What are credit risk mitigation instruments (CRMI) and CRMC?
A CRMI is defined as a credit risk mitigation agreement, certificate or other simple and basic credit derivative product for the purpose of managing credit risk. A CRMI is therefore essentially a credit derivative product. The emphasis on the CRMI being "simple and basic" is intended to distinguish it from more complex credit derivative products such as CDOs, CMBS or SIVs, the names of which became notorious during the financial crisis.
A CRMC is a transferable certificate to be issued by an entity other than the Reference Entity which provides credit protection to the certificate holder for the Reference Obligation. Therefore, the issuer of a CRMC will be the protection seller and the holder is the protection buyer. It is the reverse of a credit linked note where the note issuer is typically the protection buyer and the holder is the protection seller.
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Risk Ratios
In an effort to control the size and manage the risk of the credit derivatives market, NAFMII has included in the Guidelines the following risk ratios within the parameters of which the CRMI market should develop.
* The net (principal) amount of CRMI purchased by any Dealer of any Reference Obligation may not exceed 100% of the net outstanding amount of such Reference Obligation;
* The net (principal) amount of CRMI sold by any Dealer of any Reference Obligation may not exceed 100% of the net outstanding amount of such Reference Obligation;
* The net (principal) amount of all CRMI sold by any Dealer may not exceed 500% of its registered capital or net assets; and
* The overall outstanding (principal) amount of all CRMC in respect of any Reference Obligation may not exceed 500% of the net outstanding amount of such Reference Obligation.
Such ratios would be monitored closely through the data collected through filing with NAFMII and (where traded on such system) by the trading system.
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What is the Reference Entity and the Reference Obligation?
A Reference Obligation can be a bond or any other similar debt obligation, presumably including loans. The obligor of the Reference Obligation is the Reference Entity.
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Who can buy or sell CRMI?
Essentially all participants of the Interbank Market. However, they are divided into three categories.
A Key Dealer will be able to enter into a CRMI with any other market participant without limitation for the purpose of the transaction. A Dealer can enter into a CRMI with any other dealer (including a Key Dealer) for its own business needs. Any other market participants must enter into a CRMI with a Key Dealer and it must be for hedging purposes. It is not entirely clear whether "own business needs" is a concept similar to "hedging purposes", though we suspect that it will be narrowly interpreted to be similar to hedging, at least initially.
There are various eligibility criteria set down for Key Dealers and Dealers, including a requirement that the relevant entity's registered capital should be no less than RMB 4 billion (in the case of a Key Dealer) and RMB800 million (in the case of a Dealer). Key Dealers will need to be approved by the NAFMII Financial Derivatives Committee (the Committee) and registered with PBOC, whilst Dealers will only need to register with NAFMII. The Committee comprises the heads of business of leading financial institutions. The selection process is subject to a set of rules separately administered by NAFMII.
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Who can be an issuer of CRMC?
There are eligibility criteria set out for an issuer of CRMC, including a requirement that its registered capital should be no less than RMB 4 billion. A Key Dealer or a Dealer may register with the Committee to become an eligible issuer.
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What is the process to issue CRMC?
Issuance of CRMC will be subject to registration with NAFMII, which is essentially an approval process by a NAFMII Financial Derivatives Specialists Meeting where five specialists will determine whether to accept unconditionally, accept with conditions or postpone the issuance. The Guidelines set out the selection process of the specialists.
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What is the purpose of the NAFMII Master Agreement (CRMC version) and how does it interact with the NAFMII Master Agreement (2009) and the credit derivatives definitions?
In March 2009, NAFMII published the NAFMII Master Agreement (2009) which must be used when interbank market participants enter into financial derivative transactions in the PRC. Financial Derivative Transactions are defined to include, among others, credit derivative transactions. Credit derivatives definitions are also included in the suite of 2009 NAFMII documentation.
Why another Master Agreement? The thinking is that, where CRMC are issued to more than one holder, it would be desirable that the close-out mechanism, upon the occurrence of an event of default or a termination event of the issuer, is standardised for all CRMC holders. There should be a single decision as to whether the CRMC should be terminated and, if so, on which date. There should also be a single method of calculating the termination amount which would be applicable to all CRMC holders. Therefore the NAFMII Master Agreement (CRMC version) has incorporated a set of Special Terms (equivalent to a Schedule to the ISDA Master Agreement) which standardises the close-out and valuation process under these circumstances. A process similar to a bondholders' meeting is envisaged. The valuation method will be the Replacement Transactions Method which is similar to the calculation of the close-out amount under the 2002 ISDA Master Agreement. These standard Special Terms will not, however, apply to CRMC where there is only one holder or any event of default or a termination event of the holder.
A market participant must sign the NAFMII Master Agreement (CRMC version) in order to conduct CRMC business. The parties to the CRMC version may supplement the standard Special Terms but may not amend the substance of the existing standard Special Terms. Market participants can sign the CRMC version in a way similar to adhering to an ISDA protocol. All CRMC transactions between two market participants will be covered by the CRMC version rather than the standard NAFMII Master Agreement (2009). The commercial terms of each issuance of CRMC will be separately documented and published by the issuer which will form a transaction under the CRMC version. The NAFMII credit derivative definitions are expected to be incorporated into the commercial terms of the CRMC.
Two issues come to mind. First, would having two master agreements reduce the benefit of close-out netting? Admittedly, yes. However, it is felt that, given the uncertainty of the recognition of close-out netting under PRC law and the nature of the CRMC, the benefit of having a clear CRMC framework probably outweighs the disadvantage. Secondly, would the current NAFMII credit derivative definitions be adequate for the job? Though some technical fine-tuning may still be necessary, the current definitions are probably sufficient for a Reference Obligation Only and physically settled CRMC where the Reference Obligation is a bond, which are probably the type of CRMC that are perceived as most suitable for the pilot stage of the credit derivative business in China.
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Basis Risk
Given the divergence in documentation, there will be basis risk for any party who wishes to offload their position under standard ISDA documentation, mostly likely through a cross-border transaction. However, the uncertainty remains regarding to what extent the regulatory framework under PRC law would permit such cross-border transaction. The jurisdiction of the State Administration of Foreign Exchange as well as the China Banking Regulatory Commission (CBRC) will need to be considered.
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CBRC
Since the inception of the CRMI pilot project, the attitude of CBRC has been the centre of market attention not least because it regulates the largest derivative dealers (ie banks) in China. On various public occasions, senior CBRC officers were quoted to show support for the development of the credit derivatives market in China, though a "cautious approach" has always been one of the key messages. The derivative rules (which were first promulgated in 2004) governing the derivative business of banking financial institutions in China are now going through a new round of revision. Market participants have been consulted and various drafts circulated. The new rules are likely to have a significant impact on the pace of the development of the CRMI pilot project and the overall credit derivatives market in China.
Despite the uncertainty, it is expected that CRMI may start trading as early as the end of this week. The market in China may again, as it has done many times in the past decade, leap ahead of the legal draughtsman and go its own way.
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