Swap Connect
Swap Connect is the first initiative to open up the onshore China swap market to offshore investors and traders.
China has grown into the world’s second largest bond market after the United States with an eight percent weighting in the Bloomberg Barclays Global Aggregate Bond Index as of 2022. In recent years the Chinese bond market has opened up to offshore investors and traders through CIBM Direct and Bond Connect. Swap Connect allows foreign investors investing in these markets to hedge their interest rate exposure to these investments. Initially, Swap Connect will reference onshore interest rates.
Swap Connect is a trading and clearing mechanism that allows offshore investors and traders to trade derivative interest rate swaps with onshore PRC dealers, reducing credit risk, settlement risk and operational risk – and addressing regulatory requirements to clear interest rate swaps. With a robust clearing system, the China interest rate swap market is now aligned with the rest of the world with regards to OTC derivative risk mitigation measures.
Swap Connect builds on the introduction of China’s Futures and Derivatives Law (FDL) in August 2022. By placing the enforceability of close-out netting in law, the FDL removed a key barrier to the development of the derivatives market in China. This historic moment — which has been hugely welcomed by participants in the over the counter (OTC) derivatives market — provides the risk management and certainty required to support a rapid expansion of trading volumes in the onshore market and participation of global players that wish to trade onshore.
Swap Connect has been built by Hong Kong Exchanges and Clearing Limited (HKEX), through its clearing subsidiary OTC Clear, in partnership with China Foreign Exchange Trade System (CFETS) and Shanghai Clearing House (SHCH). OTC Clear uses a principal-to-principal clearing model which would be familiar to offshore traders who currently clear swaps using London Clearing Houses’ (LCH) Swap Clear. It is the connection between OTC Clear and the Shanghai Clearing House created by Swap Connect that is key to allowing offshore investors to access the China market since offshore investors can clear and settle offshore with OTC Clear while onshore dealers can clear and settle with the Shanghai Clearing House.
The clearing mechanism is key to providing investors with confidence in the OTC derivatives market within China. It also provides a familiarity of method that will enable consistent trading models globally and will ensure that offshore traders can address regulations from their home jurisdiction which require these types of derivatives to be cleared through a central clearing counterparty.
Challenges to address
Development of proper agreements and processes to support segregation of assets is a key objective that needs to be completed before launch date. In order for the clearing members and all the parties to get the right RWA (Risk Weighted Assessment) treatment, it is essential to ensure that margin posted by traders to the clearing members and by clearing members to the clearing house is properly protected if a clearing member becomes insolvent or a central clearing counterparty becomes insolvent. This in turn requires legal agreements to make clear that such margin is properly segregated from the clearing member and central clearing counterparty’s assets. The legal agreements then need to be mirrored in the operational set up.
The China market is taking progressive steps to open itself up and Swap Connect is another milestone that will enable global investors to increase their participation in the market. D2LT has experience with that and can help offshore traders and clearing members navigate their path to taking advantage of the opening up of the derivatives market in China. This will include ensuring that the correct agreements are established and legal analysis is performed.
Conclusion
Swap Connect is an important and welcome initiative, aligning the Chinese swap market with the rest of the world with regards to OTC derivative risk mitigation measures. Great strides have been made in implementing the infrastructure to support this. However, equally key to investor confidence will be ensuring a focus on agreements, processes and legal analysis.
By Errol Bong, managing director and head of North Asia at D2 Legal Technology (D2LT) – errol.bong@d2legaltech.com