Swap Connect: key legal documentation issues to consider

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The debut launch of Northbound Trading under Swap Connect took place on 15 May 2023. This article considers some of the key legal documentation issues that offshore and onshore Swap Connect participants may wish to consider, especially in light of the large number of Swap Connect rules and regulatory guidance published over the past few weeks.

I. What is Swap Connect?

On 4 July 2022, the People’s Bank of China (“PBOC”), the Securities and Futures Commission of Hong Kong and the Hong Kong Monetary Authority (“HKMA”) issued a joint announcement regarding Swap Connect. Swap Connect is an arrangement that allows investors to participate in the interest rate swap markets in Chinese mainland and Hong Kong through a connection between their respective financial market infrastructures, namely the China Foreign Exchange Trade System (“CFETS”) and the Interbank Market Clearing House Co., Ltd. (also known as the Shanghai Clearing House, “SHCH”), as the financial market infrastructures in Chinese mainland, and OTC Clearing Hong Kong Limited (“OTC Clear”), as the financial market infrastructure in Hong Kong. For further information about Swap Connect, please refer to our earlier article.

By way of background, there are currently three inbound channels for foreign investors to access the China Interbank Bond Market (“CIBM”), being: (1) Northbound Bond Connect; and (2) CIMB Direct Access; and (3) the (RMB) Qualified Foreign Institutional Investor (“(R)QFII”) scheme.

In recent years, there has been a slew of measures aimed at further opening up the China Interbank Bond Market to foreign investors. As foreign investors’ holdings of RMB-denominated bonds increase and more trading takes place, their demand for cost-effective interest rate risk management tools continues to grow. Today, RMB interest rate swaps are amongst the most popular and actively traded products in the China interbank derivatives market. SHCH has been providing central clearing services in respect of RMB interest rate swaps, effectively mitigating bilateral counterparty and systemic risks.  In 2016, the PBOC issued an announcement encouraging more foreign institutional investors to enter into interest rate swaps for hedging purposes.[1] We understand that CFETS has, since early 2020, allowed foreign institutions to enter into derivatives transactions via the CFETS trading system.[2] For this purpose, CFETS has agreed to on-board foreign institutions that have filed either an executed ISDA Master Agreement or an executed NAFMII Master Agreement with CFETS.

Against this backdrop, Swap Connect will further facilitate foreign investors’ participation in interest rate swaps and other derivatives transactions in the China interbank market to hedge interest rate and other risks associated with their onshore financial investments.

Similar to Bond Connect, Swap Connect comprises both a “Northbound” leg and a “Southbound” leg. Northbound Swap Connect (which launched on 15 May 2023) allows foreign investors to participate in China’s interbank derivatives market through an interconnection arrangement between the financial market infrastructures of Hong Kong and Chinese mainland relating to trading, clearing and settlement. Southbound Swap Connect will be launched in due course, which will allow Chinese onshore investors to access the Hong Kong derivatives market through the financial market infrastructure interconnection arrangement.

With regard to the conclusion and execution of derivatives transactions under Northbound Swap Connect, CFETS has established a trading link with offshore electronic trading platforms (such as Bloomberg and Tradeweb) (“Swap Connect Trading Link”) so that foreign investors do not have to make a filing with CFETS or open onshore accounts. Instead, they can place orders directly with the relevant offshore trading platforms without having to change their usual trading practices. As for the clearing of derivatives transactions concluded via the Swap Connect Trading Link, SHCH and OTC Clear have established a clearing link and each acts as a central counterparty in respect of such transactions (“Swap Connect Clearing Link”).

II. Recent publication of various Swap Connect rules and regulatory guidance

Before the launch of Northbound Swap Connect, the PBOC, HKMA and the financial market infrastructures involved in Swap Connect (i.e., CFETS, SHCH and OTC Clear) have published a series of rules and regulatory guidance which together establish the legal and regulatory framework for Northbound Trading under Swap Connect. We set out the key Swap Connect rules and guidance in the table below:

III. Derivatives master agreements are optional and not mandatory under Swap Connect

Compared to the Proposed Swap Connect Rules, one of the most important changes reflected in the Final Swap Connect Rules is that onshore and offshore Swap Connect participants are no longer mandatorily required to enter into a derivatives master agreement, although they may enter into one if they so choose.  Below is the text of Article 6 of the Final Swap Connect Rules compared against the Proposed Swap Connect Rules, showing this important change:

The Swap Connect Q&As helpfully clarify that derivatives master agreements recognised by the PBOC not only include the Chinese language NAFMII Master Agreements that are primarily used in the onshore derivatives market but also include the ISDA Master Agreements and the FIA-ISDA Cleared Derivatives Execution Agreement (“CDEA”) that are widely used in the international derivatives markets.

The Swap Connect Trading Rules help explain why derivatives master agreements between onshore and offshore Swap Connect participants are optional and no longer mandatory. Under Article 21 of the Swap Connect Trading Rules, before a trade is concluded via the Swap Connect Trading Link, the onshore participant and offshore participant must jointly select one of two prescribed consequences if the trade is rejected for central clearing: (1) resubmission; or (2) cancellation. If the parties select “resubmission”, then the trade that has been rejected for clearing is still valid and the parties will resubmit the trade for clearing in accordance with the Swap Connect Trading Rules. However, if the parties select “cancellation”, then the trade that has been rejected for clearing shall be automatically cancelled and shall become invalid. This is often referred to as “zero-cost cancellation” because once the trade is cancelled, neither party is required to make any termination or other payment to the other.

If a trade that is concluded via the Swap Connect Trading Link is accepted for central clearing, then three separate derivatives contracts will arise as follows:

1. between the onshore participant and SHCH;

2. between SHCH and OTC Clear; and

3. between OCT Clear and or the offshore participant (assuming the offshore participant is an OTC Clear Clearing Member).

Significantly, if a Swap Connect trade is accepted for clearing, there will not be a derivatives contract between the onshore participant and the offshore participant.

Under both the acceptance and the cancellation scenarios, there will not be a direct derivatives contract between the onshore participant and the offshore participant.  We understand a number of market participants view that a derivatives master agreement or CDEA between the onshore and offshore participants is not strictly necessary solely for the purposes of participating in Swap Connect where the parties have selected “cancellation” as the pre-agreed consequence for rejected trades.

There are other reasons for onshore and offshore Swap Connect participants to enter into a derivatives master agreement or CDEA. For example, a Swap Connect participant that is a regulated financial institution may be under a regulatory or internal compliance requirement to document its derivatives trades in writing.  Similarly, some market participants may prefer to have a formal master derivatives agreement to govern their Swap Connect trades to meet internal risk management policy requirements. 

Some foreign financial institutions may wish to seize the business opportunity presented by Swap Connect to establish a general derivatives trading relationship with onshore financial institutions, in the hopes of entering into more cross-border derivatives transactions (outside the Swap Connect context) with them in the future. These foreign financial institutions may prefer to use the opportunity presented by Swap Connect to negotiate and enter into a general derivatives master agreement (covering all types of derivatives transactions) with onshore financial institutions.

In essence, Swap Connect provides onshore and offshore participants with the flexibility to decide whether to sign relevant bilateral documentation (such as a derivatives master agreement or the CDEA) and, if so, which version and on what terms. The relevant Chinese mainland regulator(s) will monitor documentation signing status through the record filing that domestic participants are required to make. This arrangement maintains regulatory oversight over market conditions while maximizing flexibility for Swap Connect participants.

IV. Using the CDEA for Swap Connect

The CDEA, jointly published by the Futures Industry Association (“FIA”) and ISDA, is a standard execution agreement for market participants looking to enter into derivatives that are intended to be cleared by central counterparties located outside of the United States. The CDEA documents the process for the submission, acceptance and/or rejection of derivatives transactions that were intended to be centrally cleared. Similar to other industry standard derivatives documents, the main body of the CDEA is in a pre-printed standard form and the parties specify their elections and variables in the Annex to the CDEA. The Swap Connect Q&As helpfully state that the CDEA is one of the derivatives agreements recognised by the PBOC.

Even though they are not required to, should Swap Connect participants nevertheless choose to enter into a CDEA, it may not always be appropriate for them to simply use the standard form of the CDEA without making any modifications. Instead, the standard provisions in the CDEA may need to be adjusted to take into account the unique features of Swap Connect.

Where a bilateral derivatives transaction is rejected for clearing, the standard fallbacks under the CDEA is for the derivatives transaction to either: (1) continue as a bilateral uncleared trade; or (2) terminate early in accordance with mechanism set out in Section 6(e) of the ISDA Master Agreement.   These two standard fallbacks do not perfectly align with the resubmission and zero-cost cancellation consequences prescribed by the Swap Connect Trading Rules.  Fortunately, further alignment may be achieved by amending the Annex to the CDEA. In addition, Swap Connect participants may consider selecting a more appropriate, Asia-based venue instead of the English courts for resolving disputes arising out of the CDEA.

V. Client clearing agreements

An offshore participant which is not an OTC Clear Clearing Member will need to enter into a client clearing agreement with an OTC Clear Clearing Member. The Swap Connect Q&As helpfully clarify that in order to participate in Swap Connect, an offshore participant must either be an OTC Clear Clearing Member or a client of an OTC Clear Clearing Member and sign a client clearing agreement.

In the international derivatives market, the ISDA/FIA Client Cleared OTC Derivatives Addendum (“Clearing Addendum”), which is designed to supplement an ISDA master agreement between a clearing member and its client, essentially transforms the ISDA master agreement into a client clearing agreement. The Clearing Addendum addresses a range of issues relevant to the relationship between the clearing member and its client, including matching the terms of (1) the derivatives transaction between the clearing member and its client and (2) the cleared transaction between the clearing member and the central counterparty, the calculation and posting of margin, transferring client positions to another clearing member, default management procedures, and the consequences a default by the client, the clearing member or the central counterparty.

OTC Clear Clearing Members and their clients that have entered or will enter into a Clearing Addendum may wish to consider customising its terms to make it more fit-for-purpose in respect of Northbound Swap Connect. Relevant industry association(s) may soon publish a Swap Connect Annex to the Clearing Addendum to address some of these issues.

VI. Where can we learn more about legal documentation issues in relation to Swap Connect?

We at KWM are here to help you. KWM regularly assists international and PRC-based financial institutions and corporates with ISDA/NAMFII, CSA, VM and IM margin document negotiations, as well as with designing and documenting innovative and complex cross-border derivatives products. We also regularly advise international and PRC-based clients on margin and other regulatory requirements that apply to derivatives transactions.

KWM has been actively participating in legal developments relating to the enforceability of close-out netting, central clearing, as well as security and title transfer arrangements in the PRC. We are familiar with the unique issues faced by PRC-based financial institutions (including central counterparties) and their counterparties and would be pleased to share our insights with you. Please feel free to contact our core team members below.

*For purposes of this article, “Hong Kong” means “Hong Kong Special Administrative Region of the People's Republic of China”, and any reference made to “Chinese mainland”, “onshore” or “PRC” shall be construed as excluding Hong Kong, Macao Special Administrative Region and Taiwan.

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中国人民银行公告〔2023〕第8号 (

中国人民银行有关部门负责人就《内地与香港利率互换市场互联互通合作管理暂行办法》答记者问 (

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    中国人民银行公告〔2023〕第8号 (

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