目录
I. What is Swap Connect and the Permissible Investment Scope?
II. Which investors are eligible for Northbound Swap Connect?
III. Master Agreements Usable by Domestic and Overseas Investors
IV. Clearing Arrangements for Northbound Swap Connec
V. Trade Repository
VI. Foreign Exchange Administration
VII. Outlook
Following the implementation of Stock Connect, Bond Connect and Wealth Management Connect, the People's Bank of China (PBOC), the Hong Kong Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA) issued a joint announcement ("Joint Announcement") on July 4, 2022 and agreed that the relevant infrastructure institutions shall collaborate with each other to allow mutual access between Hong Kong and the Mainland interest rate swap markets ("Swap Connect"). This indicates that the interconnection between both financial markets will expand further from stocks, bonds, funds and wealth management products to that of financial derivatives. Detailed rules regarding Swap Connect have been keenly anticipated by the market. On February 17, 2023, the PBOC issued a circular to solicit public comments on the Interim Administrative Measures for the Mutual Access between the Mainland and Hong Kong Interest Rate Swap Markets (Draft for Comments) ("Draft Measures").
The Draft Measures comprise of 23 articles and provide rules on the investment scope, eligibility requirements for domestic and overseas investors, mechanisms for relevant infrastructure institutions in respect to trading and clearing, the duties and powers of the responsible parties, foreign exchange administration, regulatory rules and administrative penalties. In this briefing, we provide our interpretation of the Draft Measures and our outlook on Swap Connect.
I. What is Swap Connect and the Permissible Investment Scope?
According to the Draft Measures, Swap Connect refers to an arrangement which will enable both domestic and overseas investors to participate in the financial derivatives markets in Hong Kong and interbank financial derivatives markets in China’s mainland through a connection between the infrastructure institutions in both locations. Notably, the Draft Measures only apply to Northbound Swap Connect, which, consistent with the Joint Announcement, allows investors from Hong Kong and other countries and regions to participate in the mainland interbank financial derivatives market through mutual access between Hong Kong and mainland infrastructure institutions in respect to trading, clearing and settlement. The southbound trading rules will be separately formulated in due course.
The Draft Measures specify that interest rate swaps will be eligible initially under Northbound Swap Connect. The currency used for the price quotation, trading and settlement is renminbi and Northbound Swap Connect will be subject to quota restrictions which may be adjusted in due course, depending on market conditions.
II. Which investors are eligible for Northbound Swap Connect?
The Draft Measures set out the eligibility requirements for investors. Foreign institutional investors who satisfy the requirements of the PBOC and have completed filing with the PBOC for access to the interbank bond market are eligible to participate in the Mainland interbank financial derivatives market through Northbound Swap Connect. Currently, foreign investors eligible to file with the PBOC for access to the interbank bond market include: (1) qualified foreign institutional investors (i.e., QFII and RQFII); and (2) foreign investors that satisfy the requirements provided by the Circular on Matters Concerning Further Facilitating Foreign Institutional Investors to Invest in China’s Bond Market, who are currently able to access the interbank bond market through (a) direct investment in the interbank bond market ("CIBM Direct") and/or (b) Bond Connect. We note that domestic investors are required to file with the relevant authorities, including the National Association of Financial Market Institutional Investors (NAFMII), the China Foreign Exchange Trading Centre (CFETS) and the Shanghai Clearing House, prior to trading interest rate swaps through the CFETS system. Further clarification by the regulators is needed as to whether foreign investors who have already completed filing with the PBOC for access to the interbank bond market are also required to complete the relevant filing procedures, or whether they need to meet other requirements of the PBOC.
According to the Draft Measures, domestic investors who participate in Northbound Swap Connect shall be financial institutions that have a strong capacity for pricing, quotation and risk management, have a good international reputation, and have business systems and professionals supporting Northbound Swap Connect. Prior to participating in Northbound Swap Connect, domestic investors shall sign an agreement with a PBOC-recognized domestic electronic trading platform (i.e., CFETS).
III. Master Agreements Usable by Domestic and Overseas Investors
The Draft Measures require domestic and overseas investors to enter into a master agreement or other agreement recognized by the PBOC with their Northbound Swap Connect counterparties. According to the Circular of the People's Bank of China on Matters Concerning the Provision of Renminbi Interest Rate Swap Business, market participants trading interest rate swaps shall sign the Master Agreement on Financial Derivatives Transactions in the Chinese Interbank Market, which was formulated and issued by NAFMII with the authorization of the PBOC. We noted that NAFMII has issued the Master Agreement on Financial Derivatives Transactions in the Chinese Interbank Market (Cross-border – 2022 Version) in 2022, as a preparatory work for overseas investors to enter the OTC derivatives market in China through Northbound Swap Connect.
We understand that overseas investors may be accustomed to the master agreement issued by the International Swaps and Derivatives Association (ISDA) for derivatives transactions. A key concern of overseas investors is whether they are eligible for Northbound Swap Connect according to the ISDA Master Agreement executed with their counterparties. We have observed a precedent of overseas institutional investors executing the ISDA Master Agreement and completing the filing and implementation work with the Shanghai Clearing House for the centralized clearing of interest rate swap transactions.1 Since one of the intentions for the Swap Connect mechanism is to provide facilities to domestic and overseas investors to trade in RMB interest rate swaps without having to change their practices, we expect regulators will allow flexibility in using the ISDA Master Agreement, and avoid the time-consuming process of negotiating and executing an additional NAFMII Master Agreement.
IV. Clearing Arrangements for Northbound Swap Connect
According to the Draft Measures, overseas investors may send trading instructions to the CFETS system through the connection between the overseas electronic trading platforms that are recognized by the PBOC and the CFETS system. A transaction will be concluded through the CFETS system and shall be deemed confirmed upon the conclusion of the transaction.
The clearing organization (as a central counterparty) that is recognized by the PBOC (i.e., Shanghai Clearing House) and the clearing house that is recognized by the SFC (i.e., OTC Clearing Hong Kong Limited) will connect to provide the centralized clearing services. After the completion of the transaction, CFETS shall send the results of the transaction subject to centralized clearing to the domestic and overseas clearing institutions for clearing and settlement in a timely manner. The Shanghai Clearing House and OTC Clearing Hong Kong Limited will provide the clearing and settlement services to domestic and overseas investors respectively. We understand that OTC Clearing Hong Kong Limited, as the central counterparty, will become the only counterparty for overseas investors holding open positions after the clearing is completed and will bear the potential default risks of the counterparty (if any).
The domestic and overseas clearing institutions interconnected with each other shall jointly manage their netting risks, including preparing special risk reserve resources to cover any potential losses arising from the default of the domestic or overseas clearing institution, and establishing default handling measures to control risk spillover. If one of the clearing institution defaults, the other shall use risk reserve resources to handle such default in accordance with its business rules and the clearing agreement between them. The non-defaulting clearing institution may recover from the defaulting clearing institution its own risk reserve resources or those contributed by the clearing participants that have been used to handle the default.
V. Trade Repository
The Draft Measures provide for a "Trade Repository" and stipulate that domestic and overseas investors and relevant infrastructure institutions shall report the relevant data of Northbound Swap Connect to the Trade Repository that is recognized by the PBOC, and shall keep all relevant transaction data and information exchange records. Where domestic and overseas investors trade through an onshore electronic trading platform, the onshore electronic trading platform may report to the Trade Repository on behalf of the investors; if the onshore electronic trading platform is the Trade Repository that is recognized by the PBOC, there is no need to report separately. On such basis, we understand that the CFETS will undertake the trade reporting duties. To date, China has not established a legal or regulatory framework for a Trade Repository, nor has China designated or established an institution as the Trade Repository. CFETS has been clearly deemed as a TR-like Entity in the Ninth Progress Reports on Implementation of Reforms to the OTC Derivatives Market published by the Financial Stability Board (SFB). We expect that the regulatory authority will formulate the relevant rules on this new type of infrastructure in accordance with the Futures and Derivatives Law of the People’s Republic of China.
VI. Foreign Exchange Administration
The Draft Measures stipulate that overseas investors may use their own RMB or foreign exchange to participate in Northbound Swap Connect and relevant clearing and settlement activities. Overseas investors using foreign exchanges may open an RMB account at a Hong Kong-based clearing bank2 for the exchange and settlement of funds and shall in principle exchange the funds for foreign currency at the Hong Kong-based clearing bank upon the expiration of the transactions or the cessation of their participation in Northbound Swap Connect. The exchange of funds shall be subject to the administration of the RMB purchase and sale business.
VII. Outlook
With the further opening-up of China's bond market, offshore institutions trading in China's interbank bond market have an increased need of hedging RMB interest rate risk. The launch of Northbound Swap Connect is in line with market demand. Furthermore, the release of the Draft Measures marks a significant step in the implementation of Northbound Swap Connect. Northbound Swap Connect will facilitate overseas investors to conduct hedging and effective interest rate risk management following the prevailing international practice, which is of great significance to the opening-up of China's bond and derivatives markets. We expect that the regulatory authorities, and domestic and overseas financial infrastructure institutions will further formulate and promulgate detailed rules with respect to the trading, clearing and settlement mechanisms under Northbound Swap Connect. We will continue to monitor the situation and keep our clients apprised of the latest developments.
1.https://www.shclearing.com.cn/gywm/xwdt/202012/t20201211_786970.html
- This refers to Hong Kong-based RMB clearing banks and Hong Kong-based RMB business participating banks that are approved to enter the interbank foreign exchange market.