31 January, 2017
Introduction
On 23 September 2016, the National Association of Financial Market Institutional Investors (“NAFMII”) published a set of pilot rules governing credit derivatives products (the “Pilot Rules”), a circular for each of the four specific types of credit derivatives products contemplated, and a set of credit derivatives key terms and application rules (the “2016 Definitions”) serving as product definitions for NAFMII credit derivative transactions. The publication of these documents was intended to revitalize the credit derivatives market in China, which was initially launched nearly six years ago in 2010.
1 FOUR TYPES OF CRM INSTRUMENTS
The Pilot Rules referred to credit derivative products generally as “credit risk mitigation instruments” (“CRM Instruments”). This terminology is similar to that used in 2010 and is reflective of NAFMII’s intention to emphasize the risk management functions of these instruments. Two categories of CRM Instruments are contemplated under the Pilot Rules: CRM agreements and CRM certificates.
1.1 CRM agreements – Contract & CDS
Two types of CRM Instruments fall under the CRM agreements category: (i) Credit Risk Mitigation Contract (“Contract”) and (ii) Credit Default Swap (“CDS”). The Contract is not an entirely new product type: NAFMII introduced the Contracts back in 2010. However, with the proximity in time between the introduction of credit derivatives in China in 2010 with the global financial crisis, NAFMII intentionally avoided using the term “credit default swap” as that carried a negative connotation. It is interesting that now in 2016, NAFMII seems to consider it appropriate to formally introduce CDS into the Chinese financial market.
Under a Contract, the protection seller offers credit protection over a specific reference obligation. Under a CDS, the protection seller gives protection over one or more reference entities and the protected obligations are determined by reference to the obligation categories and obligation characteristics as would be further defined in the 2016 Definitions.
Both the Contract and CDS are bilateral over-the-counter derivatives which have to be documented under the NAFMII Derivatives Master Agreement (the “NAFMII Master Agreement”).
1.2 CRM certificates – Warrant & CLN
Two types of CRM Instruments fall under the CRM certificates category: (i) Credit Risk Mitigation Warrant (“Warrant”) and (ii) Credit Linked Note (“CLN”).
Warrant was quite an innovative instrument when it was firstly introduced by NAFMII in 2010. Under a Warrant, the Warrant issuer sells credit protection to Warrant holders. Holders of Warrant can transfer the Warrant by secondary trading via specially modified NAFMII derivatives agreements.
In contrast, a CLN provides the opposite exposure. The CLN issuer is the protection buyer and CLN holders are protection sellers. Both the Warrant and the CLN, once created and issued, are transferable and a holder is entitled to exercise claims against the issuer in accordance with the terms of the instrument.
Such transferability distinguishes them from bilateral CRM agreements and hence the term “certificate” is used to illustrate such key characteristic. It is also likely that because of the transferability, creation of CRM certificates is subject to more risk control parameters prescribed by NAFMII in the Pilot Rules and the relevant circulars.
2 NAFMII SUPERVISION
2.1 Who can trade – primary dealers and general participants
All members of NAFMII, after submitting their internal operation guidelines and risk management systems to NAFMII for filing, can trade CRM Instruments. They are categorised as “general participants” and “primary dealers”.
Primary dealers: The Pilot Rules specify that financial institutions and qualified credit enhancement institutions are primary dealers, so these include banks, securities companies, insurance companies, other banking and non-banking financial institutions, and China Bond Insurance Co., Ltd. Primary dealers can enter into CRM Instruments with any NAFMII member as counterparty, and only those primary dealers satisfying certain prudential criteria may act as issuers of CRM certificates.
General participants: Non-financial institutions, and financial products which are not independent legal persons (e.g., wealth management products, trust plans, private placement products) are general participants. The Pilot Rules specify that general participants can only trade CRM Instruments with primary dealers. It is not clear whether it is indeed the intention that a general participant, if holding a Warrant or CLN, can only find potential purchasers among primary dealers and not other general participants.
2.2 Condition to issuance – CRM certificates by prior registration
CRM certificates consist of Warrants and CLNs, and once a CRM certificate is “created”, that instrument can be subsequently transferred between market participants on the interbank market; thus it is like the primary issuance and secondary trading of securities.
Because of this securities-like feature, the Pilot Circular limits eligible issuers of CRM certificates to those primary dealers who are accredited by NAFMII Financial Derivatives Professional Committee (the “Committee”) to have satisfied certain standards and criteria. The quantitative criteria is having net assets of no less than RMB4 billion (note that an accredited primary dealer can issue CLNs via its special purpose vehicle entities), and there are some other qualitative prudential criteria as well.
Each time before an accredited primary dealer issues a Warrant or a CLN, the issuer must submit product creation filing materials to the NAFMII Secretariat Office (the “Secretariat”).
In contrast, market participants who are already become NAFMII members are not subject to additional quantitative or qualitative criteria in order to transact a Contract or a CDS, and these two CRM agreements are not subject to a prior filing requirement with the Secretariat.
2.3 Limitation on risk exposure
The net aggregate amount of credit protection that is sold by a general participant shall not exceed 100% of its net assets, or 100% of the product size (where the general participant is not a legal person). For a primary dealer, the limit is set at 500% of its net assets.
Specifically in relation to a particular reference obligation, the aggregate protection offered by Warrants available on the NAFMII market shall not exceed 500% of the outstanding obligation amount, and each individual NAFMII member may not hold an outstanding buy or sell position in excess of 100% of the outstanding obligation amount.
NAFMII members are not allowed to enter into self-reference credit derivatives transactions. They can trade credit derivatives over affiliated entities, but must provide adequate disclosure, and shall file quarterly report to NAFMII throughout the term of such transactions.
A Step Further: NAFMII Publishes Pilot Credit Derivatives Rules and New Credit Derivatives Definitions 3
3 DOCUMENTATION
3.1 2016 Definitions
(a) General
The 2016 Definitions are based broadly on concepts and mechanisms similar to those used in the 2014 ISDA Credit Derivatives Definitions (“2014 ISDA Definitions”) and contain a number of important updates from the Credit Derivatives Transaction Definitions Booklet (2012 version) (the “2012 Definitions”) published by NAFMII (which was suspended from use by NAFMII in 2013).
The 2016 Definitions comprise two parts: (i) definitions and (ii) rules of application in respect of the definitions. The definitions set out the basic terms to be used in a credit derivatives transaction and their meanings. The rules of application set out how particular definitions are to be interpreted and applied.
If the parties to a transaction elect to use a particular definition, they will be deemed to agree to the rules of application of that definition (including any amendments and supplements thereto). Whilst the definitions will remain unchanged, the rules of application are subject to amendment or supplement by NAFMII from time to time according to market development and feedback. Therefore, if the parties do not intend for such future amendments and supplements to apply to a transaction, they should expressly carve them out in the transaction document.
It should be noted that the rules of application, in its present form, lacks operational details on important features such as auction settlement and determination of credit events.
The parties to a transaction may amend the rules of application of a particular definition in the transaction document or specify rules of application which are different from those in the 2016 Definitions.
(b) Key Features
Obligation Categories and Obligation Characteristics
The 2016 Definitions set out a list of Obligation Categories and Obligation Characteristics which are broadly similar to those in the 2014 ISDA Definitions. Interestingly, the 2016 Definitions provide that both concepts are “open-ended” terms in that the parties are free to agree on additional Obligation Categories or Obligation Characteristics, provided that such Obligation Category or Obligation Characteristic is legal and enforceable under the applicable laws and can be described clearly and in sufficient detail.
Since the 2016 Definitions define Deliverable Obligation Categories and Deliverable Obligation Characteristics by reference to Obligation Categories and Obligation Characteristics, the open-ended feature is effectively extended to Deliverable Obligation Categories and Deliverable Obligation Characteristics.
Such open-ended feature will no doubt provide greater flexibility to users but it could potentially give rise to uncertainty and dispute if a new category or characteristic is not described in sufficient detail or lacks legal validity or enforceability. It is also unclear whether, if parties were to bilaterally specify additional Deliverable Obligation Categories or Deliverable Obligation Characteristics, this will take it out of Auction Settlement. It would be interesting to see how the market will respond to this feature.
Credit Events
The 2016 Definitions contain a list of Credit Events fairly similar to those in the 2014 ISDA Definitions. However, the 2016 Definitions do not have Credit Events which are equivalent to the Repudiation/Moratorium or Governmental Intervention events in the 2014 ISDA Definitions. In addition, the 2016 Definitions has no equivalent concept of M(M)R Restructuring in its Restructuring Event.
Settlement Mechanisms
There are three possible settlement methods in the 2016 Definitions: (i) cash settlement, (ii) physical settlement and (iii) auction settlement.
Cash settlement: If Cash Settlement is elected, the Seller will be required to pay the Buyer the relevant Cash Settlement Amount calculated in a manner similar to the Cash Settlement Amount in the 2014 ISDA Definitions. The value of the Reference Obligation is determined through a dealer poll mechanism but the 2016 Definitions does not provide for valuation using the average price on multiple Valuation Dates.
Physical settlement: In terms of Physical Settlement, the principal amount of the Deliverable Obligations that must be delivered is not as clearly defined as the Outstanding Principal Balance concept in the 2014 ISDA Definitions in that it does not seem to take into account any possible deduction due to set- off, counterclaim or defence that may be asserted by the Reference Entity.
Auction settlement: Auction settlement is one of the most important additions in the 2016 Definitions. Whilst auction settlement was alluded to when NAFMII launched credit risk mitigation instruments in 2010, it was never included in the 2012 Definitions. However, the 2016 Definitions only gave us a preview of auction settlement as only the definitions are available for now with the relevant rules of application to be published separately.
The definitions relating to auction settlement suggest that there will be determination panels formed under NAFMII’s Financial Derivatives Professional Committee, which will presumably function in a way similar to ISDA’s Credit Derivatives Determinations Committees. In addition, review panels will be formed to review any matters unresolved by a determination panel. Any decision made by a review panel will be final and binding. The secretariat formed by the staff of the secretariat of NAFMII will act as the auction administration body.
International Features
The 2016 Definitions are intended to be used primarily by China’s domestic entities on the domestic market. A number of international features have however been built in which enable credit protection to be written on non- domestic entities.
For instance, the parties are free to elect non-China Reference Entities and Reference Obligations which are denominated in foreign currencies. If so elected, in order to determine the occurrence of a Credit Event, the parties will look to the major international news media specified in the 2016 Definitions as the Sources of Publicly Available Information. Similarly, for the purposes of determining the threshold amounts that trigger certain Credit Events, foreign currency amounts will be converted into Renminbi using the exchange rate published by China Foreign Exchange Trade System.
3.2 CRM Contracts and CDS
CRM Contracts and CDS will be documented under the NAFMII Master Agreement. The 2016 Definitions set forth in its schedule a template confirmation to be used for CRM Contracts or CDS. Auction settlement is not yet included in the template confirmation as a settlement mechanism as the rules for auction settlement have yet to be finalised.
According to the CDS Business Guidelines, for a CDS transaction, the parties must at least elect Failure to Pay and Bankruptcy as the relevant Credit Events and may consider including such other events as Obligation Acceleration, Potential Obligation Acceleration and Restructuring.
3.3 Warrants
Warrants are to be documented under the NAFMII Financial Derivatives Master Agreement (Certificate Version) (the “Certificate Master Agreement”).
The Certificate Master Agreement contains two parts: general terms and special terms. The general terms are identical to the NAFMII Master Agreement without its supplement. The special terms contain provisions that reflect the unique features of Warrants as a negotiable instrument.
Unlike the bilaterally executed NAFMII Master Agreement, the Certificate Master Agreement adopts a multilateral execution approach. Each market participant will sign a Certificate Master Agreement and deposit an executed copy with NAFMII. The effect of this is that as between the issuer and holders of the same series of Warrants, there is one unified contractual relationship between the issuer and the holders, and among all holders inter se. This unified contractual relationship helps to ensure that Warrants are fungible and are freely transferrable on the interbank market.
An issuer of Warrants is required to prepare an issue prospectus and a disclosure document in connection with an issue of Warrants, both of which are to be registered with NAFMII. The issuer will be responsible for the truthfulness, accuracy and completeness of any disclosed or registered information and will be liable for fraud or misstatement. The issuer also has an on-going obligation during the life of a Warrant to disclose rating, financial and other information on the designated platform.
3.4 CLNs
To facilitate the issue of CLNs, NAFMII has provided some sample CLN terms and conditions in schedule 5 to the 2016 Definitions. Those terms and conditions are not mandatory and market participants are free to amend or supplement them as necessary.
In respect of an issue of CLNs, the issuer is required to register a suite of documents with NAFMII similar to those for Warrants. In addition, the issuer is required to prepare and register a risk disclosure statement which can be a standalone document or part of the issue prospectus. The issuer of CLNs will be liable for fraud or misstatement in any of the disclosed or registered documents.
4 LOOKING FORWARD
The publication of the Pilot Rules and the 2016 Definitions is a welcome development in China’s credit derivatives market. Despite the launch of credit risk mitigation instruments back in 2010, China’s credit derivatives market remains dormant.
As we are seeing more instances of loan and bond defaults in China, hopefully these new rules and products can revitalise the credit derivatives market and provide much needed credit risk hedging tools in the domestic market.
For further information, please contact:
Chin-Chong Liew, Partner, Linklaters
chin-chong.liew@linklaters.com
