China’s National Association of Financial Market Institutional Investors (“NAFMII”) recently published its much-anticipated Swap Connect Cleared Derivatives Agreement (“SCCDA”) , which is designed to further facilitate Northbound Trading under Swap Connect.
Pursuant to the SCCDA, an onshore Swap Connect participant and an offshore Swap Connect participant agree to take reasonable steps to enable a Northbound Swap Connect derivatives transaction (“Swap Connect Transaction”) to be centrally cleared. Significantly, the SCCDA documents the parties’ election of “cancellation” as the mutually agreed method under applicable Swap Connect rules for dealing with a transaction that is rejected for central clearing. The SCCDA expressly provides that under the cancellation method, a transaction that is rejected for clearing is void ab initio and no amount is payable by either party in respect of a rejected transaction. The SCCDA also contains an Annex that provides the parties with the flexibility to select the SCCDA’s governing law, dispute resolution mechanism and how it interacts with any existing master derivatives agreement between the parties.
This article provides a high-level overview of key provisions of the SCCDA and their significance in the context of Swap Connect.
1. Background
Swap Connect allows investors to participate in the interest rate swap markets in Mainland China* and Hong Kong* through a connection between their respective financial market infrastructures, namely: (1) 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 Mainland China; and (2) OTC Clearing Hong Kong Limited (“OTC Clear”), as the financial market infrastructure in Hong Kong.
One of the key benefits of Swap Connect is that it allows offshore investors to effectively hedge interest rate and other risks associated with their onshore financial investments. In recent years, there has been a slew of measures aimed at further opening up the China Interbank Bond Market to offshore investors. As offshore investorsʼ 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. Swap Connect works through a trading link and a clearing link that connects the onshore and offshore markets. CFETS has established a trading link with offshore electronic trading platforms (such as Bloomberg and Tradeweb) (“Swap Connect Trading Link”) so that offshore investors can place orders directly with the relevant offshore platforms in accordance with their usual electronic 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 whereby each acts as a central counterparty in respect of the transactions (“Swap Connect Clearing Link”). The following diagram illustrates these aspects of Swap Connect.
Swap Connect launched on 15 May 2023. For further information about Swap Connect and its benefits, please refer to our earlier article (available here).
NAFMII is a self-regulatory organisation established with the consent of China’s State Council for the purpose of developing China’s interbank market. NAFMII has published standard industry master documentation templates for derivatives and securities financing transactions in the PRC interbank market, including the NAFMII Master Agreement (for documenting derivatives), the NAFMII Master Repurchase Agreement and the NAFMII Master Bond Lending Agreement. The SCCDA is the latest industry standard document published by NAFMII to facilitate Swap Connect trading.
2. What happens if a Swap Connect Transaction is rejected or accepted for central clearing?
It is important to consider unique features under the Swap Connect clearing mechanism, including the consequences of a Swap Connect Transaction that is rejected for central clearing (“rejected transaction”), in assessing the rationale underlying the drafting of the SCCDA.
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 select either of the following two prescribed methods to deal with any transaction rejected for clearing. These mandatory elections differ from the standard fallback provisions under the standard form FIA-ISDA Cleared Derivatives Execution Agreement (“CDEA”) when a derivatives transaction intended to be cleared is rejected by the clearing house. [1]
(1) Resubmission method
If the parties select “resubmission”, a rejected transaction is still valid and the parties must resubmit the transaction for clearing in accordance with the CFETS Northbound Swap Connect Interest Rate Swap Trading Rules (“Swap Connect Trading Rules”), which normally occurs on the next business day.
(2) Cancellation method
If the parties select “cancellation”, a rejected transaction is automatically cancelled and becomes void ab initio. This is often referred to as “zero-cost” cancellation because upon cancellation, neither party is required to make any termination or other payment to the other.
A trade concluded via the Swap Connect Trading Link and accepted for central clearing will involve three separate derivatives transactions:
- a derivatives transaction between the onshore participant and SHCH;
- a derivatives transaction between SHCH and OTC Clear; and
- a derivatives transaction between OCT Clear and or the offshore participant (assuming the offshore participant is an OTC Clear clearing member).
Where a Swap Connect Transaction is either: (i) accepted for central clearing; or (ii) rejected for central clearing under the “cancellation” method, the onshore participant and the offshore participant will not have a direct derivatives transaction between them. Accordingly, a number of market participants take the view that a derivatives master agreement or the CDEA between an onshore participant and its offshore participant counterparty is not strictly necessary solely for the purposes of participating in Swap Connect where the parties have selected “cancellation” as their pre-agreed method for dealing with rejected transactions.
There may be other reasons for the onshore and offshore Swap Connect participants under a Swap Connect Transaction to maintain 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 transactions in writing. Similarly, some market participants may prefer to have a formal master derivatives agreement to govern their Swap Connect Transactions to meet internal risk management policy requirements.
3. How does the SCCDA fit into the picture?
The SCCDA is a cleared derivatives execution agreement that is tailor-made for Swap Connect. The cleared derivatives execution agreement that is used in the international market documents the process for the submission, acceptance and/or rejection of derivatives transactions that are intended to be centrally cleared. Similarly, under the SCCDA, the parties agree to take reasonable steps to enable a Swap Connect Transaction to be cleared. Like the cleared derivatives execution agreement that is used in the international market, the SCCDA also spells out the consequences for derivatives transactions that are accepted or rejected for clearing. Where a derivatives transaction is accepted for clearing, the SCCDA provides that neither party will have any further rights against or obligations to the other with respect to the transaction. In respect of rejected transactions, the SCCDA documents the parties’ election of “cancellation” as the mutually agreed method under applicable Swap Connect Trading Rules for dealing with such transactions.
The pre-printed form of the CDEA is not tailor-made for Swap Connect. For example, in respect of rejected transactions, the standard contractual fallbacks under the CDEA are for the transaction to either: (1) continue as a bilateral uncleared transaction; or (2) be terminated early (if the terminating party(ies) so elect) in accordance with mechanism set out in Section 6(e) of the ISDA Master Agreement. These standard fallbacks in the CDEA do not perfectly align with the resubmission and cancellation methods prescribed by the Swap Connect Trading Rules. In contrast, the SCCDA is specifically designed for Northbound Swap Connect.
4. Taking a closer look at the SCCDA
While it is not a mandatory requirement for Swap Connect participants to sign up to the SCCDA, some Swap Connect participants may choose to enter into the SCCDA for the purpose of formally documenting their selected method for dealing with rejected transactions and clearly spelling out the contractual consequences of such transactions. A Swap Connect participant that is a regulated financial institution may be required to enter into such formal documentation for regulatory or internal compliance reasons.
We summarise below the key features of the SCCDA to facilitate Swap Connect participants’ assessment on their choice of documentation for Swap Connect Transactions.
A. Parties to the SCCDA
The parties to the SCCDA are an onshore Swap Connect participant (“Party A”) and an offshore Swap Connect participant (“Party B”). The onshore participant is a market maker in the interbank derivatives market while the typical offshore participant is an investor intending to hedge its interest rate risk on its onshore bond investments.
Nothing in the SCCDA provides that the agreement can only be entered into by NAFMII members. Non-NAFMII members can also sign the SCCDA but they will need to obtain a licence from NAFMII by executing a document licence agreement with NAFMII.
B. What is the relationship between the SCCDA and any derivatives master agreements entered into between the parties?
Onshore and offshore participants are not required to enter into a derivatives master agreement in order to participate in Swap Connect. Clause 2.1 of the SCCDA provides that it shall apply to all Swap Connect Transactions between Party A and Party B, irrespective of whether the parties have entered into a derivatives master agreement.
Where the parties have in place an existing derivatives master agreement (e.g., a NAFMII Master Agreement (2009 or 2022 cross-border version) or a 1992 or 2002 ISDA Master Agreement), they can choose to specify the derivatives master agreement as “applicable” in the Annex to the SCCDA. This specification will switch on the application of both the SCCDA and the specified derivatives master agreement to Swap Connect Transactions between the parties, and that if there is any inconsistency between these two agreements, the SCCDA prevails over the specified derivatives master agreement. Under clause 2.1.2 of the SCCDA, the parties agree that where they have entered into a derivatives master agreement but do not specify it as being “applicable” in the Annex to the SCCDA, then that derivatives master agreement shall not apply to Swap Connect Transactions.
After a Swap Connect Transaction is accepted for clearing, there will not be a derivatives transaction between the onshore participant and the offshore participant. Accordingly, Clause 4 of the SCCDA provides that neither party has any further rights against or obligations to the other in respect of an accepted transaction and such transaction is not subject to the specified derivatives master agreement (if any).
C. What is the relationship between the SCCDA and any CDEA entered into between the parties?
The SCCDA performs a similar function to a CDEA, except that it is tailor-made for Swap Connect. Therefore, if the parties do sign up to the SCCDA for their Swap Connect Transactions, Clause 2.2.4 of the SCCDA expressly provides that, in respect of Swap Connect Transactions, the SCCDA shall prevail over any CDEA entered into or to be entered into between the parties.
D. Taking reasonable steps to clear Swap Connect Transactions
Clause 3.2 of the SCCDA imposes a core obligation on the parties to take “reasonable steps” to enable an executed Swap Connect Transaction to be cleared. The contractual drafting for this obligation aligns generally with the wording adopted in the CDEA, except that Section 2(b) of the CDEA includes a non-exhaustive list of what these “reasonable steps” entail, such as procuring that all transactional information required by the relevant central counterparty has been provided and consulting in an effort to resolve any issues relating to the matching and submission of transactions or to agree to an alternative course of action.
E. Rejected transactions
Clause 5 of the SCCDA provides that if a “Relevant Event” (i.e., rejection or non-acceptance for clearing) occurs with respect to a Swap Connect Transaction, the transaction is void ab initio and no amount (including any amount of margin arising out of or in connection with such transaction) is payable by either party in respect of such transaction. Specifically, “Relevant Event” means any of the following events in respect of a Swap Connect Transaction:
- OTC Clear or SHCH has not received the trade details relating to such transaction for the purposes of central clearing by the cut-off time specified in the applicable Swap Connect rules;
- Party A or Party B’s clearing member (if applicable) has not accepted (where acceptance is required) such transaction by the cut-off time specified in the applicable Swap Connect rules; or
- OTC Clear or SHCH has rejected such transaction or has not accepted such transaction for clearing by the cut-off time specified in the applicable Swap Connect rules.
Clause 5 of the SCCDA provides that it constitutes the mutual agreement between the parties to elect “cancellation” as the prescribed method for dealing with rejected transactions under the Swap Connect Trading Rules.
The parties can also select “resubmission” under the Swap Connect Trading Rules as the prescribed method for dealing with a rejected transaction, in which case the rejected transaction remains valid and the parties will resubmit the transaction for clearing in accordance with the Swap Connect Trading Rules. The drafting notes to the SCCDA provide that the standard form SCCDA can be modified to accommodate the “resubmission” method. The modified SCCDA must provide for the termination process in respect of rejected transactions, including the valuation of the early termination amount. The inclusion of these provisions makes the modified SCCDA more like a CDEA, which also allows the terminating party(ies) to elect for rejected transactions to be terminated and closed out in accordance with mechanism set out in Section 6(e) of the ISDA Master Agreement, although this may not be feasible under Swap Connect because bilateral settlement is not an option under the relevant Swap Connect rules.
F. Representations and undertakings
Clause 6 of the SCCDA contains a set of mutual representations and undertakings, some of which are specific to Swap Connect. For example, there are representations by:
- Party A that: (1) it is a Swap Connect market maker which has entered into a Swap Connect dealer agreement with CFETS; and (2) it is, or has entered into a clearing agreement with, a clearing member of SHCH; and
- Party B that: (1) it is, or has entered into a clearing agreement with, a clearing member of OTC Clear; and (2) it enters into each Swap Connect Transaction for risk management purposes in accordance with the applicable Swap Connect rules.
Since Swap Connect is a cross-border arrangement involving onshore and offshore participants, data will likely be transmitted on a cross-border basis under this arrangement. In the Annex to the SCCDA, the party that is a data provider represents that it has obtained all necessary consents and provided all necessary notices under applicable laws and regulations to transmit data to the data recipient.
G. English and Chinese versions of the SCCDA
The SCCDA is published in English and Chinese versions. The parties may select either version as they prefer, and there is no express provision in the SCCDA which provides that the Chinese version of the SCCDA prevails over the English version in the case of inconsistency.
However, as far as the trade details of each individual Swap Connect Transaction are concerned, there is an express acknowledgement by the parties under Clause 6.3.2 of the SCCDA that, where the trade details of any Swap Connect Transaction are recorded in both English and Chinese, the Chinese language version of the relevant trade details shall prevail in the case of inconsistency.
H. Governing law and dispute resolution mechanism
The SCCDA provides the parties with the flexibility to choose the governing law and dispute resolution mechanism that apply to the SCCDA and any agreement evidencing Swap Connect Transactions. The parties’ choice must be specified in the Annex to the SCCDA. The pre-printed form of the Annex sets out four combinations of governing law and dispute resolution mechanism for the parties to choose from, although the drafting note to the SCCDA clarifies that these four choices are for reference only and the parties can choose any other governing law and dispute resolution mechanism that they consider to be appropriate.
The four choices contained in the pre-printed form of the Annex to the SCCDA are:
- PRC* law as the governing law with disputes being resolved by arbitration at the China International Economic and Trade Arbitration Commission (“CIETAC”) in Beijing. The arbitral tribunal shall consist of three arbitrators and arbitral proceedings will be conducted in Chinese.
- Hong Kong law as the governing law with disputes being resolved by arbitration at the Hong Kong International Arbitration Centre (“HKIAC”) in Hong Kong. The arbitral tribunal shall consist of three arbitrators and arbitral proceedings will be conducted in English.
- A governing law chosen by the parties with disputes being resolved by arbitration at the HKIAC in Hong Kong. The arbitral tribunal shall consist of three arbitrators and arbitral proceedings will be conducted in English.
- The same governing law and dispute resolution mechanism as the derivatives master agreement specified in the Annex to the SCCDA.
I. Does a copy of the executed SCCDA need to be filed with PRC authorities?
Article 6 of the PBOC’s Swap Connect rules and accompanying Q&As provide that the onshore Swap Connect participant (i.e., Party A to the SCCDA) should make a record filing with CFETS regarding whether the parties have entered into any derivatives master agreement, CDEA or SCCDA and the type of agreement into which they have entered. NAFMII also released guidelines on the filing procedures in respect of the SCCDA. Either party can handle the filing of the signed SCCDA. Given the Chinese language interface used in the NAFMII Investor Filing Service Online Platform, it is more convenient for the onshore party to submit the SCCDA for filing. If the offshore party is a non-NAFMII member, then it should furnish the onshore party with the executed document licence agreement.
5. The SCCDA is not mandatory
Although the SCCDA is tailor-made for Swap Connect, market participants are not required to enter into the SCCDA in order to participate in Swap Connect. After all, Swap Connect has been operating since May 2023, before the SCCDA was published by NAFMII.
Article 21 of the Swap Connect Trading Rules provides, a pair of onshore and offshore Swap Connect participants must jointly select one of two prescribed methods for dealing with rejected transactions in accordance with the Swap Connect Trading Rules. However, entering into the SCCDA is not the only way for Swap Connect participants to document their selection.
Article 6 of the PBOC’s Swap Connect rules and accompanying Q&As (published on 28 April 2023) make it clear that onshore and offshore Swap Connect participants “may” (but are not required to) enter into derivatives master agreements, CDEAs or other agreements recognised by the PBOC for the purposes of Swap Connect. For instance, if the parties have already entered into a CDEA that has been specifically tailored for Northbound Swap Connect (for example, to include and apply “cancellation” as the fallback in the CDEA for rejected transactions), or have otherwise properly documented their mutual agreement regarding the treatment of rejected transactions, then it is not necessary to enter into the SCCDA.
6. 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/NAFMII, CSA, CDEA and Swap Connect 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 “Mainland China”, “onshore” or “PRC” shall be construed as excluding Hong Kong, Macau Special Administrative Region and Taiwan.
Reference
[1] The standard fallback provisions under the CDEA provide for:
(i) continuation of the rejected derivatives transaction as an uncleared bilateral trade if it is not subject to any mandatory clearing requirements; or
(ii) the terminating party having the right, within an agreed period of time, to terminate the derivatives transaction which has been rejected for clearing and to determine the relevant early termination amount taking into account the then-prevailing market conditions.
