QFI - Negotiating a PRC futures agreement

On 13 October 2021, the China Securities Regulatory Commission (CSRC) announced that starting from 1 November 2021, investors under the Qualified Foreign Investors (QFI) Scheme will be allowed to trade financial derivatives including commodity futures, commodity options, and stock index options, of which trading in stock index options shall be limited for the sole purpose of hedging (the Announcement).

More information on the QFI regime is available on our recently launched China funds insight page, which covers reporting and disclosure obligations of QFI, the basics of QFI application, QFI’s investment into PRC private fund managers and other relevant topics. Comprehensive information about the QFI regimes are also available here, in this overview of the cross border programmes and introduction of the new CSRC QFII measures.

It is expected that the relevant futures exchanges in China will issue implementing rules in the next couple of months, to clarify the scope of eligible commodity futures and options as well as give clarity on other issues such as availability of physical delivery.

In this article, we set out certain important features of the Chinese futures market and highlight a number of noteworthy issues when negotiating a PRC futures and options agreement for a QFI.

• Trading model - In China, the agency model is adopted in relation to futures trading, rather than the principal-to-principal model used in some European markets. Under the agency model, the broker will be acting as agent for the exchange. As such, the fund manager’s counterparty will be the exchange itself (rather than the broker). The broker will therefore be acting as an agent on behalf of its client, with the exchange acting as the central clearing counterparty, as well as trading counterparty. On this basis, the counterparty’s defaulting risks will be low.
• Margin - In China, margin is generally posted as collateral and therefore sufficient margin has to be posted prior to, but not after a trade takes place. Typically, the fund manager will open a futures margin account with a third-party bank, upon which the margin amount will be transferred by the fund. The margin amount will be held by such margin depository bank as opposed to the broker, and ringfenced as the fund’s assets. The amount of margin that is required to be posted to the margin account is subject to negotiation. Many brokers’ standard form agreements will initially state that they can require the fund to provide an unlimited amount of margin at any time, but it is generally possible to include certain parameters and qualifications (for example, funds with stronger bargaining power may be able to negotiate terms that they will only be required to post exchange-required margin, and not incur any additional margin which would otherwise be required by the broker). You will also need to check that the timeframes specified for delivery of margin are achievable and favorable from an operational perspective.
• Forced liquidation - PRC futures agreements will also typically include a right for the broker to initiate forced liquidations under certain circumstances. This is essentially a right for the broker to unilaterally close-out any or all of the fund’s trades if what’s known as the “risk degree” of the fund rises above a certain percentage threshold (typically 100%). There is no uniform framework to calculate such “risk degree”, but brokers will generally publish their calculation methods so to avoid disputes. In these circumstances, the brokers will want the right to make forced liquidation against the fund so as to restore the risk degree to below the percentage threshold. This is a draconian measure, but it is usually possible to negotiate at least some protections for the fund. For example, requiring the broker to first notify the fund manager if the risk degree exceeds a specified percentage and/or give the fund manager more time to respond to a margin call before the right to forced liquidation is triggered.
• Fund manager vs. fund as the contracting party - It is worth noting that in a PRC futures transaction, the contracting party is the QFI licence holder, which is often the fund manager, rather than the fund itself. This is different from the usual position where the fund itself would be the contracting party. This is due to the fact that in China, an open-ended fund is typically not structured to be a distinct legal entity. This is also because the brokers (and other QFI service providers) customarily require to hold the QFI licence holder directly liable (though the QFI’s regulatory obligations and contractual duties are not to be conflated). Therefore it is important to ensure that the QFI is merely acting as the agent, and risks are properly allocated between the QFI, the fund and the broker.
• PRC broker - We have observed that some PRC brokers are generally less accustomed to negotiating trading documents compared to UK or US brokers, and as a result the negotiation process may sometimes be prolonged. However, we have also observed that PRC brokers are generally quite flexible, and particularly for funds in strong negotiating positions, it is likely for the parties to come to a consensus and arrive at terms which are relatively beneficial to the funds.
• Brokerage agreement - In terms of market practice, each broker will have its own standard form of futures agreement and, although they all broadly cover the same grounds, do contain subtle differences with potentially huge implications, and therefore warrant careful review and consideration. If the arrangement involves multiple brokers, it is also worth negotiating these agreements in parallel, so as to reconcile these terms to the largest extent practicable, and procure a set of consistent and more favorable terms in relation to all the brokers.

Summary

The greater accessibility to a wider range of financial derivatives will no doubt enhance the attractiveness of the QFI scheme, and allow the PRC securities and futures market to become more vibrant and robust.

Whilst the market is waiting for further announcements from Chinese futures exchanges, we hope this article can aid you and further your understanding in certain regulatory issues and market practices.

Please note that this article is produced by jointly Simmons & Simmons and Shanghai YaoWang Law Offices.

Should you have any questions or require further assistance regarding any of the above, please do not hesitate to contact us.

Melody Yang
Co-Head, Partner
Shanghai YaoWang Law Offices
T +86 21 8013 5022
M +86 135 2105 2486
melody.yang@yaowanglaw.com