Chinese mainland's Opening-up Outlook for 2024: PBoC Further Opens Up the Bond Repo Market to Foreign Investors

Authors: XIE, Qing (Natasha)、ZHANG, Chi (Austin)、Danchen LUO

In recent years, there has been growing demand from foreign institutions to participate in bond repurchase transactions ("bond repos") in Chinese mainland to satisfy their liquidity management needs. This has been in tandem with the further opening-up of Chinese mainland's bond market, which has attracted an increasing number of foreign institutions and investments. In response to market demand, on January 24, 2024, the PBoC together with the State Administration of Foreign Exchange ("SAFE"), released the Circular Concerning Further Support for Foreign Institutional Investors to Engage in Bond Repurchase Business in the Interbank Bond Market (Consultation Paper) (the "Draft") and the corresponding Drafting Notes, to enhance the attractiveness of Chinese mainland's bond markets. Here are the main points that concern foreign investors:

I. Application Scope

Currently, foreign investors can trade in Chinese mainland's interbank bond market ("CIBM") through three channels, namely, (a) QFII/RQFII regime (collectively, the "QFI"), (b) direct investment in the CIBM (the "CIBM Direct"), and (c) northbound trading through Bond Connect. Among these, only overseas central banks / monetary authorities, international financial organizations, sovereign wealth funds, overseas RMB clearing banks and participating banks (collectively, "Sovereign Institutions") can participate in Chinese mainland's bond repos through the CIBM Direct. The Draft now permits all foreign institutional investors who have already carried out bond trading in the CIBM to carry out bond repos in the CIBM. This means that, in addition to Sovereign Institutions, all types of financial institutions such as foreign commercial banks, insurance companies, securities firms, fund management companies, futures companies, trust companies, and other asset management companies, as well as other medium- and long-term institutional investors such as pension funds and charity funds (collectively, "Commercial Institutions"), can participate in bond repos in the CIBM. After the Draft is officially issued, qualified overseas institutions under the CIBM Direct regime, qualified overseas institutions under the northbound trading channel of the Bond Connect, as well as QFIs, can participate in bond repos in the CIBM.

II. Participation Mode

The PBoC has authorized the National Association of Financial Market Institutional Investors ("NAFMII") to issue the Master Agreement for Bond Repurchase Business in the Chinese mainland's Interbank Bond Market (the "NAFMII Master Agreement") in accordance with the Circular Concerning the Release of the Master Agreement for Bond Repurchase Business in the Chinese mainland's Interbank Bond Market (PBoC (2012) No. 17). Market participants shall sign the NAFMII Master Agreement when carrying out bond repos in the CIBM and shall file with the NAFMII the executed NAFMII Master Agreement and any supplementary agreements in a timely manner. In practice, Sovereign Institutions have carried out bond repos in the CIBM by signing the NAFMII Master Agreement. After the Draft is officially issued, we understand Commercial Institutions can also carry out bond repos in the CIBM through the aforementioned means, and both parties to a bond repurchase agreement can be foreign institutions.

Bond Connect is a mutual market access scheme that allows investors from Chinese mainland and overseas to trade in each other's bond markets through the interconnection of the bond trading and settlement systems between Chinese mainland and Hong Kong. It adopts market making mechanisms and a multi-tier custodial structure that are common in mature markets, allowing overseas investors to access the CIBM directly with their existing Hong Kong accounts, without the need to go through a local settlement agent. As the nominal bondholder is separated from the actual beneficiary owners under the Bond Connect (that means, foreign investors under the northbound trading channel of the Bond Connect shall hold bonds through the HKMA Central Moneymarkets Unit ("CMU") and enjoy the rights and interests of the bonds purchased through the northbound trading channel of the Bond Connect, while the CMU is registered as a nominal bondholder), detailed implementation measures need to be released by the relevant Chinese mainland and Hong Kong regulatory authorities as to how foreign investors through the northbound trading channel of the Bond Connect can participate in bond repos in the CIBM and exercise their rights under the repurchase agreement through the CMU.

III. Trading Mode

Pursuant to the Draft and the Drafting Notes, foreign institutions can participate in either pledged repos or outright repos in the CIBM, both of which allow the transfer of ownership of bond collateral so as to facilitate the disposal of bond collateral by the reverse repurchase party. Pledged repo is the first, and still the most traded product with the highest trading volume in the CIBM. Under a pledged repo transaction, the bondholder (i.e., the repurchase party) pledges its bonds to the party who provides the financing (i.e., the reverse repurchase party), but the ownership of the bond collateral remains with the repurchase party and held under custody in the repurchase party's account. The pledge comes into effect when registration is completed with the relevant bond registration and depository institution, without the need to transfer the possession or ownership of the bond collateral to the reverse repurchase party. By proposing that both pledged repos and outright repos allow the transfer of ownership to the bond collateral, the Draft intends to align both types of bond repos in the CIBM in common with international market practice (where title transfer repurchase transactions are prevalent). However, this trading mode may deviate from the current practice of pledged repos where the title to the bond collaterals remains in the repurchase party's account with a "pledged" notation so that the bonds are restricted from further disposal. The trading mode of pledged repos needs to be further clarified by the regulatory authorities and relevant financial market infrastructures (i.e., the CCDC and Shanghai Clearing House) in terms of the legal basis for the title transfer and the relevant clearing and settlement arrangements.

IV. Master Agreement

Investors are currently required to sign the NAFMII Master Agreement to participate in bond repos in the CIBM. In contrast, foreign investors are more accustomed to use the Global Master Repurchase Agreement ("GMRA") issued by the International Capital Market Association ("ICMA") to carry out bond repos. CCDC has noticed this demand from foreign investors. To help foreign investors to better understand and familiarize themselves with the NAFMII Master Agreement, the CCDC sets out a comparison of the NAFMII Master Agreement and GMRA in an appendix of the White Paper: Promoting the RMB Bond Collateral to Participating in Global Repurchase Transactions jointly published with ICMA. However, it remains unclear and therefore a concern for foreign investors whether they can carry out bond repos in the CIBM in accordance with their existing or newly signed GMRA.

Article 7 of the Draft stipulates that foreign institutions shall sign a master agreement with their counterparties, and relevant self-disciplinary organizations shall file the master agreement with the PBoC. This provision has reserved space for foreign investors to use the GMRA to carry out bond repos in the CIBM. We believe the relevant regulatory authorities may be flexible in allowing foreign investors to use the GMRA because one of the intentions of the Draft is to enable foreign investors to participate in bond repos in the CIBM easily and without changing their trading habits. In addition, differing from the vague stipulations under Article 33 of the Futures and Derivatives Law ("FDL") that the master agreement for OTC derivatives transactions shall be filed in accordance with the relevant provisions, Article 7 of the Draft makes it clear that the relevant self-disciplinary organizations shall be responsible for filing the master agreements for bond repos in the CIBM. It remains to be clarified by the regulatory authorities whether foreign Commercial Institutions can file their tailor-made master agreements for bond repos in the CIBM with the PBoC.

V. Regulated Entities

Article 5 of the Draft stipulates that foreign financial market infrastructures and self-disciplinary organizations that provide services for foreign institutions to carry out bond repos in the CIBM shall be subject to PBoC's supervision and regulation. We understand that the foreign financial market infrastructure refers to those financial infrastructures in the Hong Kong market under the Bond Connect scheme, while the self-disciplinary organization refers to the domestic self-disciplinary organizations in the CIBM, which are responsible for strengthening the self-disciplinary management of bond repurchase business in the CIBM. Overseas industry associations, such as ICMA and the International Swaps and Derivatives Association ("ISDA"), seemingly do not fall within the scope of the regulated entities if they do not perform self-disciplinary functions, nor do they provide services for bond repos in the CIBM.

VI. The Enforceability of Close-out Netting

During public consultation on the FDL, market participants suggested including the enforceability of close-out netting for bond repos in statute. However, the officially implemented FDL only recognizes the legal effect of close-out netting for OTC derivative transactions. There still lacks a legal basis under Chinese law for the enforceability of close-out netting concerning bond repos and therefore the close-out netting arrangements under an outright repo transaction in the CIBM would still be subject to restrictions provided by the Enterprise Bankruptcy Law. Under a pledged repo transaction, the non-defaulting reverse repurchase party can only dispose of the bond collateral under the same pledged repo transaction by auction, sale or by agreement within the legal framework of the PRC Civil Code but cannot terminate all the outstanding pledged repo transactions with the same repurchase party and then dispose of the relevant bond collateral at the same time. Considering that close-out netting is a necessary mechanism and one of the crucial provisions documented under the GMRA, it is suggested that the relevant regulatory authorities consider recognizing the enforceability of close-out netting for bond repos in the CIBM at a statute level, so as to align Chinese mainland's legal framework with the international practice of bond repos and to allow foreign investors to use the GMRA for bond repos.

Our Observations

In addition to the above contemplated opening-up policy, as a result of the concerted effort of the PBoC and the HKMA, the HKMA recently announced expanding the list of eligible collateral for the HKMA's RMB Liquidity Facility to include RMB bonds issued by the MoF or the policy banks. These measures promote the high-level opening-up of Chinese mainland's bond markets and will be beneficial for foreign investors' RMB liquidity management and cost control. We believe that these measures will encourage the growth of foreign participation and reinforce confidence in asset allocation in Chinese mainland's bond markets.

We will continue to monitor the situation and keep our clients apprised of any important developments.