Written by Stanley Zhou, Su Meng and Jia Zhihang (China); and Minny Siu and Timothy Lo (Hong Kong)
On 26 March 2018, the Shanghai International Energy Exchange (“INE”) officially launched the listing and trading of the first RMB-denominated crude oil futures on a domestic futures exchange in China. Following the opening up of international access to other onshore RMB-traded assets (such as Stock Connect and Bond Connect), the launch of INE represents a further landmark expansion of the international access channels to RMB-traded assets, and another key milestone in the path to full RMB internationalization.
1. What is the INE?
The INE is described as an “internationalised platform, with net price trading, bonded delivery, and Renminbi denomination”. It adopts net price trading to achieve price-matching with international markets. By allowing bonded delivery of crude oil futures and taking advantage of ancillary taxation and foreign exchange policies, international crude oil futures traders have direct access to trade and participate in China’s domestic crude oil futures market.
2. Opening up of the PRC futures market to international investors
Overseas investors may trade in RMB-denominated futures on the INE through the following:
- trading directly on the INE as an overseas special broker participant (“Overseas Broker”) or an overseas special non-broker participant (each, being an “Overseas Participant”);
- trading through an Overseas Broker as its broker; or
- trading through a broker outside of China, which in turn places the trade orders through (i) an onshore futures company which is an INE member (“Onshore Futures Company”) or (ii) an Overseas Broker.
An Overseas Participant trading directly on the INE is required to settle its trades with an Onshore Futures Company.
The key channels offered by the INE to conduct futures trades:
To be admitted as an Overseas Participant, an overseas investor must satisfy the following conditions:
3. Netting mechanism with the INE as central counterparty
The regulatory framework for futures trading in China is set out in the “Regulation on the Administration of Futures Trading” issued by the State Council and the “Provisional Measures on the Administration of Engagement in Trading of Domestic Specified Futures Products by Foreign Traders and Foreign Brokers”, issued by the China Securities Regulatory Commission (“CSRC”) in June 2015 (“Provisional Measures”). The Provisional Measures state the role of the INE as a central counterparty for futures trades conducted on the INE. This is the first time that a PRC authority has expressly recognized, in a PRC regulation, the central counterparty (“CCP”) function of an onshore futures exchange. The Provisional Measures further define a central counterparty as “a legal entity that provides central protection for contractual performance of futures trading, by stepping in between the two parties to a futures trade upon completion, becoming the seller to the buyer and the buyer to the seller and settling by the net amount”. This effectively sets the regulatory foundation for settlement of trades under a netting mechanism with a central counterparty. The trading rules of the INE also clearly reinstate the INE’s central counterparty status and its role as the arranger of central settlements of trades transacted on the INE.
The diagram below provides a high-level illustration of the contractual relationship under the central counterparty model:
The trading and settlement infrastructure and framework of the INE are substantially modelled on the core characteristics of a central counterparty system, adopting the critical legal concepts of novation, netting and contractual performance guarantee.
4. Capital flow and currency conversion issues
Prior to trading on the INE, an Overseas Participant (or overseas intermediary) is required to open and put in place various account and settlement arrangements with the following features and requirements:
- the overseas investor must open a futures settlement account (“Settlement Account”) (which may comprise an offshore Renminbi sub-account and a foreign currency sub-account) with an onshore custodian bank qualified to conduct futures margin depository business (“Custodian Bank”); and
- the relevant Settlement Account will be opened as a non-resident account (“NRA”), which allows free remittances with an offshore account. In other words, funds at such Settlement Account may be remitted offshore at the overseas investor’s choice and will not be “locked up” onshore.
All funds kept at the Settlement Accounts onshore in China can only be used for the sole purpose of settlement for futures trading conducted on the INE under a closed system as summarized below:
An overseas investor may also convert foreign exchange into Renminbi (or vice versa) at its Custodian Bank for the purpose of its INE futures trading. The current Chinese rules and regulations are silent on the currency price source for such currency conversion. We anticipate any currency conversion for INE trade settlement purposes will be conducted at the onshore Renminbi exchange rate quoted by its Custodian Bank.
5. Bonded delivery
The infrastructure of the INE supports bonded delivery. By locating the INE’s designated delivery warehouses in the bonded zones, commodities under bonded supervision are able to undergo physical settlement by using standard bonded warehouse receipts at the INE without going through customs or other tax related procedures. Since the commodity is kept at the bonded area during settlement, tax is not required, and the settlement price reflects the net price excluding any tariffs and value-added tax. This bridges the transaction prices of domestic and international futures trading markets – only when the warehouse receipt holder collects the commodity and transfers it to the overseas or to a domestic non-bonded area would tariff or value-added tax issues arise.
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6. Risk Management, Monitoring and Regulatory Oversight
A CCP exchange serves as a circuit breaker or firewall in relation to counterparty default risks. However, since a CCP essentially centralises all default risks via novation and contractual performance guarantee, its creditworthiness and risk management capabilities are critical for market participants. The Exchange Rules set out the INE’s risk management systems and procedures, including a mark-to-market system, reserve-for-risks system, position-and-price-limit system, and mandatory reduction/closing of positions systems.
The INE, as a Chinese futures exchange and CCP settlement institution, bears the responsibility of monitoring and managing international crude oil futures transactions.
Overseas traders and overseas brokerage institutions engaging in futures trading within the PRC will be subject to the regulatory oversight of the CSRC under the Provisional Measures. The CSRC is also empowered to inspect customer information, as well as make enquiries over the source and usage of capital of overseas traders account and their ultimate beneficiaries relating to trades conducted through those overseas traders and brokerage institutions. The CSRC may adopt such regulatory measures with the cooperation of the relevant overseas regulator who has signed a memorandum of understanding on cross-border regulatory cooperation with CSRC.
The Administrative Regulations on Futures Trading imposes liability on participants who are found to have engaged in the following activities:
- illegal commissioning;
- non-compliance with the futures margin depository safety monitoring requirements;
- trading without sufficient futures margin;
- non-compliance with transaction settlement software requirements;
- conducting code mixing transactions; and
- such behaviors which may affect the stability of the Chinese futures market and prejudice the legal interest of other traders.
7. Key third-party service providers
The table below shows the key service providers involved in INE trading related services including designated delivery warehouses, designated inspection institutions, and information service providers and their respective key responsibilities and regulations.
|Third-party service providers
|Designated delivery warehouses
- These include warehouses and factory warehouses, which will issue standard warehouse receipts and standard factory warehouse receipts respectively. Factory space is designed for use by commodity production enterprises
- Warehouse receipts are classified into standard and non-standard warehouse receipts; standard warehouse receipts and standard factory warehouse receipts; tax-paying warehouse receipts and bonded warehouse receipts. These standard warehouse receipts are issued and managed through standard warehouse receipt management systems
- To apply for bonded delivery business, the warehouse must obtain relevant qualification for bonded warehouse operations
- Risk margin shall be paid in accordance with the requirements under the designated delivery warehouse agreement, and economic compensations shall be paid in priority using the risk margin
- During the period from the inspection and acceptance of the futures commodities for entering the warehouse to the time of commodity delivery, the designated delivery warehouse shall be fully liable for the quality and safety of the stored commodities
- Storage costs and standards shall be approved and published by the INE
|Designated inspection institutions
- These institutions are primarily responsible for carrying out quality and quantity inspections, and generating quality and quantity inspection reports as appropriate
- Mandatory storage inspections will be carried out, when goods leave the warehouses. However, if no inspection institution has been engaged for performing such inspections, the delivery of goods will be deemed to be correctly carried out by the designated delivery warehouse
- The inspection fee incurred when entering the warehouse shall be borne by the seller, while the inspection fee incurred at delivery shall be borne by the buyer
|Information service providers
The current information service providers include Thomson Reuters and Bloomberg. A list of information service providers approved by the INE can be found on http://www.ine.cn/statements/quotelist/.
- Real-time quotes will be announced to the public by the INE
- Information service includes information dissemination service and information value-added service
- Permission or authorization shall be obtained from the INE and an information licensing agreement shall be entered into with the INE
- Standard fees as prescribed by the INE are payable
8. Know your client and anti-money laundering
Participants in INE trading are expressly required under the Exchange Rules to comply with the extensive requirements on anti-money laundering and anti-terrorist financing as prescribed in the Anti-Money Laundering Law of the PRC and related requirements of the People’s Bank of China. The INE has adopted a hierarchical monitoring and centralised inspection system for its “Know Your Client” (KYC) and anti-money laundering obligations against its crude oil futures participants.
The INE will undertake an admission and screening process, as well as on-going review and monitoring of relevant information of its members, overseas special broker participants and overseas futures intermediaries (including their “principal” status, financial and income conditions and experience in investing in futures). The INE will also keep records of its client’s information and administrative records for a period of not less than 20 years. The Exchange Rules, Member Management Rules and Trading Participant Suitability Management Rules of the INE also impose specific KYC obligations on its members in respect of their end clients, risk tolerance assessments and safekeeping of client information and administrative records.
9. Future of the INE
As one of the world’s largest crude oil buyers, China has launched Renminbi crude oil futures at an apt time. The INE undoubtedly represents a major breakthrough for China’s crude oil futures market and China’s futures market as a whole, and plays a significant part in the continued expansion of the RMB internationally.
We believe the INE will play a crucial role in:
- lowering investors’ foreign exchange costs and risks in accessing onshore futures trading;
- providing impetus for the internationalisation of Renminbi; and
- strengthening China’s pricing position in the international crude oil market.
As a pioneer in the internationalisation of China’s futures market, the INE’s transaction and management solutions will serve as a model for China’s other futures exchanges as the Chinese futures market continues to evolve to align with global economy and investor consumption base. We anticipate an increasing amount and variety of hedging products as the INE continues to grow and expand to become one of the leading exchanges for RMB-denominated commodity futures available for international participants.
King & Wood Mallesons is honoured to have been working closely with the INE and other key parties on the launch of RMB-denominated oil futures allowing foreign investor access to China.
See Article 15 of the Provisional Measures
See the “General Exchange Rules of the Shanghai International Energy Exchange” (“Exchange Rules”)
See Article 23 of the Provisional Measures