China – Shanghai International Energy Exchange: Direct Trading Access For Overseas Participants.

 

5 October, 2017

 

 

Introduction 

 

After nearly two years of preparation, the Shanghai International Energy Exchange Corporation (“INE”) finally issued its rules (“INE Rules”) to the market in May 2017. As of September 2017, INE has admitted over 150 Chinese futures companies as members and is carrying out offshore registration in key commodity centres with a view to admitting trading members from outside Mainland China. It is now expected that INE’s trading platform will be officially launched within 2017. 

 

Linklaters published a bulletin on INE in April 20151 after the initial release of the draft INE rules. This bulletin has been published for the purposes of updating our bulletin of April 2015 and reflecting changes made in the final INE Rules and further market developments since then. 

 

Background 

 

INE was established in the Shanghai Free Trade Zone in November 2013 as a key initiative to promote Shanghai as Mainland China’s key hub for commodities trading and to provide trading, clearing and delivery services for energy derivatives (such as futures and options over crude oil, natural gas and petrochemical products). To date, INE has been approved by the China Securities Regulatory Commission (“CSRC”) to provide trading and clearing facilities for crude oil futures. 

 

In August 2015, CSRC published the final Interim Measures on the Administration of Overseas Trading Participants’ and Overseas Brokerage Institutions’ Engagement in the Trading of Certain Domestic Futures Products (the “CSRC Overseas Participants Rules”). The CSRC Overseas Participants Rules supplement the general framework for futures trading in Mainland China (as established by the Administrative Regulations for Futures Trading (the “Futures Regulations”)) by providing for how overseas participants may engage in such activities in Mainland China. 

 

The INE Rules are exchange rules governing futures trading on INE. Amongst other provisions, the INE Rules contain membership requirements for onshore and overseas participants. 

 

Trading on INE: Key Features 

 

Overseas participants 

 

In addition to Onshore Members, INE also admits overseas institutions to trade directly on INE as Overseas Participants.

 

The INE Rules provide for two types of Overseas Participants: 

 

• “Overseas Special Brokerage Participants” who trade on behalf of clients; and 
• “Overseas Special Non-brokerage Participants” who trade for their own account. 

 

By admitting Overseas Participants, INE is a pioneer in the implementation of the concept, first introduced in 2012 by the Futures Regulations, of qualified overseas institutions being permitted to trade futures of specified commodities on a futures exchange as a direct participant in Mainland China. 

 

An overseas entity wishing to conduct both proprietary trading for its own account and trading for clients would be interested to note that there appears to be no impediment under INE Rules for it to be admitted as both an Overseas

 

Special Brokerage Participant and an Overseas Special Non-brokerage Participant. 

 

We set out in Diagram 1 below the differences between the different types of onshore and overseas membership. 

 

 

We set out in Diagram 2 below the key eligibility criteria for Overseas Participant. We note that these are marginally more extensive than those for Onshore Members. 

 

 

Overseas clients 

 

An overseas institution or individual who is not a direct participant of INE can trade as a client of (i) an Overseas Special Brokerage Participant or (ii) an Onshore Futures Company through an overseas intermediary in the same jurisdiction as the overseas institution/individual. 

 

The eligibility requirements applicable to overseas clients and onshore clients are very similar. We set out in Diagram 3 below the key eligible criteria applicable to overseas/onshore institutions and overseas/onshore individuals for trading as a client. 

 

 

Clearing with INE 

 

Overseas Participants can trade directly on INE; however, they cannot clear directly with INE and can only clear as clients of Onshore Futures Companies (the Onshore Futures Companies being the clearing members of INE). This is a key difference between being an Onshore Member and an Overseas Participant of INE. 

 

INE as central counterparty 

 

As provided in INE Rules, INE is a central counterparty (“CCP”) and acts as the buyer to every seller and the seller to every buyer. 

 

Segregation of trading positions 

 

Each Overseas Special Non-brokerage Participant and each overseas client of an Overseas Special Brokerage Participant or an Onshore Futures Company will be assigned a unique trading code by INE. All trades entered into by a client will be recorded under such client’s own trading code. 

 

The INE Rules contemplate that certain institutional clients may be required by Mainland China law to segregate different parts of their assets (for example, a fund management company may have to segregate the assets of different funds managed by it) by allowing such clients to apply for multiple trading codes. Although not explicitly provided under the INE Rules and further clarification may be needed from INE, it seems reasonable for such flexibility to apply to Overseas Participants to the extent that equivalent segregation requirements are imposed by foreign law. 

 

Obligations of clearing members 

 

INE Rules provide that Onshore Futures Companies as clearing members of INE are required to settle with INE all trades entered into by its clients, even if the clients default. This suggests that the clearing members will be treated as principal when facing INE. 

 

Margin 

 

Onshore Futures Companies as clearing members are required to post collateral with INE to secure their clearing obligations. Onshore Futures Companies engaging in client clearing will also require its clients to post collateral to secure their clearing obligations. As between INE and the clearing member, the INE Rules provides for the following in relation to margin: 

 

• What collateral will be accepted? Cash, standard warehouse receipts, treasury bonds and other liquid assets approved by INE. 
• How much collateral will be needed? INE can adjust the required level of collateral in accordance with market conditions and clearing members (i.e. the Onshore Futures Companies) will be required to top up their collateral to the extent needed to guarantee performance of their trades. The amount of margin required by an Onshore Futures Company as clearing member from its clients cannot be lower than the amount such Onshore Futures Company is required to post to INE. 
• Would excess collateral be allowed? Clients may wish to pre-fund their margin account from time to time with excess collateral for operational reasons. Settlement between INE and the clearing members will be on a daily basis. It remains to be seen whether clients are allowed to post excess collateral with the clearing members and how such excess collateral would be held by the clearing member. 
• Who owns the collateral? Ownership of the collateral remains with the posting party. Under the rules of the Supreme People’s Court and the State Council (which apply to existing futures transactions), cash collateral is expressly recognised as a “futures security deposit”2 which is protected from the bankruptcy of the collecting party. Under INE Rules, cash collateral provided by the Onshore Futures Companies as clearing members will be protected from INE’s bankruptcy, and cash collateral provided by clients (which include Overseas Participants) will be protected from the bankruptcy of the Onshore Futures Company receiving such cash collateral as clearing member. 
• How will collateral be posted? 

 

• non-cash collateral: a security interest in the form of a pledge will be created over any non-cash collateral. 
• cash collateral: the rules of the Supreme People’s Court and the State Council on “futures security deposit” as applicable to existing futures transactions will apply to INE transactions. Futures security deposits provided by the Onshore Futures Company as clearing member are protected from the bankruptcy of INE; futures security deposits provided by clients are protected from the bankruptcy of the Onshore Futures Company as clearing member. 

 

Default waterfall 

 

Upon any default of a clearing member (i.e. an Onshore Futures Company), INE will be required to apply the funds at its disposal in the following order: 

 

• firstly, collateral of such defaulting clearing member; 
• secondly, risk reserve fund set aside by INE (further rules to be published by INE on how this fund will be sourced and used); then 
• proprietary assets of INE, for which INE will have recourse against the defaulting clearing member. 

 

It is important to note that non-defaulting members will not be required to provide cover for defaulting members of INE. 

It is hoped that INE will provide further clarification to the effect that any collateral posted by a particular client of a clearing member will not be used to cover losses resulting from the default of the clearing member or other clients of that clearing member

. 

Overseas Participants’ exposure 

 

Overseas Participants will not become clearing members and therefore will have no direct exposure to INE. As mentioned above, INE may require additional collateral from a clearing member as a result of marked-to-market movements and such request will flow through to the clients of the clearing member. 

 

Client clearing: segregation and porting 

 

As Overseas Participants can only clear as clients of an Onshore Futures Company, issues in relation to client clearing will be of paramount importance to Overseas Participants: 

 

• Segregation of clients’ collateral: An Onshore Futures Company is required by Mainland China law to segregate client collateral from its own assets. It appears that INE’s intention is to adopt legal segregation with operational comingling of client assets at the clearing member level. 
• Porting of clients’ positions: INE Rules specifically provide that upon the bankruptcy of an Onshore Futures Company (as clearing member), its clients can apply to port their positions to another clearing member. 
• Return of collateral: The Futures Regulations and INE Rules recognise that client collateral does not fall within the bankruptcy estate of the futures company with which it is posted, and that collateral posted with an exchange does not fall within the bankruptcy estate of the exchange. The rules are less clear, however, on the extent to and timing within which a client would be entitled to retrieve collateral posted to INE on the bankruptcy of a clearing member, and whether this will be paid by INE, or by the bankruptcy administrator of the clearing member. 

 

Risk management measures 

 

The INE Rules provide for the following measures in order to mitigate the risks from dramatic price movements and trading member defaults. 

 

• Position limits: trading through INE by each client or Overseas Special Non-brokerage Participant will be subject to position limits determined by INE. 
• Price limit: INE will set cap and floor price limits (by reference to the previous day’s closing price) on the maximum daily range that the price of a contract may fluctuate. 
• Forced trading: if INE determines that market risk has increased or will increase significantly, INE may automatically match uncompleted orders with the positions held by participants who are in the money at the applicable cap/floor price on a pro rata basis. 
• Forced liquidation: INE will be able to liquidate open positions of Onshore Members, clients or Overseas Special Non-brokerage Participants who fail to meet margin calls on a timely basis or commit other breach of INE rules. 

 

It is important to note that INE has the discretion of selecting which positions to liquidate. In the instance where an Onshore Futures Company (as clearing member) defaults on its settlement with INE as a result of a default by its client, INE may regard this as a default by such clearing member for its client account. It is possible that INE may decide to liquidate positions of a non-defaulting client of that clearing member. 

 

• Enforceability of close-out netting: The INE Rules expressly recognise close-out netting between INE and its Onshore Members. This clarification is timely: it has been reported that Mainland China’s national law for futures (the “Futures Law”), which the market expects will confirm the enforceability of close-out netting, is under review by National People’s Congress and is expected to be finalised in the near future. 
• Recognition of finality: INE Rules provide for settlement finality. Under INE Rules, any payment made by INE’s participants and any default management measure taken by INE will be final and irrevocable so long as it was made or taken in accordance with the INE Rules, irrespective of the bankruptcy of a member or the invalidation of the legal status of any asset transferred. The market expects finality and enforceability of INE payments and default management measures to be further confirmed when the Futures Law is passed. 

 

Other observations 

 

Tax 

 

Under Mainland China tax laws, overseas entities are required to pay (i) income tax on any income sourced from Mainland China and (ii) business tax on any profits gained from trading in intangible assets in Mainland China. There is otherwise no separate category of “capital gains tax”. Absent clarification from the tax authorities, profits from INE trades technically will be subject to income tax and/or business tax. Accordingly, it is hoped that the tax authorities will clarify the position that applies to Overseas Participants. 

 

Separately, it should be noted that value added tax for bonded delivery under crude oil futures traded through INE has been expressly exempted by the Ministry of Finance and State Administration of Taxation.3 

 

Funds settlement4 

 

Trades conducted on INE are payable in Renminbi or other currency approved by INE. Overseas Participants and overseas clients may trade on INE’s platform by remitting their Renminbi or foreign currency into Mainland China. All INE participants will be required to open a cash settlement account with an onshore commercial bank. The onshore account bank will provide settlement and currency conversion services to the relevant Overseas Participants and overseas clients pursuant to the actual trading results. Both INE and the relevant onshore account bank will be responsible for reporting the relevant trading, settlement, currency conversion and remittance data to the State Administration of Foreign Exchange. 

 

Physical delivery 

 

Physical delivery will be one of the settlement options, and delivery of warehouse warrants is expected to be accepted as a method of fulfilling the delivery obligation under INE trades. However, warehousing and the use of warehouse warrants in Mainland China could give rise to legal issues and require diligence (please refer to our previous bulletin for further details).5 

 

In light of the instances of alleged fraud in relation to warehouse warrants at the port in Qingdao, it is expected that INE will formulate procedures to protect against warehouse mismanagement and fraud. Such procedures are expected to focus on areas such as licensing of warehouses, maintenance of records, capital adequacy, liquidity, managerial qualities, insurance and bonding cover. 

 

Documentation6 

 

The China Futures Association has published the following template documents: 

 

• template futures clearing agreement to be entered into by an Onshore Futures Company and an Overseas Participant; and 
• template futures brokerage agreement to be entered by an Onshore Futures Company and an overseas entity that is not an Overseas Participant (e.g. an end client or broker). 

 

In such template documents, overseas entities will make a representation on their status and acknowledge to be bound by Mainland China laws, regulations, industry self-disciplinary rules and exchange rules by agreeing to the terms set out in the template agreements. Although there is no mandatory requirement on an overseas entity to follow exactly the same terms as set out in the templates published by the China Futures Association, it might be difficult for an overseas entity to negotiate different terms with an Onshore Member. 

 

Looking Ahead 

 

Given China’s pre-eminent role in the international energy markets, the huge interest generated by the Shanghai Free Trade Zone and the price differential between onshore and overseas energy markets, the establishment of INE as an international trading platform will have considerable significance both globally and regionally. It is expected that the launch of INE will attract many international participants and bring about sweeping changes to the onshore futures market. 

 

Linklaters will continue to monitor further developments on INE, in particular, with respect to any new market developments and the draft Futures Law which may be published for consultation in the near future.

 

2 The corresponding term in Chinese for “futures security deposit” is 期貨交易保證金.  

3 Relevant rules issued the Ministry of Finance and State Administration of Taxation are available here (only in Chinese language). 

4 Rules issued by the State Administration of Foreign Exchange on foreign exchange related issues in connection with INE are available here (only in Chinese language). 

5 Linklaters: Shanghai Free Trade Zone – a powerful springboard to China’s commodities markets 

6 Such template agreements are available here (only in Chinese language).  

 

 

For further information, please contact:

 

Chin-Chong Liew, Partner, Linklaters

chin-chong.liew@linklaters.com