Two years ago, China published its first derivative regulations. While the rules did not require any particular form of agreement to be used for derivative transactions, regulators have encouraged market participants to use internationally recognized documentation. International Swaps and Derivatives Association Master Agreements and other industry standard documentation have since been frequently used for cross-border derivative transactions.
A year later, however, the renminbi was unpegged from the U.S. dollar, paving the way for a largely onshore-based RMB derivatives market. Given the highly regulated nature of the RMB market, rather than rely on industry standard documentation, the regulators decided to publish a bespoke master agreement which is now mandatory for parties entering into RMB forwards and swaps on the interbank market.
Renminbi Instruments
Renminbi forward transactions have been permitted in China since October 2005 and RMB swap transactions since April 2006. They can be traded on the National Interbank Market between financial institutions or outside the interbank market between financial institutions and their customers. For trading on the interbank market, its eligible members need to sign up to a standard master agreement approved by the State Administration of Foreign Exchange and published by the China Foreign Exchange Trade System which also functions as the National Interbank Funding Centre. Until recently, the only approved master agreement was the Master Agreement for forward transactions that was published by CFETS Oct. 18, 2005. While the Master Agreement for RMB forward transactions came out together with the trading rules mandating the use of such Master Agreement, the Master Agreement for RMB swap transactions was not published together with the relevant trading rules. Almost three months later, July 24, CFETS published a RMB Forward and Swap Master Agreement to cover both the RMB forwards essentially replacing the previous master agreement and the RMB swaps on the Interbank Market.
The three-month wait turned out to be more than worthwhile. The Master Agreement published for the RMB forward transactions in October was not a master agreement in its true sense. It was more like a common terms agreement that was incorporated separately into each trade confirmation. There was no concept of single agreement or close-out netting. Market participants, primarily onshore foreign financial institutions, requested the Master Agreement for RMB swap transactions be more in line with the international market standards. Together with some major domestic banks, participants also proposed that RMB forwards and swaps should be covered under the same agreement. The regulator in charge, SAFE, after listening to the views from the industry, commissioned two consultation drafts. A consultation meeting was hosted by SAFE May 21 and more than 20 major banks in China, as well as foreign banks, attended. After an open debate among the attending institutions, the draft reflecting the international market standard--rather than the one largely based on the structure of the previous RMB Forward Master Agreement--was chosen.
Primary features
1. General
The RMB Master Agreement is a bilateral agreement incorporating many key features of industry standard documentation including provisions relating to termination rights and close-out netting. The architecture includes General Terms, Specific Terms and Confirmations. The parties may use the Specific Terms to make elections and supplement the General Terms. Confirmations will be generated by CFETS and contain terms specific to a particular trade.
2. Scope Of Transactions
All RMB forward and swap transactions are now covered under the RMB Master Agreement. RMB forward transactions entered prior to the Master Agreement will be automatically swept under the agreement unless the parties agree otherwise. The Master Agreement also expressly allows the inclusion of other types of transactions to the extent permitted by law. At this time, no other master agreements are approved for trading RMB forwards and swaps through CFETS.
3. Close-Out Netting
Despite the uncertainty of its enforceability under the PRC insolvency regime and much debate over its inclusion, close-out netting mechanics including termination, valuation and netting provisions remain in the published RMB Master Agreement. It is hoped that, together with the reform of the bankruptcy law, the inclusion of close-out netting in the RMB Master Agreement will lead to greater focus on the issue by regulators and participants in China
4. Hierarchy Of Terms
The RMB Master Agreement makes it clear that, with the exception of a couple of specified mandatory provisions, the Specific Terms prevail over the General Terms and the Confirmation prevails over both in respect to a particular trade. The mandatory provisions, which may not be contracted out by the parties, include primarily those on the scope of the Transactions covered under the RMB Master Agreement, the governing law and jurisdiction and the filing requirements.
5. Governing Law And Jurisdiction
PRC law is the governing law and the parties are not allowed to choose any other governing law. The agreement does state that market practice may be referred to where PRC law has not made any provision, but it is somewhat unclear what the actual effect of this proviso will be on the interpretation of the contract in a legal proceeding. The parties may choose to use PRC courts or arbitration in China (excluding HK, Macau and Taiwan) to settle any dispute arising from the RMB Master Agreement. In the absence of any express election by the parties through Specific Terms, the default forum will be the China International Economic and Trading Arbitration Commission in Beijing with a panel of three arbitrators and the proceedings will be conducted in Chinese.
The issue of governing law and jurisdiction was among the most hotly debated topics during the drafting of the RMB Master Agreement. While the onshore foreign banks largely prefer English law for greater certainty of interpretation and to reduce documentation basis risk, many domestic banks prefer PRC law with which they are more familiar. The regulators also prefer PRC law citing the highly regulated nature of the RMB market as the main reason for its mandatory application.
6. Other Notable Features
There is no set-off clause for offsetting debts under the RMB Master Agreement with those under other agreements. There are also no tax related provisions such as a gross-up obligation or tax related representations. It does, however, contain provisions on posting collateral.
The First--And The Last?
There has been talk about other Chinese regulators such as the People's Bank of China and the China Banking Regulatory Commission contemplating other master agreements possibly for RMB interest-rate swaps and other derivative transactions. Master agreements are extremely important for documenting derivative transactions, but they are of limited use if there are separate master agreements for different types of transactions. If there are too many master agreements, the credit and documentation efficiency of a single agreement is likely to be diluted. To the extent that the Chinese regulators create new master agreements, one would hope this first onshore master agreement will be used as a blueprint. Better still, one would hope the Chinese regulators might be able to reach a consensus that this first onshore master agreement should be the only onshore master agreement and that its scope be expanded to cover all types of onshore derivative transactions.
This week's Learning Curve was written by Thomas Jones, partner, and Jane Jiang, senior associate at Allen & Overyin Hong Kong.
