Regulation, supervision and oversight of FMIs (Responsibility A)

14. The legal framework for the regulation, supervision and oversight FMIs in China consists of several ‘segments’, along the lines of different financial markets and laws. The availability of a statutory supervisory framework differs per segment, as well as the availability of clearly defined criteria for the identification of FMIs that should be subject to regulation, supervision and oversight.

15. Payment systems for interbank transactions are subject to regulation and supervision of the PBC based on the PBC law. The PBC Law prescribes that the PBC maintain the normal operation of the payment, clearing and settlement systems (Article 4(9)) and shall organize, or assist in organizing, a clearing system for banking financial institutions (Article 27). The PBC Law does not include explicit criteria for FMIs to be subject to regulation, supervision and oversight of the PBC.

16. The PBC’s role as regulator, supervisor and overseer is clear from regulations and public statements. In 2011, the PBC published the Notice of Business Supervision and Management Rules of the China Foreign Exchange Trade System. In 2016, the PBC issued the Notice on Amending the Related Management System of the Payment System, amending six regulations on HVPS and identifying “Settlement finality” in HVPS and BEPS. Furthermore, the PBC has publicly declared that it will apply the PFMI to the China National Clearing Center (CNCC),³ CIPS, China Union Pay, the Clearing Center for City Commercial Banks, and the Rural Credit Banks Funds Clearing Center.

17. Similarly, securities settlement systems, CSDs and CCPs for interbank bond and FX markets are regulated and supervised by the PBC based on the PBC Law and subsequent regulations and notices. In 2011, the PBC published the Notice of Business Supervision and Management Rules of SHCH, and the Notice of Business Supervision and Management Rules of CCDC. In 2014, the PBC published a notice related to the establishment of a CCP for OTC derivatives, effectively mandating the central clearing for certain CNY IRS contracts. Furthermore, the PBC has publicly declared that it will apply the PFMI to CCDC and SHCH.

18. Securities settlement systems, CSDs and CCPs for securities markets are regulated and supervised by the CSRC based on a statutory framework. The securities law (Articles 155 and 157) specifies that CCPs and CSDs for the securities market are subject to the supervision of the CSRC. The CSRC has identified the CSDC as a CSD and CCP that falls under its regulation and supervision, and publicly declared that the PFMI apply to the CSCD. OTC transactions in the securities market are regulated through the Regulation for the National Equities Exchange and Quotations (NEEQ) system.

19. CCPs in the futures market are regulated and supervised by the CSRC based on a dedicated regulation and underlying measures. There is no specific law covering futures markets; the futures markets are regulated based on the Regulations on Administration of Futures Trading (2017 revision), issued by the State Council, and the Measures for the Administration of Futures Exchanges (2007), issued by the CSRC. The CSRC has identified the SHFE, DCE, ZCE, CFFEX, and CSDC as CCPs that fall under its regulation and supervision, and publicly declared that it will apply the PFMI to these exchanges. Futures transactions in OTC markets are not covered by the existing regulations.

20. The current supervisory framework contains potential legal risks. A main vulnerability relates to the lack of a statutory framework for futures markets. Rights and obligations defined in other laws might not be (fully) consistent with the CSRC’s measures, potentially creating potential legal uncertainty about the CSRC’s powers to enforce changes, where needed, as its powers are based on secondary legislation. The statutory basis of the PBC’s regulation and supervision does not contain clear criteria for FMIs that are subject to its oversight. This may create confusion about the scope and powers of the PBC’s responsibilities in relation to the responsibilities of other authorities. With a further growth and development of the market, for example, when new cross-sector products are developed, such as in the OTC derivatives markets, gaps or overlaps in regulation may appear with subsequent risks for financial stability.

21. The mission encourages strengthening of the legal framework for the regulation and supervision of FMIs, and welcomes in that regard the following ongoing legal initiatives:

• Authorities have started developing the ‘China Financial Infrastructure Supervisory Rules’ with the intention to further develop these into a law, outlining the regulatory, supervisory and oversight responsibilities for the all relevant authorities for FMIs in China, and reflecting the principles and concepts of the PFMI.

• The securities market Law is currently being revised, seeking to add new requirements for the risk management frameworks of securities CCPs and CSDs.

• The CSRC drafted a comprehensive futures market law, which will provide the CSRC with a legal basis to regulate and supervise futures markets, including CCPs. The draft law may include requirements for CCPs, based on the PFMI, including finality and netting. The draft law has been send to the National People’s Congress of the People’s Republic of China. No timeline has been set yet for its promulgation.

• The drafting of a national payments law to provide a clear legal basis for the regulation and supervision of payment systems and payment instruments, and subsequent requirements.

22. Authorities may benchmark their proposed national model for the supervision of FMIs against jurisdictions with comparable markets in size and complexity. For example, the approach taken in the United States can be considered. Similar to China, the U.S. FMI landscape consists of a relatively high number of FMIs, which are supervised by various authorities. The Dodd-Frank Act, Title VIII, identifies supervisory agencies (i.e. the Federal Reserve, Securities Commission and Commodity Futures Trading Commission) that have a primary jurisdiction over a designated FMI, which, in case an FMI is regulated by multiple regulators, have the primary responsibility for prescribing and implementing risk management standards. In addition to the identification of primary regulators, the Act expands the Federal Reserve’s role in the supervision, examination, and rule enforcement of all systemically important FMIs. For example, a primary regulator should conduct its annual examinations in consultation with the Federal Reserve as to the scope and methodology of the examination. The Federal Reserve may also participate, at its discretion, in such examinations. This approach allows the Federal Reserve, in cooperation with the other agencies, and complementary to existing supervisory and regulatory provisions, to address systemic risks consistently and strengthens its authority to induce change where necessary from a macroprudential perspective.⁴

Powers and Resources (Responsibility B)

23. The PBC has sufficient powers to obtain information and induce change or enforce corrective action if needed. Formal powers are vested with the PBC under the PBC law and various Administrative Measures. The PBC draws its powers from Articles 4 (9), 27, 32 and 46 of the PBC law. These are supplemented by administrative measures such as: (i) Measures for the administration of the entry and exit payment system of banking financial institutions; (ii) Administrative measures of PBC payment system participants; (iii) Business approach of HVPS; (iv) Operational management approach of payment system of PBC; and (v) Crisis management plan for payment and settlement systems.

24. The CNCC, the operator of the main payment systems, is a public entity within the PBC, and the CCDC and SHCH are supervised by the PBC, allowing the PBC to obtain information of the payment system’s functions, activities and overall financial condition, risk management, and whatever information it deems necessary. The information enables the PBC to assess adherence to the relevant regulations and policies, as well as the risks of the payment systems on its members and the broader economy. The PBC also approves the risk management measures of the FMIs before they are published. Its powers reach as far as critical service providers (CSPs).

25. The legal and regulatory framework provides the CSRC with sufficient powers to supervise and oversee the CSDC and the four futures CCPs, however, the futures market should be supervised based on a law, as mentioned under Responsibility A. According to the provisions of the securities law, the regulation on the administration of futures trading, and other relevant laws and regulations, as well as the authorization of the State Council, the CSRC has the following powers:

• Request information where needed.

• Approval of the articles of association and business operational rules and review and approval of the appointment or removal of the general manager.

• Approval of the business implementation rules, relevant systems, new products and business models. Major incidents need to be reported.

• Evaluation of the annual performance of the CSDC and the four CCPs, including their board of directors and management.

• Use of enforcement tools, if needed, which include penalties, the issuance of warnings or orders to correct, confiscation of illegal gains and issuing orders to close down in severe cases. The CSRC may also use its powers towards responsible staff through warnings or eventually a disqualification.

Nevertheless, as mentioned under Responsibility A, the lack of a dedicated futures law may create legal uncertainty about the CSRC’s enforcement powers.

26. The CSRC has the ability to supervise CSPs. The CSRC published several normative documents including the Information System Audit Standards for Securities and Futures Industries, which provide the CSRC with the possibility to conduct a comprehensive assessment and on-site inspection of the IT management, server room management, network management, and key information systems used by the CSDC and four CCPs.

27. Resources to fulfill the respective mandates are tight for the PBC and the CSRC. Despite increased responsibilities the number of staff has not increased in line with the new responsibilities under the PFMI and new market developments. The PSD and the financial markets department have 32 and 36 staff members respectively, which is tight given that these departments are responsible for many other issues in addition to regulation and oversight of FMIs. The number of staff involved in PFMI assessments is relatively small. The PBC currently draws resources from other departments and locations. With regard to the CSRC, the CSDC is mainly regulated and supervised by the market supervision department with a staff of approximately 40 members to cover all equity exchanges as well as the CSDC, of which 3 staff members are engaged in the CCP and CSD. The four futures exchanges, including the CCPs, are supervised by the futures supervision department with 27 full time staff resources, of which one staff member is involved in the supervision of the CCPs. Other departments within the CSRC may assist as needed, such as the fund and intermediary supervision department, bond market supervision department, international affairs department, enforcement bureau, and the legal affairs department.

28. Authorities should ensure that they get the appropriate staff levels, both in quantity and quality. Ensuring an appropriate level of human resources, both in quantity and quality, will allow adequate regulation and supervision of the FMIs in line with the PFMI, and contributes to financial stability. Not only an increase in the absolute number of staff is needed, but also an increase in staff with good knowledge of international standards and risk management practices. This includes knowledge of quantitative risk models for CCPs, such as margin, credit and liquidity models.

Transparency (Responsibility C)

29. The PBC discloses its policies and regulations related to payment systems. The basic policy objective of the PBC on HVPS is to “maintain normal operation of payment system and clearing systems” as stated in the PBC Law. The PBC discloses the regulations and any revisions to the regulations to the public through its annual report, website, and press announcements.

30. The PBC discloses its policies and regulations on the securities depository and the CCP for the OTC interbank derivatives bond market. The basic policy objective of the PBC for the CCDC and SHCH is “ensure efficiency, security and protection of investors’ legitimate rights”. The PBC law, administrative measures on bond register and custody in the inter-bank bond market and regulations on SHCH have defined the roles and the basic institutional arrangements of SHCH and CCDC.

31. The CSRC discloses its policies and regulations on securities depositories, clearing institutions, securities and derivatives FMIs. The basic policy objective of the CSRC on these FMIs is “ensuring safety and high efficiency.” The securities law, regulations on the administration of futures trading, measures for the administration of securities registration and clearing, measures for the administration of futures exchange and other relevant laws and regulations have defined the roles and the basic institutional arrangements of for these FMIs.

Implementation of the PFMI (Responsibility D)

32. The authorities have publicly stated that they adopt the PFMI. According to the Circular on Implementation of Principles for Financial Mark Infrastructures (Yin Ban Fa [2013] No.187 and Zheng Jian Fa [2013] No.42) and the Circular on Conducting Assessment on Financial Market Infrastructures (Document Yin Ban Fa [2013] No.239) jointly issued by the CSRC and the PBC, the PBC and the CSRC fully adopt the FMI principles.

33. The PBC and CSRC have established a Steering Group on FMIs. The PBC and the CSRC jointly released the Notice on Establishment of Steering Group and its secretariat on Financial Market Infrastructures (Document Yin Ban Fa [2014] No.106). According to the Notice, the steering group is responsible for guiding the development and reform of FMIs, coordinating on major issues pertaining to development and reform, and jointly promoting the implementation of the PFMI. In addition to the steering group, as mentioned before, a PFMI office has also been established by both regulators. The establishment of the steering group and the PFMI office underline the authorities’ commitment towards the adoption and consistent application of the PFMI in China.

34. As requested by the authorities, all relevant FMIs have carried out a self-assessment. The self-assessment was followed by an external assessment by a joint team of experts from the PBC and the CSRC under the umbrella of the steering group and PFMI office. The set timelines for the self-assessment and external assessment were January and March 2014 respectively. The PBC is currently deciding what the next step should be.

35. The implementation of the PFMI should be strengthened by reviewing and where necessary strengthening the regulations and measures of the authorities, as well as the rules of the FMIs. The CSRC is referencing the PFMI to review its regulations and measures for possible improvements. Also, the rules of the CSDC and four futures CCPs could be further updated to reflect the practices in line with the PFMI. This exercise may be accomplished by taking into account the results of the self-assessment and the external assessment. Such an approach would result in mitigating the identified risks and contribute to systemic and financial stability.

36. The team found that the compliance with the PFMI varies among FMIs. Where some FMIs seem to have adopted the PFMI largely in their rules and daily operations, i.e., the CCDC and SHCH, other FMIs would need further implementation of the requirements in their organization and daily processes.

37. Illustratively, the CSDC should be advised to improve its delivery-versus-payment (DVP) arrangements in the settlement of the exchange traded securities and strengthen the validation of its existing margin methodology:

• Although DVP is addressed in the legal framework, the actual DVP arrangements do not sufficiently protect counterparts against the loss of the full principal value of transactions. DVP should be implemented by linking the final settlement of securities to the final settlement of the funds leg. The current practice of final settlement of securities taking place on T+0 and final funds settlement on T+1 exposes CSDC to both principal and replacement cost risks. Though Article 49 in Chapter 6 of the Regulations on Securities Registration and Settlement states that settlement should take place in a DVP mode, it is possible for the buyer of the securities to sell the securities, before making the payment for the securities and the settlement of the funds leg. Though it is understood that there is a provision of claw-back of the securities from the buyer, this is an ex-post measure which does not mitigate the principal risk. In order to mitigate credit risk and achieve greater safety and efficiency, the authorities could introduce ex-ante measures such as: (i) blocking the delivered securities in the buyer’s account till the settlement of the funds leg is completed with CSDC enjoying a lien on the blocked securities in the account of the buyer; or (ii) alternately, create a special securities account of CSDC where the securities are lodged, till the completion of the settlement of the funds leg and transferring the securities to the buyer’s account thereafter. Adoption of such measures would result in mitigating credit risk and result in DVP.

• The valuation models used for calculation of initial margin should be independently validated by a qualified external expert on an annual basis, to mitigate model risk. At a minimum, the validation should be carried out by staff with sufficient expertise who are independent of the developers and the users of the margin model. Additionally, margin calculation and back-testing should be carried out on a daily basis, the latter to evaluate whether there are any exceptions to the initial margin coverage. The model used to determine the adequacy of the default waterfall financial resources should also be subjected to validation.

38. In addition, the futures exchanges should further enhance the quality of their risk management framework by establishing a dedicated risk management department, in line with international best practices. The risk management department should have an independent reporting line to the Council (equivalent to the Board of directors). This arrangement provides the advantage to the Council to get to weigh risk (as provided by the risk management department) and business potential (as reported by the business departments) and take appropriate decisions based on the risk appetite and the type of products. In the existing arrangements, the risk management is often divided between business departments (the settlement department being responsible for stress testing) and the market supervision department for other areas of risk management.

39. The risk management governance structure of the futures exchanges should be aligned to make the risk management department responsible for managing the enterprise wide risk management, rather than the RMC, which is an executive level body, comprising heads of departments and the CEO. The risk management department should lay down a clear and documented enterprise wide risk management strategy, which should be approved by the RMC and endorsed by the Council. In addition, the RMC should be chaired by a sufficiently knowledgeable individual who is independent of the executive management and it should have an independent reporting line to the Council, to which it reports on a regular basis on all matters pertaining to risk management.

40. Closer scrutiny on the composition of the components of the default waterfall and its use for taking care of the default of a participant should be carried out. The waterfall composition for instance also includes resources used for overcoming liquidity shortfalls. The financial resources in the revised waterfall composition should be subjected to the ongoing regular stress tests by the individual exchanges as also by the China futures monitoring center (responsible for stress tests across all futures exchanges). The results of such examination by the China futures monitoring center should be shared with the CSRC, if not already being done so. This would enable the regulator to get an overarching view on the safe and efficient functioning of the futures exchanges and would be another enabling tool in its supervision and oversight kit.

41. In line with transparency norms as outlined in Principle 23, the regulatory authorities should advise all FMIs under their respective regulatory jurisdictions, to complete and publicly disclose their responses to the CPMI-IOSCO Disclosure framework for financial market infrastructures. It is noted that the SHCH and CCDC have publicly disclosed their responses to the disclosure framework in English and Chinese.

42. The existing governance and oversight arrangements over CCDC should be recalibrated to clearly distinguish the roles of the PBC, MOF, and CBRC. The recalibration should establish the PBC as the authority responsible for overseeing the functioning of the CCDC as an FMI. The respective roles of the MOF and the CBRC should be reset taking into account the above approach. Such a measure would provide clear reporting lines to CCDC as also help in avoiding any conflicts of interest and minimize regulatory arbitrage, if any.

43. To facilitate greater understanding of the PFMI, the CSRC may hold dedicated workshops on the PFMI for the staff of FMIs on a periodical basis. This would facilitate capacity building and contribute to the ongoing implementation process of the PFMI. It is understood that the PBC already provides such workshops.

44. In line with international best practices, the operator and overseer roles of the PBC with regard to the HVPS and other payment systems are distinct. The HVPS is operated by the CNCC, a separate public entity in the PBC, while the PSD is responsible for the oversight and regulation of all payment systems including the HVPS. The CNCC and the PSD are staffed by different personnel of the PBC.

Cooperation Among Authorities (Responsibility E)

45. Cooperation between the PBC and the CSRC is well established with regard to the implementation of the PFMI, through the Steering Group for FMIs and the PFMI office. This cooperation could be further strengthened in the law. The PBC is responsible for the overall planning and coordination of the implementation of PFMI, and takes the lead to report the progress to the State Council and the international organizations. This is supplemented by the establishment of the PFMI office in the PBC, consisting of technical staff of both regulators. The PBC and the CSRC invite each other into their respective assessment teams, officially exchange the self-assessment reports of the relevant FMIs, and jointly facilitate the implementation of the PFMI. To ensure the efficiency and effectiveness of their regulatory cooperation, the CSRC and the PBC hold periodical meetings with the deliberations being recorded in minutes to facilitate coordination. The reviews of the legal framework, as discussed under Responsibility A, could reflect these cooperation practices to further strengthen and formalize them.

46. Domestic cooperation between the PBC, the CBRC, the CSRC, and the CIRC (China Insurance Regulatory Commission) is multi-tiered. These are: (i) coordinating and cooperating through the State Council which is responsible for overall financial stability and crisis management; (ii) cooperating through the existing financial regulation and coordination mechanism, i.e., the Financial Regulatory Coordination Joint Ministerial Committee (JMC); and (iii) others. In case of a crisis event related to FMIs, the authorities will coordinate under the leadership of the State Council to jointly establish an interim work team to facilitate communication, consultation and coordination. The JMC is tasked with a coordination role in maintaining financial stability and mitigating regional and systemic risks. The JMC reports to the State Council.

47. CSDC and SHCH have multiple roles as a CCP, CSD, and SSS. CSDC, CCDC, and SHCH are FMIs that have cross-border links. The CSDC has link arrangements with the Hong Kong Stock Exchange under the Shanghai-Hong Kong and Shenzhen-Hong Kong Stock Connect programs. The CSDC also has a link arrangement with the CSD in Singapore to support transfer of share stocks, which however is limited to the shares of one listed company and the volume and value of trades is insignificant. CCDC and SHCH linked to the central money-markets Unit after the launch of the Bond Connect pilot program on July 3, 2017.

48. As for cross-border cooperation, the CSRC and Hong Kong Securities and Futures Commission (HKSFC) have a memorandum of understanding (MOU) on strengthening of regulatory and enforcement cooperation under Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect. In terms of regulation of the above inter-jurisdictional business, the CSRC has established a periodical coordination and supervisory cooperation mechanism with HKSFC for ensuring the safe and efficient functioning of the FMIs involved.

49. Link related risks should be evaluated by the CSRC. Evidence of the exchange of information between authorities concerning PFMI assessments of the involved FMIs, was not available in English to the assessment team. The cross-border link arrangements covered by the Stock Connect programs should be evaluated to identify, monitor and manage legal, credit, and liquidity risks, including a high level of protection of investor for the rights of the investor CSD participants.

50. The FCPS provides multicurrency services. Before adding a new currency, the PBC consults with relevant central banks of issue for their comments and suggestions. The PBC does not designate FCPS as a SIPS, as its turnover is not very significant. Notwithstanding this, the PBC notifies the volume and value of the foreign currency transaction to the relevant authorities on a quarterly basis.

Interdependencies between FMIs and financial institutions

52. China’s landscape for FMIs is an interconnected network of financial institutions, with a significant overlap of members between multiple FMIs. Figure 2 displays the network for the main FMIs in China and 609 members, consisting of 318 banks, 239 brokers, 2 insurers, and 50 other.⁵ The large majority of members are Chinese entities.

China: Network Graph for the Main FMIs in China and their Members

Citation: IMF Staff Country Reports 2018, 192; 10.5089/9781484363805.002.A001

Sources: PBC, CSR, and IMF staff estimates.

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China: Network Graph for the Main FMIs in China and their Members

Citation: IMF Staff Country Reports 2018, 192; 10.5089/9781484363805.002.A001

Sources: PBC, CSR, and IMF staff estimates.

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China: Network Graph for the Main FMIs in China and their Members

Citation: IMF Staff Country Reports 2018, 192; 10.5089/9781484363805.002.A001

Sources: PBC, CSR, and IMF staff estimates.

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53. The network graph shows that the largest FMI node in the network is clearly HVPS, followed by CCDC, as these systems have the largest settlement values and the highest number of members. CSDC is the third largest FMI in turnover, and SHFE the third largest FMI in number of members. The importance of HVPS is further emphasized by direct links to other FMIs (CCDC, SHCH, and CIPS) and indirect links to the remaining FMIs (Figure 1).

54. There are nine banks that have a membership in all FMIs, of which eight are Chinese banks and one is a U.S. bank. The Chinese banks are all among the largest banks in the country. Another eight banks have a membership in seven FMIs, and 76 banks have a membership in four FMIs (Figure 3).

China: Number of Members (Y axis) and their Number of Memberships in FMIs (X axis)

Membership Number, Discrete

Citation: IMF Staff Country Reports 2018, 192; 10.5089/9781484363805.002.A001

Source: IMF Staff estimates.

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China: Number of Members (Y axis) and their Number of Memberships in FMIs (X axis)

Membership Number, Discrete

Citation: IMF Staff Country Reports 2018, 192; 10.5089/9781484363805.002.A001

Source: IMF Staff estimates.

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China: Number of Members (Y axis) and their Number of Memberships in FMIs (X axis)

Membership Number, Discrete

Citation: IMF Staff Country Reports 2018, 192; 10.5089/9781484363805.002.A001

Source: IMF Staff estimates.

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55. The network graph further shows the existence of several clusters:

• The four futures CCPs have a highly overlapping member base. ZCE and DCE’s overlap for more than 90 percent, whereas CFFEX’s member base overlaps with the other three futures exchanges for more than 80 percent (Table 3). Turnover and exposures (measured in margin) are somewhat concentrated with approximately a quarter to a third of the member based responsible for 80 percent of turnover and exposure (Figure 4).

  Table 3.

  China: Overlapping Members between FMIs: (At a consolidated level)¹

  

  Sources: PBC, CSRC, and IMF staff estimates.

  ¹Numbers are for September 30, 2016, except for HVPS and SHCH, for which the dates are December 31, 2016 and November 24, 2016, respectively. The sample of participants contain 609 members, which is a consolidated membership set, based on the top 200 members of the CCDC and all members of the other FMIs. The different members were consolidated at the highest level possible.

  Table 3.

  China: Overlapping Members between FMIs: (At a consolidated level)¹

  	HVPS	CCDC	SHCH	CSDC	CFFEX	SHFE	ZCE	DCE
  HVPS	100%
  CCDC	39%	100%
  SHCH	21%	28%	100%
  CSDC	13%	30%	53%	100%
  CFFEX	5%	12%	24%	38%	100%
  SHFE	8%	17%	36%	40%	82%	100%
  ZCE	5%	12%	23%	38%	83%	61%	100%
  DCE	5%	13%	25%	39%	86%	63%	91%	100%

  Sources: PBC, CSRC, and IMF staff estimates.

  ¹Numbers are for September 30, 2016, except for HVPS and SHCH, for which the dates are December 31, 2016 and November 24, 2016, respectively. The sample of participants contain 609 members, which is a consolidated membership set, based on the top 200 members of the CCDC and all members of the other FMIs. The different members were consolidated at the highest level possible.

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  Table 3.

  China: Overlapping Members between FMIs: (At a consolidated level)¹

  	HVPS	CCDC	SHCH	CSDC	CFFEX	SHFE	ZCE	DCE
  HVPS	100%
  CCDC	39%	100%
  SHCH	21%	28%	100%
  CSDC	13%	30%	53%	100%
  CFFEX	5%	12%	24%	38%	100%
  SHFE	8%	17%	36%	40%	82%	100%
  ZCE	5%	12%	23%	38%	83%	61%	100%
  DCE	5%	13%	25%	39%	86%	63%	91%	100%

  Sources: PBC, CSRC, and IMF staff estimates.

  ¹Numbers are for September 30, 2016, except for HVPS and SHCH, for which the dates are December 31, 2016 and November 24, 2016, respectively. The sample of participants contain 609 members, which is a consolidated membership set, based on the top 200 members of the CCDC and all members of the other FMIs. The different members were consolidated at the highest level possible.

  

  

  China: Percentage of Members Responsible for Exposure in Each CCP

  Concentration in each CCP by exposure, (top 100 members, cumulative)

  Citation: IMF Staff Country Reports 2018, 192; 10.5089/9781484363805.002.A001

  Source: IMF Staff estimates.

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  China: Percentage of Members Responsible for Exposure in Each CCP

  Concentration in each CCP by exposure, (top 100 members, cumulative)

  Citation: IMF Staff Country Reports 2018, 192; 10.5089/9781484363805.002.A001

  Source: IMF Staff estimates.

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  China: Percentage of Members Responsible for Exposure in Each CCP

  Concentration in each CCP by exposure, (top 100 members, cumulative)

  Citation: IMF Staff Country Reports 2018, 192; 10.5089/9781484363805.002.A001

  Source: IMF Staff estimates.

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• CSDC also highly overlaps with the four futures CCPs, with around 40 percent of CSDC’s members also being member of these CCPs.

• The overlap between members of CCDC and SHCH is more than 50 percent, which may relate to the fact that both FMIs are active in the interbank bond market.

• The member base of HVPS is more related to those of CCDC and SHCH, illustrating also that CCDC and SHCH settle their cash payments directly in the HVPS.

56. This high interconnectivity suggests that contagion from a financial or operational failure of a FMI or critical member could quickly spread through the financial system if proper safeguards are not in place. Data for CSDC and CCDC show that the default of the two participants, and their affiliates with the largest losses, not only affects these FMIs, but also other FMIs, due to the multiple memberships of these participants. For example, a default of the two participants with the largest exposures in CSDC coincides with the default of these participants in another 5-12 FMIs, including several CCPs. For CCDC, the default of the two largest participants (measured in turnover) would coincide with the default of these entities in 4-8 other FMIs.

57. This analysis emphasizes the need for: i) resilient FMIs that are able to stop a contagion of losses and act as firewalls following the default of one or more participants. This requires full implementation of the PFMI for each FMI and a strengthening of the legal framework through the adoption of finality and netting; ii) the need for recovery and resolution planning to ensure the provision of critical operations and services as a going concern, also during extreme circumstances; and iii) crisis preparedness and an ex-ante understanding of how, potentially, losses may spread through the financial system. This underlines the need for cooperation among authorities at a domestic level and an international level as well as joint crisis exercises that simulate the default of operational disruptions at members and FMIs. It also requires an ex-ante policy of the PBC with regard to the provision of central bank services, including liquidity support.

Finality and Netting

58. Finality and netting are addressed in China at the level of regulations, measures and rules. Since the FSAP in 2011, the PBC, CSRC, and individual FMIs have taken measures to define finality and netting in their regulations, notices and rules. Although this is an improvement to the regulatory framework it does not provide watertight protection against a potential revocation of transactions or collateral payments, or an unwinding of netted positions, following the bankruptcy of a bank, as the concepts of finality and netting are not unambiguously included in the Securities Law, as required by international standards.⁶ Finality and enforceability of netting and collateral arrangements should be at the level of the law, because they derogate from the Insolvency statute (a formal law in its own right). A lower level of regulatory norm (or FMI self-regulation) cannot validly and with legal certainty do it. Revocation of transactions, collateral payments or unwinding of positions may result in large liquidity and credit losses and represent systemic risk for FMIs and their members.

59. It is recommended to unambiguously include these concepts in statutory law to provide a high degree of legal certainty for all relevant material aspects covering all FMIs. The legal basis should be strengthened among other things to provide for recognition of settlement finality in the event of insolvency of a participant; recognition of multi-lateral netting; provisions for bankruptcy remoteness of pledged collateral; close out netting; and prescriptions to overcome any zero-hour rules. The drafting of new laws, or reviews of existing laws, as discussed under Responsibility A, create a good opportunity to introduce these concepts at a statutory level. Alternatively, authorities may enact a comprehensive statute on finality and netting. This will improve the consistency with the Bankruptcy Law, among others, and also facilitate the determination of Chinese CCPs as qualifying CCPs, or QCCPs, by foreign authorities or banks.⁷

Cyber Resilience of FMIs

60. Authorities have identified cyber risk as an important supervisory topic in relation to financial institutions, including FMIs. A cyber security law was issued in 2016 and will come into effect as per June 2017. The law applies to all critical institutions in China and identifies key institutions in different sectors that are required to take specific measures to protect IT systems and enhance their security level. Within the financial sector the law specifically identifies FMIs as critical institutions for financial stability. In 2016, the CSRC organized an industry-wide contingency test on information security. More than 10 institutions participated in the test, including securities exchanges, futures exchanges, CSDC and market institutions. The test was jointly planned with the Ministry of Industry and Information Technology and the National Energy Administration, and was observed by the Cyberspace Administration of China and the PBC. The exercise tested the emergency response capabilities of the FMIs supervised by the CSRC. The PBC and CSRC have both issued information security requirements, and focus on strengthening the autonomous control of information systems for the FMIs under their respective responsibility.

61. Authorities may strengthen their joint efforts and address cyber resilience explicitly under the PFMI office. With the promulgation of the cyber security law, cooperation between the PBC, the CSRC and FMIs may further improve insights on cyber security and contribute to the awareness and assessments of cyber risks. The CPMI-IOSCO guidance on cyber resilience for FMIs may be used as a benchmark.⁸ Joint crisis coordination mechanisms and testing of crisis communication protocols can further improve the management and monitoring of these risks. Where weaknesses were identified, these should be addressed in the PBC’s and the CSRC’s supervisory activities as a priority.

Recovery, Resolution and Liquidity Support

62. FMIs have developed recovery plans. Where some FMIs have developed recovery plans in line with international standards, recovery plans of other FMIs need further development, beyond business continuity planning (BCP) and default management.

63. Resolution planning is at an early stage. Resolution planning has the objective to sustain critical operations and services if an FMI potentially becomes non-viable as a going concern, while avoiding a bail out at the expense of taxpayers’ money. The PBC is studying the features of these arrangements in the Chinese context. So far, no legal framework has been developed, or a resolution authority been appointed.

64. Resilience of FMIs can be strengthened through the provision of central bank services to solvent, systemically important FMIs. The PBC currently provides settlement services to CCDC and SHCH. It may consider extending these services to the CSDC and other CCPs, under the condition that the FMIs strengthen their risk management practices, and, in addition to the CSRC’s supervision, are subject to macroprudential oversight of the PBC. Although private sector liquidity must constitute the first line of defense for FMIs against liquidity shortfalls, there could be extreme circumstances in which their liquid resources turn out to be insufficient or unavailable. Special financing arrangements could be made by the central bank for the above circumstances to ensure that they can continue to make payments to counterparties and would thereby maintain the stability of the market. Furthermore, the provision of central bank accounts will reduce FMIs’ dependence on collateral services provided by commercial banks and may also be used for settlement purposes, significantly reducing credit and liquidity risks related to the use of settlement banks.

Analysis of HVPS

66. The HVPS is generally a robust, safe and efficient system with a “V” topology. The HVPS system was upgraded in 2013, with several advanced features. HVPS version 2 features include: (i) liquidity saving offsetting mechanism; (ii) single point access to the participants; (iii) ISO 20022 message formats; and (iv) an increase in operating hours which is 8:30 am to 5:00 pm for normal settlement and 5:00 pm to 8:30 pm for specific business. Further, business continuity and disaster recovery is being enhanced with three operating centers in two locations (with the third operating center becoming functional this autumn).

67. The PBC Law provides the legal basis for the PBC to operate the HVPS. Article 27 of the PBC Law prescribes that the PBC shall organize, or assist in organizing, a clearing system for banking financial institutions and provide clearing services and in conjunction with the banking regulatory authority under the State Council, formulate rules for payments and settlements. Further, as part of its functions and responsibilities, the PBC under Article 4 (9) is enjoined to maintain the normal operation of the payment, clearing and settlement systems.

68. A dedicated RMC for the HVPS, chaired by the Deputy Governor, is tasked with the responsibility for the overall risk management framework for the HVPS. The heads of relevant departments of the PBC such as the PSD, CNCC, and IT are members of the RMC. Select participants are also invited for the meetings of the RMC, which is held every quarter. All risk related measures pertaining to credit, liquidity and operational risks are discussed during these meetings and action plans for further improvements to the system are drawn up for implementation.

69. Participants in HVPS are divided into direct and indirect participants. There are 305 direct participants and 141,023 indirect participants by the end of 2016. Most of direct participants are commercial banks with RMB reserve accounts at PBC, and the others are PBC’s Accounting Department, Treasury Department and FMIs, having direct participant interfaces with HVPS. Indirect participants are other smaller commercial banks (mainly rural) which route their transactions through direct participants for making and receiving payments in the HVPS.

70. Credit risk is largely mitigated in HVPS. Transactions are settled in real time on a gross basis based on availability of funds in the sending participant’s account. Secondly, the PBC provides intraday liquidity support to participants on a fully collateralized basis in the form of intraday repos with a fee, thereby mitigating its own credit risk exposure. The intraday liquidity funds have to be repaid by the participant by the end of the day, failing which it is converted into an overnight facility at a penal rate of interest. Participants tend to use the OMO facility or borrow in the interbank market, for their liquidity needs as these are cheaper sources of liquidity compared to the fee based intraday repo facility.

71. The PBC should review the existing practices related to the fees and the timings of the intraday repo window, and the use of OMO facility. The fee for the intraday repo facility, acts as a disincentive and limits the use of intraday repo by the participants, as it is in addition to the opportunity costs borne by them. Secondly, intraday repo is available only till 5:00 pm, though the operating hours of the system continue till 8:30 pm. The non-availability of the intraday repo facility beyond 5:00 pm could impose liquidity pressures on the participants especially, in times of stressed market conditions.

72. The use of OMO (which is primarily a monetary policy tool), by participants for their intraday liquidity needs in the HVPS, would need to be reviewed and examined by the PBC. Participants either use the OMO facility or borrow in the interbank market, as these are cheaper sources of liquidity compared to the intraday repo facility. Participants could be exposed to liquidity risk pressures if either the OMO is not available on a daily basis or if the interbank market timings do not match with the operating hours of the HVPS.

73. Collateral management practices should be reviewed by the PBC and brought in line with the PFMI. A uniform haircut ratio of 10 percent is imposed on all collateral, which, set in 2004 has not been changed till now. The mark to market module for valuing the collateral on a daily basis, though developed, has not been made operational. In order to mitigate residual credit risk, the PBC should review its haircut methodology and mark to market the collateral on a daily basis. In addition, the haircut methodology and procedures should be subject to an independent validation at least once a year.

74. Enhanced liquidity risk management tools under HVPS version 2, comprise: (i) queuing and settlement of transactions on a first-in-first-out (FIFO) basis; (ii) priority levels for transactions; (iii) use of automated bilateral and operator initiated multilateral offsetting mechanisms; (iv) online queue monitoring by participants and the system operator; and (v) online verification of clearing account balances by participants. Transactions are settled in HVPS using a combination of FIFO and priority levels. Transactions with the same priority level will be taken up for settlement based on the time at which the transaction has been received. The PBC will alert the participants on a queue build-up, but by itself does not change the priority levels; only the participants have the ability to change the priorities of their own transactions.

75. Given the systemic nature of the instant transfers (which are DVP transactions and net clearing settlement files from FMIs), these should be assigned a higher priority in order to mitigate liquidity risk. In the extant framework, instant transfers have the lowest level of priority at priority 7. A rejection of an instant transfer transaction could have unintended liquidity and system-wide risks on participants and other FMIs, given the system-wide dependencies, especially if it were to take place at the end of the day when funding markets may not be in operation and the intraday repo window is closed. Though the rules specify that the FMI originating the instant transfer is responsible for its settlement, as the system operator, the PBC should take measures to mitigate liquidity and credit risks. Accordingly, these instant transfer transactions should be assigned a higher priority to bring them on par with either priority level 3 or 4 transactions.

76. The PBC should deploy other liquidity risk mitigation tools such as:

• a. prescribing a cut-off time in the rules of the system, beyond which a participant cannot withdraw a transaction pending in the queue for settlement, to avoid creating liquidity risks. Currently, participants can withdraw pending transactions at any time during the operating hours, which may cause liquidity pressures for other participants. The rules should accordingly be revised to clearly define the point in time after which unsettled payments may not be revoked by a participant.

• b. introducing a time varying fee structure. Participants currently pay a flat fee per payment transfer irrespective of the time at which the payment transfer is sent. Under a time varying fee scheme, participants would pay a lower fee for those payment transfers sent earlier to the system for settlement, while those sent towards the end of the operating hours would attract a higher fee. Such a measure would aid in improving liquidity flows in the HVPS system, and also act as an incentive to participants to submit their payment transfers earlier into the system.

77. The RMC is responsible for the operational risk management strategy of the HVPS which is divided into managing internal and external operational risks. HVPS has a main operating center and a backup center located 300 kilometers away from the main center. A third operating center is coming up in a different location and would start functioning this autumn. The HVPS system functions with a high level of reliability, operational capacity and adheres to the recovery point objective (RPO) and recovery time objective (RTO). HVPS has a holistic BCP involving the central system and all the participants including the other FMIs with a crisis and event management component. Apart from the FMIs, around 70 key direct participants (with significant volumes and value of transactions) also have backup centers.

78. A consultative approach is followed by the PBC before effecting any changes to the HVPS rules and regulations. The proposed changes are circulated to the participants and their feedback is elicited and taken into consideration, before the changes are implemented. In addition, HVPS user group meetings are held every six months.

79. HVPS as an FMI, should complete and disclose publicly responses to the CPSS-IOSCO Disclosure framework for financial market infrastructures on a regular basis. The responses to the Disclosure framework should be publicly disclosed both in Chinese and English. It is understood that a self-assessment of HVPS has been carried out, but it should be noted that the self-assessment and the public disclosure of responses to the Disclosure framework are distinct and serve different purposes with different objectives.

Analysis of SHCH

Generally, risk management practices of the SHCH are well designed, and in line with the PFMI. Nevertheless, the mission found several issues of concern that would benefit from further development to align SHCH fully with the PFMI. The SHCH has modern risk management systems, a risk management department, a RMC, and a set of responsibilities, rules, procedures and practices to manage both operational and financial risks. Several issues for improvement, identified by the mission, are described in the following paragraphs.

80. The risk-management governance should be further strengthened by appointing an independent chair for the RMC. Currently, the Chairman of the Board of Directors also chairs the RMC, which does not support an independent analysis of risks within the RMC. The Chairman of the Board of Directors may include ‘business’ considerations in the risk assessment of the RMC. It is therefore recommended to appoint a sufficiently knowledgeable person as chair of the RMC, who is independent of the SHCH’s executive management, and who leads independent risk analysis and subsequent reporting to the Board of Directors. This construction allows the Board to receive complete and unbiased information about the risks faced by the SHCH and the management of those risks and balance these against business considerations. Independent reporting enables board members to exercise objective judgment after fair consideration of all information and views.

81. Operational and IT risks should be regularly reported to the CRO. Currently, the risk management department is the only department within SHCH that reports to the CRO. As the risk management department ‘only’ covers the management of credit, liquidity and market risks, other risks, such as operational and IT risks, are not regularly reported to the CRO. It is recommended to address this, preferably by having the risk management department also cover operational and information technology (IT) risks. Alternatively, staff of the Operational and IT Departments that are responsible for risk management should have a direct reporting line to the CRO. The CRO reports all types of risks to the RMC through his/her direct reporting line.

82. SHCH has defined exposure thresholds per clearing member, which may result in uncovered exposures for the CCP and can therefore not be part of SHCH’s risk management approach. SHCH monitors its exposures towards clearing members during the day. If, due to new positions or market volatility, a clearing member’s exposures are not fully covered by collateral, SHCH does not necessarily call for intraday margin. Instead, it has defined thresholds per clearing member, and will only call for intraday margin if these thresholds are reached. This means that, during the day, the CCP may be exposed to credit risks. The requirement of Principle 4 that ‘current and potential future exposures to each participant should be fully met’ is not fully implemented by SHCH. SHCH’s initial margin calculation should be further developed to ensure that its potential future exposures are covered with a single-tailed confidence level of 99 percent.

83. SHCH does currently not apply a haircut to cash collateral. Only the CCP service for FX spot and derivatives transactions accepts foreign currency, i.e., USD. USD collateral currently comprises only a small part of all margins. Nevertheless, it is recommended to adopt haircuts for cash collateral in line with the PFMI and international practices to protect the CCP against potential fluctuations in the exchange rate.

84. SHCH’s margin and collateral models should be subject to independent validation. The credit risk models, including the margin and haircut models, are not validated by reviewers that are sufficiently independent. Validation of the models should be performed by personnel with sufficient expertise, who are independent of the personnel that created and use the models. These experts could be drawn from within SHCH. However, review by external experts, such as academics or consultants, is also possible. Independent validations should take place at least annually.

85. Liquidity stress testing needs to take place daily. Currently, SHCH conducts liquidity stress tests on a quarterly basis. In line with Principle 7, SHCH must be able to effect intraday and multiday settlement and meet other payment obligations on time under a wide range of potential stress scenarios. To that purpose the FMIs should be able to conduct liquidity stress testing on a daily basis.

86. BCP is well-developed; however, it is recommended to deploy a hot backup site and continue developing BCP arrangements. Apart from the main operational center in Shanghai, SHCH has a disaster recovery site in Shanghai and in Beijing. BCP plans are developed and regularly tested. While the backup sites can take over the IT operations, operational staff needs to be transported from the primary to the secondary site. Also, testing does not necessarily test the full load of operations at the backup site. It is recommended to further strengthen the BCP, for example, through full and regular switching of all operations between the primary and secondary sites and the establishment of a hot backup site.

87. Finally, SHCH may increase the number of liquidity providers and settlement banks for foreign currencies to reduce potential disruptions in case one of these supporting banks fails. SHCH has contracted 2 banks as liquidity provider for USD liquidity needs and 2 banks for credit lines in other currencies. Furthermore, SHCH has selected 2 settlement banks for USD settlements and 1 for other currencies. It is recommended to increase the number of liquidity providers and settlement banks for non-RMB to mitigate concentration risks and interdependencies. This is important as the default of one of these banks may significantly impact SHCH, and its ability to fulfil its obligations as a CCP. For example, in times of stress, one of SHCH’s liquidity providers may default, resulting in no or reduced access to credit lines, causing potentially significant liquidity risk to SHCH. The loss of a settlement bank exposes SHCH to operational problems.