Front Matter Page

© 2012 International Monetary Fund

April 2012

IMF Country Report No. 12/82

People’s Republic China: Detailed Assessment Report: Observance of CPSS-IOSCO Recommendations for Securities Settlement Systems and Central Counterparties

This assessment report was prepared by a staff team of the International Monetary Fund and The World Bank as part of the 2011 Financial Sector Assessment Program documentation. It is based on the information available at the time it was completed on March 2012. The views expressed in this document are those of the staff team and experts and do not necessarily reflect the views of the government of People’s Republic of China nor the Executive Board of the IMF.

The policy of publication of staff reports and other documents by the IMF allows for the deletion of market-sensitive information.

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Front Matter Page

Financial Sector Assessment Program

People’s Republic of China

Assessment of Observance of CPSS-IOSCO Recommendations for Securities Settlement Systems and Central Counterparties

Detailed Assessment of Observance

March 2012

International Monetary Fund

Monetary and Financial Systems Department

The World Bank

Financial and Private Sector

Development Vice-Presidency East Asia

and Pacific Region Vice Presidency

Contents

• Glossary

• Executive Summary

• I. General

• II. Information and Methodology Used for Assessment

• III. Securities and Derivatives Settlement Systems Infrastructure Overview

  • A. Clearance and Settlement Arrangements for the Interbank Bond Market and Bank Counter Market

  • B. Clearance and Settlement Arrangements for the Stock Exchanges

  • C. Clearance and Settlement Arrangements for the Futures Exchanges

• IV. Main Findings from the Assessment with International Standards

• V. Authorities’ Response

• Tables

• 1. Exchanges Volume and Value Compared to GDP, 2009

• 2. Detailed Assessment of Observance of the CPSS-IOSCO Recommendations for Securities Settlement Systems—OTC Bonds Market-China Government Depositary & Clearing Corporation Limited

• 3. Detailed Assessment of Observance of the CPSS-IOSCO Recommendations for Securities Settlement Systems—Stock Exchanges (SSE, SZSE)-the China Securities and Clearing Corporation Limited

• 4. Detailed Assessment of Observance of the CPSS-IOSCO Recommendations for Central Counterparties—the Shanghai Futures Exchange

• 5. Summary Assessment of Observance of CPSS-IOSCO RSSS—OTC Bonds Market-CCDC

• 6. Summary Assessment of Observance of CPSS-IOSCO RSSS—Stock Exchange (SSE, SZSE)-SD&C

• 7. Summary Assessment of Observance of CPSS-IOSCO RCCP—SHFE

• 8. Recommended Actions to Improve Observance of CPSS-IOSCO RSSS—OTC Bonds Market-CCDC

• 9. Recommended Actions to Improve Observance of CPSS-IOSCO RSSS—Stock Exchange (SSE, SZSE)-SD&C

• 10. Recommended Actions to Improve Observance of CPSS-IOSCO RCCP—SHFE

• Figures

• 1. Market Structure Trading, Clearing and Settlement in People’s Republic of China

• 2. Issuance of Bonds in 2009

• 3. Growth in Settlement Transactions of Bonds (Indexed at 1998)

• 4. Share Value of Trading Volume on the SSE and SZSE from 2001–2009

• 5. Third Party Custodian System Arrangements

• 6. SD&C Settlement Agent Role

• 7. International Derivatives Exchanges Ranked by Volume

• Boxes

• 1. Clearance and Settlement Process for a Typical Transaction (A Shares)

• 2. Shares Clearance and Settlement in Shenzhen Stock Exchange

Glossary

Executive Summary

The Securities Settlement Systems (SSS) in the People’s Republic of China (PRC) are organized around three different types of markets, which are the bond market, the corporate securities market and the futures market. The bond market comprises the interbank bond market, the exchange bond market and the bank counter market. The interbank bond market is the most dominant market, with more than 97 percent of total bond trading volume. The two stock exchanges, the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE), were established in 1990 and offer trading in the same type of securities, being shares, bonds, funds and warrants. Turnover on both stock exchanges is relatively high and has grown tremendously during the last decade. According to the World Federation of Stock Exchanges, as of 2009, the SSE ranks as the 3rd exchange worldwide in share trading with RMB 34 trillion, and the SZSE as the 6th with RMB 18 trillion. There are also three commodities exchanges: Shanghai Futures Exchange (SHFE), Dalian Commodities Exchange (DCE) and Zhengzhou Commodities Exchange (ZCE). The SHFE ranks as the 10th derivatives exchange worldwide, measured in number of contracts traded and the second largest commodity exchange. A financial futures exchange (China Financial Futures Exchange (CFFEX)) was established in 2006 as a joint venture of the SSE, SZSE, SHFE, DCE, and ZCE but still volume and value of transactions are relatively modest.

The China Government Depositary and Clearing Corporation Limited (CCDC) is the SSS as well as the central securities depository (CSD) for bonds. It is the only institution entrusted by the Ministry of Finance (MOF) to be the depository for Government securities. The CCDC was established in 1996 as a Government entity and since then it is regulated by the People’s Bank of China (PBC) and overseen by the PBC and MOF. In addition, the China Banking Regulatory Commission (CBRC) is in charge of the appointment of Executive Managers of CCDC. The CCDC settles bond transactions (spot, repo, forward) on a gross basis for both bonds and funds, though CCDC management is currently considering introducing also a netting facility. Securities are held at the end-investor level in most cases (98 percent). The CCDC book entry system is interconnected with the interbank trading system (operated by the China Foreign Exchange Trading System (CFETS)). Cash settlement takes place in the central bank high value payment system (HVPS). Settlement takes place on T+0 for most transactions (82.9 percent of total value settled in 2009). In addition to the commonly used delivery versus payment (DvP) settlement, CCDC allows for other settlement modalities, Payment after Delivery (PaD), Delivery after Payment (DaP) and Free of Payment (FoP).

The China Securities Depository and Clearing Corporation Limited (SD&C) is the central counterparty (CCP), SSS, as well as the CSD for all instruments traded on the SSE and SZSE. The SD&C was established in 2001 and is jointly owned by the SSE (50 percent) and the SZSE (50 percent). Securities settlement arrangements for SSE and SZSE are based on front-end availability of securities and funds, otherwise transactions do not take place. Securities are held at the investor level detail in the SD&C while funds are kept through a system of third party custodian banks with the SD&C acting as the settlement agent.

The four futures exchanges have their own clearing and settlement departments, which offer the function of a CCP. Settlements can be either in cash (daily mark to market) as well as physical settlements (delivery on expiration). The exchanges operate a pre-margining system, that is, futures contracts can only be purchased under the premise of sufficient margin deposits. In addition to the pre-margining system the exchanges have established other risk management controls including: price limits, limits to speculative positions and large holders, compulsory closed-out of positions, a system of warning indicators, and settlement reserves. Cash settlement is effected through the accounts of five commercial “settlement” banks. The “settlement” banks only operate as custodians for margins and facilitators for transfers of funds with the futures exchanges conducting settlement functions. Also, the China Futures Margin Monitoring Center (CFMMC) was established in 2006 as a non-profit company under the sponsorship of the three futures exchanges to guarantee the safety of futures margin.

The CCDC, SD&C, and SHFE/DCE/ZCE operate important securities and derivatives settlement systems both, due to the large volume and value of transactions (GDP comparison) and the fact that they support key financial sector markets (interbank bond market, stock exchanges and futures). Therefore, the CCDC and SD&C are being assessed below against the 19 Recommendations for Securities Settlement Systems (RSSS) and the SHFE is being assessed against the 15 Recommendations for Central Counterparties (RCCP). The SD&C operates as a CCP for most of the market transactions but given the “unique” features of its settlement process (front-end control of securities and funds) it is being assessed against the RSSS (see Section III.B). The other two commodities futures exchanges, DCE and ZCE, follow very similar settlement procedures to the SHFE, thus, findings and recommendations for the SHFE are also applicable to DCE and ZCE.

The assessment of the bonds market-CCDC system against the RSSS concludes that the system observes (observed or broadly observed) thirteen of the 19 recommendations, being one not applicable. However, there are improvement opportunities in several areas:

• Legal foundation: undertake an overall review of the legal and regulatory framework to provide a solid legal basis for bond market operations ensuring protection of finality at the Law level. The efficiency of the collateral disposal should be analyzed and improved as soon as possible.

• Pre-settlement and settlement risk: in order to minimize settlement risk it will be important: (i) to ensure all transactions are confirmed on T + 0; (ii) finalize the process to determine if the typology of the market and other legal, and institutional considerations justify the establishment of a CCP mechanism; (iii) introduce securities lending and borrowing mechanisms beyond bilateral arrangements; and (iv) further increase the use of DvP settlement to reach as soon as possible 100 percent settlement on a DvP basis.

• Custody risk: ensure that customer’s assets are protected from claims to CCDC participants. This protection should be included at the Law level.

• Governance, transparency and efficiency: a clear separation should be made from the oversight function of the PBC, the other supervisory tasks of CBRC and MOF, and the operational responsibility of PBC. The CCDC should disclose the answers to the questionnaire set out in the Committee on Payment and Settlement Systems (CPSS)/International Organization of Securities Commissions (IOSCO) disclosure framework or the answers to the key questions set out in the assessment methodology for RSSS. In addition, CCDC is encouraged to continue improvement of its service level.

• Regulation and oversight: the overseer should ensure that the system observes all CPSS-IOSCO RSSS and therefore, supervisors and regulators should continue to exercise their action effectively. The PBC should clarify the roles it plays with respect to the CCDC by clearly distinguishing its oversight and supervisory role from its participation in the governance of the system. Also, further fine tuning is needed in the cooperation arrangements of the different regulators in respect to clearance and settlement issues.

• Finally, communication procedures and analysis of cross-border links risks can be enhanced.

The assessment of the stock exchanges-SD&C system against the RSSS concludes that the system observes (observed or broadly observed) seventeen of the 19 recommendations. However, there are improvement opportunities in several areas:

• Pre-settlement and settlement risk: the front end control of securities and funds plus other risk management tools clearly mitigates settlement risk but China Securities Regulatory Commission (CSRC) and SD&C should consider to make public a description of how clearance and settlement arrangements operate to avoid a potential perception that by not following a more “orthodox” DvP structure the system does not comply with the DvP principle. Also as the market develops, CSRC and SD&C should consider if current arrangements would address market needs (e.g., growth of the wholesale market) and, thus, may consider evaluating how to strengthen its robustness as a CCP.

• Governance and transparency: the SD&C should ensure full observance with the RSSS. Also, the SD&C should disclose the answers to the questionnaire set out in the CPSS/IOSCO disclosure framework or the answers to the key questions set out in the assessment methodology for RSSS.

• Regulation and oversight: the CSRC should ensure that the system observes all CPSS-IOSCO RSSS and therefore, supervisors and regulators should continue to exercise their action effectively. Although a high level cooperation framework among relevant authorities does exist, cooperation at the technical level might be structure more formally. Authorities should also further foster cooperation between them and the private sector and other relevant stakeholders by creating an appropriate forum to discuss payment and settlement matters.

• Finally, communication procedures and analysis of cross-border links risks can be enhanced.

The assessment of the commodities futures markets-SHFE system against the RCCP concludes that the system observes (observed or broadly observed) eleven of the 15 recommendations, being one not applicable. However, there are improvement opportunities in several areas:

• Legal foundation: Most key concepts of clearing and settlement are covered by the SHFE rules and regulations, however, not in statutory law. A statutory law should contain provisions on derivative trading including among other issue, the enforceability of trades, finality, netting, novation, investor protection and collateral protection.

• Margin requirements: no clear legal basis exists for the acceptance of warehouse receipts as collateral to deposit as margin for the coverage of market risk exposure.

• Governance: the SHFE is urged to engage in a self assessment with the new standards under preparation by the CPSS and IOSCO which will be released in 2011. A workshop on these standards might be organized with the participation of local authorities and market participants, as well as international practitioners from both the public and the private sector.

• Transparency: the SHFE should publish the disclosure framework for the CPSSIOSCO RCCP.

• Regulation and oversight: given concentration of risks in a CCP and its potential effect on financial stability CSRC and PBC should establish a cooperative oversight framework for CCPs.