China’s key financial regulator, the National Financial Regulatory Administration (“NFRA”), has published its highly-anticipated uncleared margin rules. The NFRA’s uncleared margin rules impose initial margin (“IM”) and variation margin (“VM”) requirements on non-centrally cleared derivatives transactions entered into by Chinese banking and insurance sector financial institutions regulated by the NFRA. The new rules are broadly consistent with the global regulatory margin standards published by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (“Basel Margin Standards”).
Given the relatively short implementation timeline under the NFRA’s uncleared margin rules, Chinese financial institutions (including the Chinese operations of overseas financial institutions) will need to undergo a significant compliance and documentation exercise which involves, among other things, negotiating and entering into (1) various VM and IM documents with their derivatives counterparties and (2) IM custody arrangements with independent third-party custodians.
This article provides, in the form of Q&As, a high-level overview of key takeaways from the NFRA’s uncleared margin rules. A bilingual version of the NFRA’s uncleared margin rules is available here.
What are the uncleared margin rules?
By way of background, after the global financial crisis in 2008, the G20 leaders committed to develop and implement, among other derivatives regulatory reforms, the uncleared margin rules in their respective jurisdictions to reduce systemic risk and create a level playing field across the globe.
Under the uncleared margin rules, counterparties to non-centrally cleared over-the-counter derivatives are required to post and collect margin (also referred to as collateral) to and from each other. This is designed to reduce counterparty credit risk because the collateral (usually in the form of high-quality liquid assets, such as cash or highly liquid debt securities) is available to offset losses following the default of a derivatives counterparty.
The uncleared margin rules distinguish between IM and VM. VM is collateral that protects derivatives counterparties from the current exposure that one counterparty has to the other. The amount of VM reflects the size of the current exposure, which can change regularly due to market movements. IM is collateral that protects derivatives counterparties from the potential future exposure that can arise from future changes in the mark-to-market value during the time it takes to close-out and replace derivatives following a counterparty default.
Most major jurisdictions have adopted and implemented the uncleared margin rules. While there are important differences in the detailed rules in each jurisdiction, their overall requirements are quite similar because they are all based on the Basel Margin Standards. With the publication of the NFRA’s uncleared margin rules, China becomes the latest major jurisdiction to implement the Basel Margin Standards.
Who is subject to the NFRA’s uncleared margin rules?
The NFRA’s uncleared margin rules apply to banking financial institutions, insurance financial institutions and financial holding companies that are regulated by the NFRA as well as asset management products issued by such entities (collectively, “NFRA-regulated Financial Institutions”). Note that foreign-invested banks (including onshore branches of foreign banks) are also banking financial institutions under the supervision of the NFRA, and are also addressees of the NFRA’s notice announcing its uncleared margin rules.
Notably, the NFRA’s uncleared margin rules do not directly apply to financial institutions that are not regulated by the NFRA, such as securities and futures companies regulated by the China Securities Regulatory Commission (“CSRC”). In this respect, we note that the CSRC’s draft Derivatives Trading Administrative Measures published in November 2023 contemplate the formulation of margin rules by various derivatives self-regulatory organisations overseen by the CSRC. It remains to be seen what shape these margin rules would take and how similar they will be to the NFRA’s uncleared margin rules.
Which derivatives transactions are subject to margin requirements under the NFRA’s uncleared margin rules?
The NFRA’s uncleared margin rules apply to non-centrally cleared derivatives transactions where one or both parties are an NFRA-regulated Financial Institution. However, the uncleared margin rules do not require an NFRA-regulated Financial Institution to exchange margin with all types of counterparties. Instead, there are different rules that apply to different counterparty types. These rules provide, among other things:
- Transactions with non-financial institutions for risk-hedging purposes: If an NFRA-regulated Financial Institution’s counterparty is not a financial institution at all, an uncleared derivatives transaction between them is exempted from margin requirements if the transaction is within the risk-bearing capacity of the non-financial institution counterparty and is based on its genuine risk-hedging needs. The current derivatives rules in China do not in fact allow NFRA-regulated Financial Institutions to enter into derivatives transactions with corporate clients for non-hedging purposes. Therefore, we expect that this “end-user hedging exemption” from margin requirements would cover most derivatives transactions between NFRA-regulated Financial Institutions and non-financial institution counterparties.
- Transactions with certain systemically important non-financial institutions: If an NFRA-regulated Financial Institution’s counterparty is not a financial institution, but it has an aggregate average notional amount (“AANA”) of uncleared derivatives calculated at the group level at the end of March, April and May of the most recent year exceeding RMB 60 billion and does not satisfy the risk-hedging conditions set out in the above paragraph, the NFRA-regulated Financial Institution must collect margin from such counterparty.
- Transactions with central banks and government entities etc: If an NFRA-regulated Financial Institution’s counterparty is a central bank, government entity, public sector entity, multilateral development bank, the Bank for International Settlements or a Chinese policy bank, uncleared derivatives transactions between them are exempted from margin requirements.
- Intragroup transactions: If an NFRA-regulated Financial Institution’s counterparty is an affiliate that is included in the same consolidated financial statements of a group, uncleared derivatives transactions between them are exempted from margin requirements.
- Transactions with finance/treasury companies: The NFRA’s uncleared margin rules provide that uncleared derivatives transactions carried out by finance/treasury companies of an enterprise group on behalf of the group and its members based on genuine risk-hedging needs are exempted from margin requirements.
Exemptions based on transaction type: Besides the foregoing rules which are based on counterparty type, certain types of transactions are also exempted from aspects of the NFRA’s uncleared margin rules. Specifically, the following types of uncleared derivatives transactions are not subject to IM requirements:
- physically settled foreign exchange forwards and swaps transactions;
- physically settled gold forwards and swaps transactions;
- the fixed principal exchange component of physically settled cross-currency swap transactions; and
- transactions that do not have counterparty credit risk.
What are the VM requirements under the NFRA’s uncleared margin rules?
VM must be calculated on a netting set basis at the end of each business day. VM margin calls must be made by the end of the next business day, and the exchange of VM must be completed by the end of the second business day following the margin call notice.
There is no threshold amount for VM, although a minimum transfer amount of no more than RMB 4 million (or its equivalent in foreign currency) may be applied in respect of margin exchanges, and can be allocated between IM and VM. We note that RMB 4 million (which is approximately EUR 530,273) is broadly equivalent to the EUR 500,000 minimum transfer amount permitted under the Basel Margin Standards.
Collateral used as VM may be either (1) directly provided to the counterparty (e.g., on a title transfer basis) or (2) entrusted with a qualified third-party custodian. VM may be re-pledged or re-used.
What are the IM requirements under the NFRA’s uncleared margin rules?
Initial margin must be calculated on a netting set basis and exchanged in full (on a gross basis) between both parties. IM must be calculated at least every 10 days and must be recalculated whenever there is a change in the netting set, triggered by events such as the entry into of new transactions and the termination or expiration of existing transactions. IM margin calls must be made by the end of the next business day, and the exchange of IM must be completed by the end of the second business day following the margin call notice.
The threshold amount for exchanging IM (calculated at the group level) must not exceed RMB 400 million or its equivalent in foreign currency. We note that RMB 400 million (which is approximately EUR 53 million) is broadly equivalent to the EUR 50 million threshold amount permitted under the Basel Margin Standards. As noted above, a minimum transfer amount of no more than RMB 4 million may be allocated between IM and VM.
Consistent with the Basel Margin Standards, IM may be calculated using either the standardised method or a quantitative model (including a third-party vendor model) that has been assessed by the NFRA. We note that the ISDA Standard Initial Margin Model (ISDA SIMM®) is an industry standard methodology for calculating IM.
An NFRA-regulated Financial Institution must use consistent IM calculation methodologies for transactions in the same asset class and the same netting set, and must not switch IM calculation methodologies for the purposes of regulatory arbitrage.
Consistent with the Basel Margin Standards, collateral used as IM must be held with a qualified independent third-party custodian. In addition, collateral used as IM must be effectively segregated from the proprietary assets of the parties to the derivatives transaction as well as the proprietary assets of the third-party custodian and the collateral of other derivatives counterparties under its custody. Collateral used as IM may not be re-pledged or re-used.
What constitutes eligible collateral?
Consistent with the Basel Margin Standards, the NFRA’s uncleared margin rules restrict eligible collateral to highly liquid high-quality assets. Specifically, eligible collateral includes:
- Cash;
- Government bonds issued by China's Ministry of Finance, bills issued by the People's Bank of China, and bonds and bills issued by Chinese policy banks;
- Bonds issued by China’s provincial people's governments (including autonomous regions and direct-administered municipalities) and cities under separate state planning;
- High-quality bonds issued by other national or regional governments and their central banks, sovereign-equivalent public sector entities, the Bank for International Settlements, the International Monetary Fund, the European Central Bank, the European Union, the European Stability Mechanism and the European Financial Stabilisation Mechanism, and multilateral development banks;
- High-quality corporate credit bonds;
- High-quality financial bonds;
- Gold; and
- Other eligible collateral recognised by the NFRA.
A haircut must be applied to the value of eligible collateral. The NFRA’s uncleared margin rules prescribe standardised haircuts (which are broadly consistent with those found in the Basel Margin Standards). Alternatively, parties may use an internal or third-party model that has been assessed by the NFRA to calculate haircuts. An additional collateral haircut must be applied where the currency of denomination of collateral is not the same as the termination currency of the derivatives transaction or the base currency specified in the relevant collateral agreement. However, this FX haircut does not apply to VM in the form of cash.
An NFRA-regulated Financial Institution must adequately address foreign exchange risk, concentration risk and wrong-way risk associated with collateral used for IM or VM. For example, to mitigate wrong-way risk, securities issued by the counterparty or its affiliates may not be used as collateral.
Consistent with the Basel Margin Standards, the NFRA’s uncleared margin rules permit parties to agree to substitute posted collateral with other eligible collateral.
How should parties handle margin disputes?
Broadly consistent with the Basel Margin Standards, the NFRA’s uncleared margin rules include provisions on how margin disputes should be handled. As a general principle, if a margin dispute arises, both parties should make all necessary and appropriate efforts, including timely initiation of dispute resolution protocols, to resolve the dispute and exchange the required amount of margin in a timely fashion. In the meantime, the undisputed portion of margin should be exchanged.
How are cross-border derivatives transactions dealt with under the NFRA’s uncleared margin rules?
In a cross-border derivatives transaction, if an NFRA-regulated Financial Institution “needs to satisfy” the margin requirements of an offshore jurisdiction, it may choose to apply the margin requirements of that offshore jurisdiction, provided that such margin requirements are consistent with the Basel Margin Standards and are equivalent to, or are more prudent than, the NFRA’s uncleared margin rules.
The scope of application of this substituted compliance regime depends, to an extent, on the breadth of interpretation of the term “needs to satisfy”. Market participants would also be keen to understand more about how equivalence with the NFRA’s uncleared margin rules would be determined, including who can make such determination and the procedures involved.
According to the NFRA’s uncleared margin rules, an offshore branch of an NFRA-regulated Financial Institution engaging in derivatives transactions may apply the margin requirements of the host jurisdiction where the branch is based. This likely means that, for example, a Hong Kong branch of a Chinese commercial bank may apply the HKMA’s uncleared margin rules for transactions booked in the branch, instead of also having to comply with the NFRA’s uncleared margin rules, notwithstanding the fact that the branch is part of the same legal entity as the Chinese commercial bank, which is an NFRA-regulated Financial Institution.
The NFRA’s uncleared margin rules provide that offshore institutions engaging in derivatives transactions directly in China’s domestic financial markets must comply with relevant requirements for onshore transactions.
The NFRA’s uncleared margin rules also encourage NFRA-regulated Financial Institutions to use RMB-denominated assets as margin, and to use margin calculation models that can reflect the volatility of RMB-denominated assets objectively and reasonably.
What is the effective date of the NFRA’s uncleared margin rules?
While the general effective date of the NFRA’s uncleared margin rules is 1 January 2026, the VM requirements do not come into effect until 1 September 2026.
The IM requirements will be implemented over three phases, based on the relevant AANA. Specifically, if an NFRA-regulated Financial Institution and its counterparty has an AANA at a group level at the end of March, April and May of the most recent year exceeding RMB 500 billion, the IM requirements will be implemented from 1 September 2027. Where the relevant AANA exceeds RMB 300 billion, the IM requirements will be implemented from 1 September 2028. Where the relevant AANA exceeds RMB 60 billion, the IM requirements will be implemented from 1 September 2029. In calculating AANA for these purposes, all non-centrally cleared derivatives transactions (including physically settled foreign exchange forwards and swaps and physically settled gold forwards and swaps) must be included.
If, after becoming subject to IM requirements under the NFRA’s uncleared margin rules, an NFRA-regulated Financial Institution’s AANA falls below the relevant threshold, it may cease exchanging IM from 1 September of that year. However, if its AANA exceeds the relevant threshold at a later date, it must resume exchanging IM.
The VM and IM margin requirements only apply to new transactions entered into on or after the applicable effective date for VM and IM requirements, respectively. Immaterial amendments to existing transactions would not cause them to become “new transactions”. However, material amendments or amendments intended to extend the term of existing transactions to circumvent margin requirements will be regarded as “new transactions”.
What are the next steps?
Given the relatively short implementation timeline under the NFRA’s uncleared margin rules, NFRA-regulated Financial Institutions will need to undergo a significant compliance and documentation exercise which involves, among other things, negotiating and entering into (1) various VM and IM documents with their derivatives counterparties and (2) IM custody arrangements with independent third-party custodians. In this respect, we note that industry bodies such as NAFMII and ISDA are in the process of preparing standard VM and IM documents that cater for the NFRA’s uncleared margin rules. In addition, certain Chinese market infrastructure organisations are getting ready to provide IM custody services in respect of onshore RMB-denominated collateral.
Where can we learn more about the NFRA’s uncleared margin rules and related legal and documentation issues?
We at KWM are here to help you. KWM regularly assists international and PRC-based financial institutions and corporates with ISDA/NAFMII, VM and IM documentation 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 “China”, “onshore” or “PRC” shall be construed as excluding Hong Kong, Macau Special Administrative Region and Taiwan.
