The participation of foreign investors in the China Interbank Bond Market (CIBM) has steadily increased in recent years due to the implementation of various opening regimes allowing access to CIBM, such as CIBM regimes Direct, Bond Connect and QFI. , and the inclusion of Chinese bonds in major international indices. At the end of 2021, foreign investors held RMB bonds worth RMB 4 trillion, or about 3.5% of the total CIBM market size.
On July 4, 2022, the People’s Bank of China (PBoC), the Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA) issued a joint announcement1 (there “Joint announcement”) on the Swap Connect (the “Exchange Connect”), which aims to meet the growing demands of foreign investors to manage the interest rate risk arising from their bond holdings at the CIBM. The Swap Connect will promote the development of mutual access between the Hong Kong and Mainland Interest Rate Swap (IRS) markets and facilitate the trading of IRS, among other derivative products, in the two markets through collaborative efforts between the China Foreign Exchange Trade System (National Interbank Funding Center) (CFETS), Shanghai Clearing House (SHCH) and OTC Clearing Hong Kong Limited (OTC Clearing, together the “Infrastructure establishments”). The PBoC has additionally published a Q&A2 to clarify certain issues related to Swap Connect.
Key points to remember
- Launch time. The Swap Connect is expected to be officially launched in about six months, after the relevant rules are finalized, system development is completed and other necessary preparations are made, according to the joint announcement.
- Trading and Clearing Links. Similar to the Bond Connect scheme, the Swap Connect will include two links: (a) Northbound Trading, which allows foreign investors to participate in the mainland’s interbank financial derivatives market through mutual access between Hong Kong’s infrastructure institutions and the continent with respect to trade, clearing and settlement; and (b) Southbound Trading, which provides mainland investors with access to the Hong Kong financial derivatives market through mutual access between infrastructure institutions in both locations.
At the initial stage, Northbound Trading will start first while the implementation of Southbound Trading will be explored in due course.
- Northward Trade and Settlement Pattern. According to the PBoC Q&A, in general, the Swap Connect will leverage the Bond Connect framework and experience. Specifically:
- Foreign investors can follow their existing trading practices under Bond Connect Northbound Trading to transact on CFETS through its connections to international electronic trading platforms to trade eligible derivatives (i.e. RMB IRS ) as part of Swap Connect.
- Swap Connect Northbound Trading will adopt the trading model of listing institutions, which is similar to Bond Connect Northbound Trading, i.e. foreign investors can obtain quotes from various onshore dealers in the PRC by sending requests for quotations (RFQ) and confirming transactions after receipt. response from dealers. Completed IRS RMB transactions will be transmitted in real time to OTC Clearing and SHCH as Qualified Central Counterparties (QCCP) for central clearing and settlement.
- OTC Clearing and SHCH, as clearing infrastructure institutions in both markets, will jointly provide centralized clearing services with respect to IRS RMB for foreign investors.
Although the detailed settlement rules have not yet been published by the relevant clearing infrastructure institutions, we anticipate that OTC Clearing may become a clearing member of SHCH and be responsible for clearing and settlement with all foreign investors. and could in turn settle with SHCH. SHCH may be responsible for central clearing with relevant PRC onshore brokers. and
- The Swap Connect may be subject to a trading quota by reference to that of the Stock Connect.
- Eligible instrument. Initially, IRS RMB will be the only instrument eligible for Northbound Trading under Swap Connect, while other derivatives, such as bond futures and credit default swaps, may be included over time. desired depending on market conditions.
- Coverage requirement. On May 27, 2022, the PBoC, together with other financial regulators, issued the Announcement on Issues Regarding Facilitation of Investments in the Chinese Bond Market by Foreign Institutional Investors, which provides that foreign investors are allowed to trade relevant derivatives for risk management purposes in the Chinese bond market. Effective today, foreign investors can trade IRS RMB for hedging purposes under the CIBM Direct and QFI schemes. Therefore, investments in IRS RMB under the Swap Connect by foreign investors must also comply with this coverage requirement.
- Transaction documents. Although this remains to be confirmed by the final implementation rules of the Swap Connect, given that foreign investors can already choose the ISDA or NAFMII master agreements to document their RMB IRS transactions under the CIBM Direct and QFI regimes, we think the same documentation would apply to Swap Connect Northbound Trading.
- Collateral. SHCH currently accepts cash and eligible bonds that are held with SHCH to meet margin requirements (i.e. bank bonds, financial bonds, non-financial corporate debt financing instruments, such as commercial paper and negotiable certificates of deposit). Treasury bills and local government bonds are not accepted as collateral by SHCH as they are deposited with China Central Depository & Clearing Co., Ltd. (CCDC). However, it remains unclear which assets OTC Clearing will accept as collateral, which awaits further clarification in the implementing rules.
- Applicable laws. The Swap Connect is subject to the applicable laws and regulations of both markets. The Swap Connect Northbound Trading will follow the existing policy framework for opening up the continent’s interbank financial derivatives market and take into account international practices.
- Cooperation of regulators. Regulators of financial derivatives markets in Hong Kong and on the mainland will cooperate with each other to deal with any misconduct on both sides in a timely manner to maintain stability, fairness and orderly trading in financial markets.
The Swap Connect Northbound Trading will be warmly welcomed by the overseas investor community to meet their growing demands for interest risk management. However, several issues are still waiting to be clarified by relevant regulators or infrastructure institutions. These include, among others:
I. Compliance with foreign regulatory requirements
Since the intention of Swap Connect Northbound Trading is to provide foreign investors with access to the PRC derivatives market, infrastructure institutions will need to consider foreign regulatory requirements in order to be able to provide services to foreign investors.
For example, US Commodity Futures Trading Commission (CFTC) Letter 20-463 extends the relief to SHCH until (i) July 31, 2022 or (ii) when the CFTC exempts SHCH from registration as a derivatives clearing organization under Section 5b(h) of the Commodity Exchanges Act and expands the scope of the product under the previous relief of “swaps subject to mandatory clearing in China” (only certain IRS RMB products are subject to the mandatory clearing requirement under the laws of PRC)4 be the clearing of “swaps accepted for clearing by SHCH”. Accordingly, SHCH may rely on this exemption to clear swaps for proprietary trades of SHCH Clearing Members that are US Persons or affiliates of US Persons.
However, the impending expiration of the CFTC relief and the uncertainty of its extension may prevent US investors from trading IRS RMB under the Swap Connect.
There are also similar issues for SHCH and other infrastructure institutions to provide relevant services under Swap Connect to foreign investors in other different jurisdictions.
II. Trading “standard” IRS RMB accepted by SHCH for central clearing under Swap Connect Northbound Trading
Consistent with the joint announcement and relevant Q&A, it appears that all IRS trades will need to be subject to central clearing and settlement, but bilateral settlement will not be available under Swap Connect.
The benefit of mandatory central settlement is that foreign investors will be exposed to less risk and need less capital for IRS transactions, as SHCH and OTC Clearing are QCCPs under local laws.
However, SHCH’s existing central settlement rules may limit the range of products available under Swap Connect Northbound Trading, as in the current onshore market, not all products may be accepted by SHCH for central clearing. To provide convenient color, SHCH now performs element compliance check against its own standards5 on the transaction elements of the RMB IRS transactions, the data of which is received from CFETS in real time, and decides whether or not to accept this RMB IRS transaction for novation, central clearing and settlement. SHCH will reject the IRS RMB transaction that does not pass the item compliance check.
Given that bilateral settlement is not available under Swap Connect, it appears that the IRS products available to foreign investors may be the “standard” IRS acceptable to SHCH for central clearing, subject to staking rules. specific implementations that will be issued by SHCH for Swap Connect. .
III. Collateral accepted to meet margin requirements
As noted above, it remains unclear which assets OTC Clearing will accept as collateral. Considering that most bonds held by foreign investors in China are treasury bills and political bank bonds6if these bonds cannot be used as collateral to meet margin requirements for IRS trading under Swap Connect, foreign investors will need to use alternative assets (e.g., cash) acceptable to OTC Clearing to meet margin requirements, which may affect the costs of foreign investors.
Following the joint announcement, regulators and infrastructure institutions will continue to work together to formulate detailed implementation rules for the Swap Connect. We will keep a close eye on hardware developments and update you in due course.