New NAFMII Master Bond Lending Agreement

China’s National Association of Financial Market Institutional Investors (“NAFMII”) has just published a standard industry document for bond lending transactions[1] entitled Master Agreement for Bond Lending Transactions in China Interbank Bond Market (2022 version) (“NAFMII Master Bond Lending Agreement” or “NAFMII MBLA”). In January, the People’s Bank of China (“PBOC”) published the Administrative Rules on Interbank Bond Market Bond Lending Business (“Bond Lending Rules”).

Market participants are required to use the NAFMII Master Bond Lending Agreement for their onshore bond lending transactions under the Bond Lending Rules (which will take effect on 1 July 2022).

Eligible foreign investors have been able to enter into onshore bond lending transactions since 2016, but only for hedging purposes. Currently, eligible foreign investors may engage in bond lending transactions in the China Interbank Bond Market (“CIBM”) through two cross-border programmes as shown in the diagram below:

It is important for CIBM Direct investors and (RMB) Qualified Foreign Institutional Investors (“(R)QFII” or “QFI”) that wish to enter into CIBM bond lending transactions to understand the new NAFMII MBLA.

1. Parties to bond lending transactions

Similar to international industry standard master documentation such as the Global Master Securities Lending Agreement (“GMSLA”), parties to the NAFMII MBLA include the Bond Lender and the Bond Borrower.

The chart below illustrates the flows of underlying bonds, margin and lending fees between the parties to a typical lending transaction in respect of CIBM bonds:

2. No “single-agreement” provision

Although the NAFMII MBLA (as its name suggests) provides a master contractual framework for multiple bond lending transactions between two parties, it does not include a single agreement provision. This is one of the key differences between the NAFMII MBLA and the GMSLA (see GMSLA paragraph 17).

Instead of a single agreement provision, the NAFMII MBLA provides that, in respect of each bond lending transaction, the NAFMII MBLA, the Supplement and the relevant confirmation applicable to that bond lending transaction together form a complete agreement between the parties.

This type of drafting is not new to NAFMII master agreements. The 2013 NAFMII Master Repurchase Agreement (“NAFMII MRA”) similarly provides that each pledge-style repurchase transaction (“Pledge-style Repo”) is documented under a complete set of agreements comprising the NAFMII MRA, the supplement thereto and the confirmation for that Pledge-style Repo, with each Pledge-style Repo being separate from other Pledge-style Repos transacted under the same NAFMII MRA.

3. “Bond Lending with Pledge Feature” – title transfer of underlying bonds; security interest over cash margin and margin securities

The NAFMII MBLA suggests that there could be various types of bond lending transactions, but only the “Bond Lending with Pledge Feature” is specifically defined and referred to in the NAFMII MBLA. The name “Bond Lending with Pledge Feature” actually describes two components of the transaction.  First, the “Bond Lending” component involves an outright transfer of title in the underlying bonds from the Bond Lender to the Bond Borrower.  Second, the “Pledge Feature” component refers to the fact that cash margin and margin securities provided in respect of the bond lending transaction shall be subject to a PRC law pledge.

Significantly, the NAFMII MBLA does not use the word “pledge” in respect of the transfer of the underlying bonds. Furthermore, the China Central Depository & Clearing Corporation (“CCDC”) refers to “transfer” of the underlying bonds in its rules applicable to bond lending business, which is essentially a title transfer arrangement. In respect of margin securities, the NAFMII MBLA and the CCDC Rules expressly characterise the arrangement as involving a “pledge”.

Therefore, “Bond Lending with Pledge Feature” should not be confused with Pledge-style Repos in the China onshore market.  Under a Pledge-style Repo, there is no title transfer even in respect of the underlying bonds – both the underlying bonds as well as cash margin / margin securities are subject to a pledge.

For completeness, we are of the view that, in the context of a financial transaction (such as a bond lending transaction) involving a PRC financial institution, the risk of a genuine title transfer arrangement being recharacterised by the PRC courts as a security interest is not material.

4. Termination and Set-off

Another key difference between the NAFMII MBLA and other internationally recognised master agreements (such as the GMSLA) is the absence of close-out netting provisions in the NAFMII MBLA, which is not surprising given the absence of a “single agreement” provision.

Under the NAFMII MBLA, upon the occurrence of an event of default (or a termination event where all outstanding bond lending transactions are affected), the non-defaulting party (or the determining party) is entitled to exercise its right to terminate all outstanding transactions and calculate the lending fee and compensation amounts in respect of each terminated transaction separately. Unlike the third step of a classic close-out netting mechanism where a single net early termination amount is calculated, the NAFMII MBLA allows parties to settle the unpaid lending fees and compensation amounts on a gross basis.

Instead of close-out netting, the parties to a NAFMII MBLA would rely on the standard “set-off” provisions therein to reduce the exposures between them.  Where a bankruptcy proceeding has been commenced against a PRC counterparty, the right to set off may be subject to certain restrictions under the PRC Enterprise Bankruptcy Law as applied by PRC courts.  Having said this, where the defaulting party to a NAFMII MBLA is a regulated financial institution incorporated in the PRC, it would undergo a regulator-led takeover or resolution process before its financial regulator consents to the commencement of bankruptcy proceedings.  Under applicable PRC laws and regulations, the rights and obligations of the PRC financial institution being taken over shall not be altered by the takeover.  This should provide market participants with comfort about the enforceability of the NAFMII MBLA’s termination and set-off mechanism during a takeover or resolution.

It is worth noting that the recognition of close-out netting in the Notice on Issues Concerning the Measurement Rules for the Default Risk Assets of Derivatives Counterparties issued by the China Banking and Insurance Regulatory Commission in November 2021 (which applies to derivatives and repos, but not bond lending transactions) and the recently enacted PRC Futures and Derivatives Law (which applies to derivatives but not bond lending transactions) would not apply to bond lending transactions.

5. Next steps

Like other industry standard master agreements published by NAFMII, the NAFMII MBLA adopts a protocol-like multilateral signing mechanism, meaning that each market participant only needs to sign on a pre-printed NAFMII MBLA and file it with NAFMII. The NAFMII MBLA will apply to transactions between two parties if both parties have filed their respective executed version of the NAFMII MBLA with NAFMII.  However, a Supplement to the NAFBMII MBLA is still required to be negotiated and executed bilaterally between the parties and filed afterwards with NAFMII.

The publication of the NAFMII MBLA is an important milestone in the development of the onshore bond lending market.  We look forward to further interesting developments in the near future, including:

（1）With the introduction of CIBM Direct 2.0, which may allow foreign investors to access China’s exchange-traded bond market directly or through a mechanism known as financial market infrastructure connect (“FMI Connect”)[2], it will be interesting to see whether the NAFMII MBLA can also be used to enter into bond lending transactions in the exchange-traded market, in addition to exchange-organised short-selling transactions.

（2）In light of the willingness of Chinese regulators to explore multi-layer custody structures[3] in China, it will be interesting to see whether new types of bond lending transactions (e.g., “Bond Lending with Title Transfer Feature” where, consistent with international market practice, cash margin and securities margin are subject to title transfer arrangements) will emerge in the onshore market.

（3）With the further development of bond repos and bond lending businesses and the comprehensive opening up of China’s bond markets, centralised bond lending services provided by bond clearing institutions to market participants will become a highlight of the onshore market. Centralised bond lending can promote the efficient use of idle bonds, and can meet temporary demand for certain bonds. We eagerly await this important development.

KWM has been actively participating in legal developments relating to bond lending, the enforceability of close-out netting, security interest and title transfer arrangements in the PRC.

We are familiar with the unique issues faced by PRC-based financial institutions and their counterparties and would be pleased to share our insights with you. Please feel free to contact our core team members below.

Thanks to Dolores Xie for her contribution to this article.