August 2014 Shanghai Clearing House Launches Client Clearing Service On 1 July 2014, China introduced mandatory central clearing for standard Renminbi interest rate swaps ( RMB IRS ) concluded on the interbank market. On the same day, Shanghai Clearing House ( SCH ) launched its client clearing service to enable non-clearing members to clear their RMB IRS trades. This client clearing service is based on an agency model (as opposed to a principal model) and can only be offered by a comprehensive clearing member of SCH (a CM ). Contents Contractual relationship 1 Segregation of margin 2 Client's right to position and margin 3 Looking Ahead 4 In June 2014, SCH also released a suite of documents on client clearing, including, inter alia, the updated RMB IRS central clearing guidelines (the Clearing Guidelines ), a form of the supplemental clearing agreement between a CM and SCH (the Supplemental Agreement ) and a form of the client clearing agreement to be entered into between a client and a CM (the Client Clearing Agreement ). Financial institutions which have not joined SCH as clearing members must now clear all their standard RMB IRS trades through client clearing. We have summarised below the key features of the client clearing service as well as the major issues that a client should bear in mind when negotiating a Client Clearing Agreement with a CM. Is there a contractual relationship between SCH and a client given that no contract is signed between them? There is a contractual relationship between SCH and a client, even though no contract is signed between them. To participate in the client clearing service, a client signs the Client Clearing Agreement with a CM to appoint that CM to be its agent for the purposes of participating in the client clearing service. The CM will submit client contracts to SCH and secure the performance of the clients obligations under such contracts after they have been accepted by SCH for central clearing. Pursuant to the PRC Contract Law, if an agent, within its scope of authority, enters into a contract in its own name with a third party and such third party is aware of the agency relationship between the principal and the agent at the Shanghai Clearing House Launches Client Clearing Service 1
time the contract is made, then the contract will be binding on the principal and such third party. 1 Applying this analysis to SCH s client clearing service, although a CM participates in client clearing in its own name in respect of the client contracts, as it is acting under the authority of its client and SCH is aware of the identity of the client at the time it accepts a client contract for central clearing, a novated client contract will be binding on SCH and the client. To reinforce the agency concept, a client may consider inserting express provisions into the form of the Client Clearing Agreement regarding the appointment of the CM as its agent and spell out the scope of the agent s authority. Is there any segregation for the initial margin posted by a client? A client may be required to post two levels of initial margin: the initial margin required by SCH and the extra initial margin required by the CM (if any). Under the clearing documentation, SCH and a CM are each required to segregate the margin posted by a client. Initial margin required by SCH Although not specifically set out in the clearing rules, our understanding is that client margin is likely to be held by SCH in a bank account maintained in SCH s name with a third party custodian bank. The account will be an omnibus account shared by all the clients of a CM but SCH and the CM will keep detailed records to keep track of the margin posted by each client. This arrangement is consistent with SCH s obligation to segregate client margin from its own property as required by the People s Bank of China in its Circular on Matters Relating to Establishment of A Central Clearing Regime for OTC Financial Derivatives Products and Launch of Renminbi Interest Rate Swap Central Clearing Business (the PBOC Circular ) 2 and the Supplemental Agreement. 3 The client margin so held is also segregated from the margin posted by the CM for its proprietary business. Extra initial margin required by a CM A CM has a right to require its clients to pay extra initial margin to be held by the CM. The Clearing Guidelines expressly require a CM to segregate client margin from its own assets. 4 It is unclear whether all CMs are required to offer the same segregation arrangement but our understanding is that a few CMs are able to offer to their clients either an individually segregated margin account or an omnibus margin account shared with the other clients of that CM. An individually segregated client margin account maintained with a third party bank clearly affords better protection to the client as it shields the client margin from the so-called fellow customer risk. 1 2 3 4 Article 402, PRC Contract Law Paragraph 5, PBOC Circular Clause 3(2), Supplemental Agreement Guideline 3.2, Clearing Guidelines Shanghai Clearing House Launches Client Clearing Service 2
As the form of the Client Clearing Agreement provided by SCH is silent as to how a CM will hold the extra initial margin posted by its clients, it is crucial that it be amended to expressly set out the agreed segregation arrangement. Can a client get back its initial margin and positions if SCH or CM becomes insolvent? The PBOC Circular provides that the margin posted by a clearing participant (i.e. including clearing members and clients) to SCH belongs to the provider. 5 The Clearing Guidelines also stipulate that the margin paid by a non-clearing member is owned by the non-clearing member. 6 Thus, a client has a proprietary right to the margin it posts with SCH and has a right to get back its initial margin from SCH if SCH becomes insolvent. At the level of the CM, the form of the Client Clearing Agreement requires a CM to return the client assets to the client if a CM is declared to be in default by SCH and if porting is unsuccessful. More importantly, article 404 of the PRC Contract Law provides that an agent should return to its principal any assets it has acquired in relation to the matter the agent is authorised to handle. Therefore, if the CM becomes insolvent, the client margin it holds does not form part of its bankruptcy estate and a client should have a right to be refunded such margin. It is worth noting that article 404 refers generally to assets, so this principle is sufficiently broad to cover client margin as well as client positions. Given that the CM handles funds settlement and margin payments vis-a-vis SCH on behalf of the client, this legal principle is of crucial importance to a client. As such, a client is recommended to insert appropriate wordings in the form of the Client Clearing Agreement to underscore its proprietary right to its positions and initial margin. Will a client be able to port its positions and initial margin? Both pre-default porting and post-default porting are permitted under the client clearing service. In addition to the porting of client positions, the Clearing Guidelines also permit the porting of client initial margin. This is possible because, as mentioned above, a client has a proprietary right to the initial margin it posts with SCH and the CM. In the case of pre-default porting, a client is required to settle all outstanding debts and liabilities with the original CM before porting can be effected. 7 For post-default porting, a client is required to find a new CM and submit relevant documents to SCH within five working days after SCH has initiated the forced liquidation process. 8 The clearing documents published by SCH do not provide the detailed porting mechanics and it remains to be seen whether SCH will release further details on the porting procedures. From a client s perspective, it may be preferable to 5 6 7 8 Paragraph 5, PBOC Circular Guideline 3.2, Clearing Guidelines Guideline 8, Clearing Guidelines Guideline 8, Clearing Guidelines Shanghai Clearing House Launches Client Clearing Service 3
set out the relevant details in the form of the Client Clearing Agreement, in particular, in relation to the porting of the extra initial margin held by the CM. Looking Ahead The launch of the client clearing service marks the beginning of a new era in client clearing of OTC derivatives in China. As outlined above, the clearing documents published by SCH and an appropriately negotiated Client Clearing Agreement will afford good protection of clients assets. Looking ahead, it is worth mentioning that China is in the course of revising the PRC Securities Law and legislating on a Futures Law. This is a good opportunity for China s legislators to review the current legal framework for central clearing and address the relevant legal issues in the legislation to better support the central clearing of OTC derivatives. * Linklaters is proud to have worked with a group of 22 banks and Shanghai Clearing House in preparation for the launch of central clearing of RMB interest rate swaps, and have made presentations on behalf of the industry at meetings with PBOC and other Chinese regulators in this process. Our close involvement in OTC derivatives clearing in the region means we are uniquely positioned to assist market participants to navigate this new world of derivatives clearing. Shanghai Clearing House Launches Client Clearing Service 4
Contacts For further information please contact: Hong Kong Chin Chong Liew Partner (852) 2842 4857 chin-chong.liew@linklaters.com Karen Lam Counsel (852) 2842 4871 karen.lam@linklaters.com Simon Zhang Managing Associate (852) 2842 4844 (86) 10 6535 0688 simon.zhang@linklaters.com Derek Chua Managing Associate (852) 2842 4805 derek.chua@linklaters.com Wayne Huang Associate (852) 2901 5432 wayne.huang@linklaters.com Ying Zhou Associate (852) 2842 4153 ying.zhou@linklaters.com Jodie Cheng PRC Advisor (852) 2901 5221 jodie.cheng@linklaters.com 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, or contact the editors. Linklaters LLP. All Rights reserved 2014 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC326345. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters 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 together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ or on www.linklaters.com and such persons are either solicitors, registered foreign lawyers or European lawyers. Please refer to www.linklaters.com/regulation for important information on our regulatory position. 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 emailing us at marketing.database@linklaters.com. 10th Floor, Alexandra House Chater Road Hong Kong Telephone (+852) 2842 4888 Facsimile (+852) 2810 8133