonds. China Launches Credit Derivatives Market 3

4 working days, and the subscription needs to be completed within 5 working days after such publication. Tiered market access qualifications In the Chinese interbank market, market participants are often divided into different categories, each subject to different requirements including conducting transactions for certain specified purposes and/or entering transactions with certain types of counterparties only. The Guidelines adopt a similar approach for the interbank credit derivative market by dividing market participants into three categories, namely Dealers, Primary Dealers and Non- Dealers. 4 Dealers To become a Dealer, the relevant market participant must meet certain requirements, such as having a registered capital or net equity of not less than RMB800 million, having not less than 3 staff members with relevant experience and qualifications, and having the requisite internal capability to conduct valuation and risk assessment. An applicant should file materials to NAFMII s secretariat office to demonstrate that it satisfies the qualification criteria, and upon such filing being made with NAFMII, such applicant will become a Dealer. Primary Dealers Only a Dealer may apply to become a Primary Dealer. To be qualified as a Primary Dealer, a Dealer should have a registered capital or net equity of not less than RMB4 billion, be a market maker on either the interbank bond market or the interbank foreign exchange market, and shall have not less than 2 years track record of conducting financial derivatives business. An applicant shall submit documentary proof and application materials to NAFMII s secretariat office, and then the NAFMII Financial Derivatives Professional Committee (the Professional Committee ) will review the application to decide whether to grant an approval. After granting approval, the Committee will make filing with the People s Bank of China (the PBOC ), whereupon such Dealer will become a Primary Dealer. Non-Dealers A market participant in the interbank credit derivative market, which is neither a Dealer nor a Primary Dealer, falls into the category of Non-Dealers. There is no particular filing or approval requirement applicable to Non-Dealers. Tiered market access A Non-Dealer can only trade CRM Instruments with Primary Dealers, and must do so for hedging purposes only. A Dealer can trade CRM Instruments with other Dealers or Primary Dealers, but not with Non-Dealers. In addition, the Guidelines require a Dealer to trade CRM Instruments for its own needs, which raises an interesting 4 On 4 November 2010, NAFMII published two lists on its website; the first is a list of 17 Dealers which could trade in CRM Instruments, and the other is a list of 14 Dealers who could issue CRM Certificates. China Launches Credit Derivatives Market 4

5 question as to the precise scope of this restriction on a Dealer. Given that there is already a reference to conducting trades for hedging purposes (which is a restriction on Non-Dealers), it would appear that conducting trades for its own needs should be broader than, and not limited to, hedging. Accordingly, it would seem reasonable to construe transactions carried out by a Dealer for hedging purposes, or alternatively for making profit, to be for its own needs, 5 whereas trades on behalf of clients or on an agency basis by a Dealer may not be considered for its own needs. On the other hand, a Primary Dealer can trade CRM Instruments with all market participants and is not subject to any hedging or own needs requirements. It should be noted that the Guidelines only govern CRM Instruments on the interbank market. Accordingly, although Dealers (currently most of which are banks) are not permitted to trade CRM Instruments with Non-Dealers in the interbank market, they (as banks) are generally competent under the current regulatory regime to transact OTC trades or credit linked wealth management products with individuals and corporates outside the interbank market. Risk management One of the most notable features under the Guidelines is the lack of requirement on the buyer of protection to hold the reference obligations. In other words, there is no prohibition on naked CDS, which has caused much controversy internationally during the current global financial crisis. In any event, in terms of Non-Dealers, it is unlikely that they can conduct any naked CDS since such trades would not meet the hedging requirement. In fact, it is questionable whether Non-Dealers can ever sell any credit protection, since it is difficult to see how selling protection can satisfy the hedging requirement. The Guidelines prohibits what is known as self-referencing credit derivatives where the reference obligation under a CRM Instrument is a debt obligation of any of the parties or their affiliates. In addition to any CRM Instruments where the seller of credit protection or its affiliate is the reference entity, this prohibition also prevents a CRM Instrument where the buyer of protection or its affiliate is the reference entity. Further, an issuer will not be able to issue CRM Certificates over its or an affiliate s debt obligations notwithstanding that the CRM Certificates could be secured over security deposit or other collateral. There are also various position limits under the Guidelines: each Dealer s net long (or short) position regarding any one reference obligation must be no more than 100% of its outstanding principal; its net short positions in respect of all the Instruments it has entered into or issued or purchased shall not be more than 500% of its registered capital or net equity; and the total market positions of all CRM Certificates referencing any one reference obligation shall not be more than 500% of its outstanding principal. 6 Such limits are 5 6 We understand that this is also the intention of NAFMII. If an issuer does not have information regarding the outstanding principal amount of an underlying obligation, or the current total size of CRM Certificate, it would not be able to China Launches Credit Derivatives Market 5

6 imposed to prevent a Dealer from being over-exposed to a particular name, and to ensure that the credit derivative market does not grow out of proportion with the underlying bond market. Documentation CRM Contracts NAFMII has published a suite of master derivatives agreements (the latest version being published in 2009) for OTC derivatives trading in the interbank market. As part of the documentation, there is a NAFMII product definition booklet which contains, apart from definitions for other types of derivatives, certain basic credit derivative definitions (totalling around five pages). Understandably, this booklet does not contain a number of key provisions, which have been widely adopted in the international credit markets. For example, there is no concept of Grace Period Extension, Notice Delivery Period or Event Determination Date and there are also no provisions regarding the valuation process or delivery procedures. The establishment of a Determination Committee and adoption of auction settlement as the default settlement method have been two of the most important features in the July 2009 ISDA Supplement to the 2003 ISDA Credit Derivatives Definitions. These have emerged in the international markets during the past 2 years as a way to address certain critical issues with the credit derivative market exposed by the global financial crisis. Interestingly, while the NAFMII product definition booklet does not contain equivalent provisions, the Guidelines contain references to auction settlement (the rules of which are to be published by the Professional Committee). The Guidelines also provide that, if parties have a dispute over the occurrence of a credit event, they may request the Professional Committee to provide an opinion. Whether determination by the Professional Committee will be hardwired into CRM Instruments in the future remains to be seen. To improve liquidity and be eligible for central clearing, CDS traded on the international markets contain certain common features, such as the Credit Event Backstop Date or Succession Event Backstop Date provisions. Premium payment dates and premium rates have also been fixed. Again, there are no equivalent provisions in the product definition booklet or the Guidelines and it is unclear at this stage whether CRM Contracts will become standardised over time in a similar manner. CRM Certificates and NAFMII Master (Certificate version) Simultaneously with publication of the Guidelines, NAFMII also published a new version of the NAFMII Financial Derivatives Master Agreement (Certificate Version) (the Certificate Master ) to resolve a technical issue unique to CRM Certificates. determine whether such position limits have been exceeded. This would be particularly the case where the relevant underlying is a loan. China Launches Credit Derivatives Market 6

7 Structure of Certificate Master Under relevant PBOC rules, all derivative transactions traded on the interbank market are to be governed by the NAFMII Financial Derivatives Master Agreement (2009 version) (the NAFMII Master ), which means that CRM Certificates must also be governed by the NAFMII Master. However, CRM Certificates are tradable and transferrable instruments, which are very different from normal bilateral contracts from a documentation perspective. As a result, the Certificate Master was introduced to bring CRM Certificates within the NAFMII Master documentation structure. The Certificate Master contains two parts: general terms and special terms. The general terms are identical to the NAFMII Master without its supplement (i.e., without the schedule). On the other hand, the special terms contain provisions that reflect features peculiar to CRM Certificates. These general terms and special terms together set out the contractual relationship between the CRM Certificate issuer on one hand and CRM Certificate holders on the other hand. For each CRM Certificate, the Certificate Master (consisting of general terms and special terms) and the effective transaction agreement between the issuer and the holder altogether constitute the entire agreement between the parties with respect to the CRM Certificates. Normally for OTC derivatives under the NAFMII Master, the effective transaction agreement is the confirmation signed by the parties, or the trade slips generated by the interbank trading system (i.e., CFETS). However, under the Guidelines, an issuer of CRM Certificates should supply certificate explanation notes to the NAFMII Expert Panel for its examination and approval (as discussed earlier), which shall include information such as the reference entity, reference obligation, notional amount, credit events, and settlement mechanism. After the Expert Panel gives its consent to accept the issuer s application for the issuance of CRM Certificates, the issuer will publish the CRM Certificate disclosure documents on the NAFMII website. It seems that the certificate explanation notes will be disclosed publicly and their content can be regarded (through the mechanics of the clearing system such as China DTC) as evidencing an effective transaction agreement between the issuer and holders of the CRM Certificates, which in turn form part of the entire agreement with respect to the relevant CRM Certificates. Mode of execution Unlike the bilaterally executed NAFMII Master, the Certificate Master adopts a multi-lateral execution approach. To this end, each market participant will sign a Certificate Master and deposit an executed copy with NAFMII. The effect of this is that as between the issuer and holders of the same series of CRM Certificates, there is one unified contractual relationship i.e., one entire contract (being the Certificate Master (general terms and special terms) and the certificate explanation note as the effective transaction agreement as described above) - firstly, between the issuer on one hand and the holders on the other hand, and secondly, among all holders inter se. This unified China Launches Credit Derivatives Market 7

8 contractual relationship helps to ensure that CRM Certificates are fungible and are freely transferrable on the interbank market. Importantly, in order to achieve uniformity in the determination of credit events and settlement amount and in the exercise of CRM Certificate holders rights, the special terms of the Certificate Master provide that where there are multiple holders in respect of a CRM Certificate, the holders shall collectively make relevant decisions and enforce their rights in relation to the occurrence of events of default and termination events. In contrast, if a CRM Certificate has only one single holder, the holder and the issuer can deal with each other in accordance with the general terms of the Certificate Master (i.e., same as the NAFMII Master). Observations Under the Derivative Rules 7 and other applicable regulations issued by the China Banking Regulatory Commission ( CBRC ), a bank with derivatives approval from CBRC is generally competent to transact derivatives (including credit derivatives) for hedging or for profit. This does not pose any issue to the trading of CRM Instruments contemplated in the Guidelines. However, the CBRC is currently looking at revamping the Derivative Rules. To this end, it has been proposed that credit derivatives should be classified as non-basic derivative products - which could only be transacted by a bank for clients only (and not for hedging or profit). If this were the case, it would appear that banks as Dealers or Primary Dealers in the interbank market will not be able to trade for hedging purposes or profit, which could severely curtail the trading of CRM Instruments contemplated under the Guidelines. The new credit derivative market in the interbank market is expected to create new and exciting business opportunities as to which many open questions could be raised. To name but a few - will OTC credit derivatives and credit linked wealth management products targeted at individuals and corporate investors, who do not have access to the interbank market become more common? Will subsidiaries or branches of foreign banks (which are members of the interbank market) onshore China be able to offer offshore clients access to the China credit derivative market? Recently, in a bid to internationalise the RMB, PBOC allowed foreign banking entities with offshore RMB access to the China interbank bond market. Will these entities be able to provide a link between the offshore RMB denominated credit assets and the onshore CDS market? The interplay between the interbank and the end-user credit derivative markets onshore China, as well as between the onshore and offshore credit derivative markets, will be closely watched from all sides. 7 The Interim Administrative Rules Governing Derivative Activities of Financial Institutions (amended version effective as of 3 July 2007, the "Derivative Rules"). China Launches Credit Derivatives Market 8

9 Conclusion In the last few months, the market witnessed concerted efforts from Chinese regulators to encourage financial innovations and to reform the local credit market, including the establishment of an interbank loan transfer market in Shanghai, granting Chinese listed banks access to the listed bonds market, and the establishment of credit assets exchanges in Tianjin and Beijing. To this end, the launch of credit derivative market in the interbank market is yet another giant step. Given the colossal sizes of the 8 trillion RMB bond market and 40 trillion RMB loan market, it would be extremely interesting to see how quickly, and in what direction, the credit derivative market in China will develop. Your contacts: HONG KONG OFFICE Chin Chong Liew, Partner Andrew Malcolm, Partner chin-chong.liew@linklaters.com andrew.malcolm@linklaters.com Simon Zhang, Managing Associate Toby Gray, Partner simon.zhang@linklaters.com toby.gray@linklaters.com Chris Zhao, Associate I-Ping Soong, Managing Associate chris.zhao@linklaters.com i-ping.soong@linklaters.com BEIJING OFFICE Benjamin Liu, Counsel Cheng Yuan, Counsel benjamin.liu@linklaters.com cheng.yuan@linklaters.com SHANGHAI OFFICE Nicola Mayo, Partner William Liu, Partner nicola.mayo@linklaters.com william.liu@linklaters.com SINGAPORE OFFICE Kevin Wong, Partner Jeanne Ong, Managing Associate kevin.wong@linklaters.com jeanne.ong@linklaters.com China Launches Credit Derivatives Market 9

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