China’s First Ever Law on Futures and Derivatives: Implications for Foreign Investors

China’s Futures and Derivatives Law (FDL) is a historic development and follows the gradual liberalization of the country’s financial services sector. It will come into force August 1, this year, and enable foreign players to apply for regulatory licensing to advertise, promote, and sell futures products in the country. The FDL also recognizes single stock futures and close-out netting in the Chinese futures market.

The Chinese government has called for further improvement in the development and supervision of the country’s futures and derivatives market.

Approved during a meeting of the Standing Committee of the National People’s Congress, the new Futures and Derivatives Law of the People’s Republic of China (FDL) is the first of its kind since the very beginning of futures and derivatives trading in the country about three decades ago. According to the legislation, which will take effect on August 1, 2022, foreign enterprises will have to seek regulatory licensing to advertise, promote, and sell futures products in the country.

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The China Futures Association reported that transaction volume hit 7.5 billion lots in 2021, with the overall trading value peaking at RMB 581.2 trillion (US$90.8 trillion) – an all-time high. Specifically, China has become the leading global futures market for agricultural, nonferrous metals, coal, and steam coal items.

It is imperative for foreign stakeholders to understand both the development and regulatory setting of China’s futures and derivatives market, as it gains a significant foothold both home and abroad.

China’s Futures and Derivatives Law – highlights for foreign investors

The FDL approved on April 20, 2022, is composed of 155 articles divided into 13 chapters. The China Securities Regulatory Commission (CSRC) reported that the law will be used to serve the real economy, control financial risks, and deepen financial reforms. It does so by mandating three objectives:

• Setting out a comprehensive legal framework within the PRC underpinning futures and derivatives trading, settlement, and clearing
• Introducing reporting requirements for derivatives
• Strengthening regulations of marketing run by foreign institutions in China

The FDL establishes a much-needed legal framework for cross-border futures and derivatives trading, potentially expanding the sector’s appeal to overseas investors. Foreign investors in China’s mainland financial markets have long complained about a lack of hedging and derivatives tools that would help them better manage risk. China has been hesitant to grow its derivatives market and allow international investors to join, but the process has accelerated in recent years.

As foreign entities will now need regulatory approval to advertise and promote futures goods in China, we recommend paying attention to the following legal changes and practices.

How will the FDL regulate the futures and derivatives market in China?

The law mandates regulations for derivatives exchanges, settlement institutions, and industry groups. For example, it requires futures and derivatives exchanges to get regulatory clearance before beginning operations. Financial institutions are also required to apply for approval before the start of derivatives-trading operations that are not limited to futures.

Illegal activities, such as insider trading and market manipulation, are punishable under the new law – an individual or entity found guilty of manipulating futures or derivatives markets might face penalties of up to US$1.5 million, or 10-times the value of their illegal gains. Similarly, those engaging in inside trading will be fined up to US$700,000, or 10-times their unlawful profit.

Single stock futures and close-out netting

In a critical development, the FDL legally recognizes the practices of single stock futures and close-out netting in the futures market.

The first refers to the stipulation of a futures contract between two parties, in which the buyer promises to pay a specified price for 100 shares of a single stock at a predetermined future delivery date. The latter is a procedure that involves terminating contractual commitments with a defaulting party and merging positive and negative replacement values into a single net payment. Both these practices are favorable for foreign investors, as they conform to international standards and ensure a certain level of protection from related risks.

Similar protection will be also granted to cleared derivatives, with both direct and indirect futures marketing activities by foreign institutions inside China being subject to regulatory approval.

Moreover, foreign investors will be glad to hear that, under the FDL, close-out netting and filing requirements have been decoupled:

• Article 32 of the FDL clarifies that where derivatives transactions are subject to a master agreement, the master agreement, together with all supplements and other confirmations thereto, shall be deemed as a single agreement, without reference to the Filing Requirement.
• The Filing Requirement is expressed as a separate mandate in Article 33 of the FDL, which states that the master agreement and other template contracts referred to in Article 32 must be submitted in compliance with the appropriate authorities’ requirements.
• Article 35 states that derivatives transactions performed in compliance with the legislation can be closed out on a net basis upon the occurrence of agreed events and abiding by the relevant conditions of the applicable master agreement. The enforceability of close-out netting is not affected (stayed, annulled, or revoked) by any party’s filing for bankruptcy.

Marketing activities

Under the FDL, unless approved by CSRC, foreign institutions are prohibited from conducting marketing, promotion, and solicitation activities related to futures (exchanges or brokers) in China (or set up a branch to do so). The legislation further clarifies that, Chinese institutions equally need to be approved by the CSRC to carry out such activities on behalf of a foreign institution. These restrictions must not be violated by any entity or individual.

Trade reporting

The FDL calls for the creation of trading databases, which will be in charge of gathering, storing, analyzing, and maintaining information on informal derivatives transactions. Specific trading repository regulations will be issued separately.

Cleared derivatives

Close-out netting can be carried out in accordance with the law where an approved settlement institution (such as a clearing house) serves as the central counterparty for conducting centralized clearing, and is not stayed, invalidated, or revoked by the entry into bankruptcy proceedings by any party participating in the central clearance. Furthermore, any cash or securities involved in this procedure will be utilized only for settlement and clearance and will not be used for any other purpose.

The backstory of China’s futures market and regulatory development

The China Zhengzhou Grain Wholesale Market opened in Zhengzhou, Henan Province, in October 1990, marking the introduction of futures trading in China. Following two decades of expansion, China’s commodities futures market has grown to become one of the worlds’ largest. By the end of 2011, the country boasted 29 futures contracts, covering more than 10 commodities – such as corn, wheat, copper, steel, and others, with a total trading volume of more than US$44 billion.

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Historically, the Chinese government has always implemented strict regulations to keep foreign capital out of its financial sector.

However, the country has implemented several financial liberalization initiatives in recent years, allowing international investments to flow into Chinese futures businesses. The first joint venture futures firm in China was established by ABN AMRO and Galaxy Futures Co., followed by JPMorgan Chase and Zhongshan Futures Co. Ltd., while Goldman Sachs sought to acquire Qiankun Futures Co. Ltd. shares.

Today, China hosts four futures exchanges, namely, The Zhengzhou Commodity Exchange (ZCE, founded in 1993), the Dalian Commodity Exchange (DCE, founded in February 1993), the Shanghai Futures Exchange (SHFE, founded in 1999), and the China Financial Futures Exchange (CFFEX, founded in Shanghai in 1999).

Regulatory developments

The country’s leading securities and futures regulatory regulator, the CSRC, announced a set of new regulations in 2014 – the Opinions of Promoting the Healthy Development of the Capital Markets (alternatively called New Nine Directives) with the goal of launching pilot programs to facilitate overseas trading by domestic entities, as well as a regulatory framework for permitting foreign investors to access to China’s futures market.

Up to that moment, these markets had been largely off-limits to traders and investors based outside of China. While the Chinese authorities had created some openings, allowing a small number of joint ventures between foreign brokers and local firms, and permitting certain qualified foreign investors to use the stock index futures market in places such as Shanghai, it had still been very difficult for foreign entities to breach in. Hence, the 2014 regulatory framework was a true game changer.

In the same year, the four mainland exchanges transacted 2.5 billion contracts across 38 commodity futures and two financial products, securing a spot in the top 20 derivatives exchanges for transaction volume worldwide.

Ever since, China has been working on its first legislation that matches international norms to enhance oversight of the futures and derivatives market on the one hand, while seeking to attract more foreign investors, on the other.

Another milestone in the development of China’s futures market law came in January 2020, when the government relaxed restrictions on foreign ownership of futures enterprises.

This happened because of two main reasons:

• First, in response to demand from overseas institutional investors, Chinese regulators had committed to developing the derivatives market and providing new products. Thus the government needed to put in place some further regulations. S
• Second, several high-profile incidents were responsible for riling China’s financial derivatives industry, including Bank of China Ltd.’s failed speculation on a paper crude product launched in 2020 – a derivative based on crude oil futures that resulted in massive losses for individual investors during the global oil price drop.

All these factors combined led to the drafting of a regulatory document in 2021 that had been 30 years in the making, and eventually resulted in the FDL.

China’s futures and derivatives market – looking ahead

The finalization of the FDL has paved the way for significant changes in China’s futures and derivatives market. Market players should consider compliance steps, according to the new regulations, to carry on investments within the legal framework.

The articles contained in the FDL are a clear indicator of the determination of Chinese regulators to tighten control over direct and indirect marketing activities by foreign institutions inside the country. Furthermore, in line with these principles, the State Council will design and adopt specific rules to control and oversee derivatives trading and related activities. There are also indications that PRC regulators may enact domestic laws requiring forced margin exchange for derivatives.

Although it remains to be seen what effect this new law will have on the market, the upward growth trajectory of China’s futures and derivatives sector is bound to continue.

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