China Derivatives Opportunity Further Highlights Endemic Data Problem

By Errol Bong, managing director North Asia at D2 Legal Technology

2022 was a landmark year for institutions looking to increase their presence in China. China’s Futures and Derivatives Law (FDL) placed the enforceability of close-out netting in law, removing a key barrier to the development of the derivatives market in China. This was swiftly followed by the introduction of the Swap Connect clearing house by Hong Kong Exchanges and Clearing Limited (HKEX), representing another key step to allow offshore investors to access the China market. These changes have been welcomed by the over-the-counter (OTC) derivatives market, providing the risk management and certainty required to support a rapid expansion of global participation. However, while ISDA opinions and the FDL recognise the enforceability of close-out netting in Chinese law, the changes have also highlighted additional complexities.

Clearly it should be straightforward to link trades to the right Master Agreement at the point of trade, but this is frequently not achieved due to a lack of data confidence. Within China, for example, should the agreement be linked to a NAAFMI or ISDA Master Agreement?  What changes are required to evolve from bilateral trading to the use of the Swap Connect clearing house and correctly determine the terms applicable?

Ineffective processes for tagging trades to the correct Master Trading Agreements are already widespread. Many firms have unfortunately only tactically solved the problem of trade tagging, looking to do this post-trade and with a lack of accurate and complete client, trade and legal agreement data.  It therefore continues to cause significant problems. How confident are firms that their trade tagging activity is not causing poor resource management (in terms of capital, liquidity and collateral), regulatory reporting and compliance?

This issue is not limited to China, far from it. But the expanding China capital markets trading market simply highlights a problem that firms have consistently failed to address. Errol Bong, managing director North Asia, and Emma Wooldridge & Jack Matthews of D2 Legal Technology, outline the opportunity for legal operations teams to take the lead in resolving this problematic area.

Continued Complexity

China is now a netting friendly jurisdiction. To capitalise on that from a practical perspective, trades need to be allocated to the correct trading master agreement. This is what trade tagging achieves and ensures exposures can be appropriately netted.  

FDL does not specifically reference repo and securities lending, although ISDA’s counsel have interpreted statements from PRC regulators to take the view that repos and securities lending trades are nettable. ICMA’s counsel take the same view in the recent GMRA opinions, that repos and securities lending trades are nettable against PRC institutions. For any institutions using Repo or Stock loan specific Master Agreements, such as GMSLA and GMRA, again, trade tagging should be put in place to allocate trades to the appropriate GMSLA or GMRA to achieve netting on a practical basis.

Essentially, there is still work to be done in order to achieve netting on a practical basis.

Trade Tagging buffeted from one issue to another

The opening up of China is just one more example of the legal agreement data issues facing financial institutions. Trade matching processes need more complete and accurate data – across client, trade, legal agreement and risk data domains – else significant problems will arise.

With larger financial institutions having tens of millions of legacy trades, without highly automated, efficient and accurate trade matching, trade tagging issues are inevitable. There are often genuine reasons for the existence of multiple Master Agreements to counterparties, yet misunderstanding can lead to one or more being incorrectly marked invalid. As can be seen from above, there is often confusion over product coverage of agreements. As a result, institutions not only have large volumes of exceptions that must be manually researched and corrected, but they are creating significant issues in credit risk, liquidity, client assets and money, and regulatory capital reports. 

In an era of heightened regulatory scrutiny and a significant commitment to increasing financial stability through changes such as close-out netting, the lack of data quality is unnecessarily introducing legal risk. Institutions are eroding the very basis of the stability the industry is looking to create by adding complexity and failing to getting the basics of client, agreement or legal data correct.

Opportunity

It is truly frustrating that every time trade tagging issues lead to a problem – such as regulatory fines due to capital or liquidity reporting – institutions opt for a tactical solution to fix one very small part of the data problem. The failure to address trade tagging as a whole, leads to a vicious cycle of fines and tactical remediation.

This is not a problem that can be resolved with a simple algorithm to allocate trades to the correct Master Agreement – the underpinning data sources are too diverse, too numerous and too institution-specific. Best practice is evolving but it will require fundamental redesign of the trade tagging process and a reliance on high-quality data sources. This requires expertise, knowledge and commitment across a wide number of operational areas, including credit and legal, to progress and achieve a golden source of trade data that supports each department’s information needs and view on trade tagging. 

Critically this strategic change must have the support of the legal function. A legal team can evolve from an advisory role to adding tangible business value by taking a strategic approach to data governance, including trade tagging. By resolving this problem at a strategic level, the legal team can minimise an institution’s risk of unknown exposure to business or regulatory issues associated with inaccurate or incorrect close-out netting.

The use of legal agreement, opinion and data standards – such as the clause taxonomies and libraries published now by ISDA, ICMA and ISLA in respect of their respective master agreements can also greatly assist given the presence of sweep-up clauses and specification of product coverage.

Conclusion

The evolution of China as a netting friendly jurisdiction has brought this lack of data accuracy and consistency to the fore again in the context of trade tagging and legal agreement linkage. And no doubt, institutions will implement tactical solutions to address this specific issue. But next month, or next year, the problem will surface again. For how much longer can institutions afford to kick this can down the road before someone takes the initiative and embraces real change?

This is legal data. Legal teams have a key powerful role to play in encouraging the institution to move beyond tactical solutions that have no long-term value and embrace a strategic approach that will reduce risk and improve operational control.