| Since the innovation of Over-the-counter(OTC)derivatives in the 1970 s,they have been widely used in the risk management of various financial markets.With rapidly growing trading volume and complicated variety of products,OTC derivatives market has become one of the core elements of modern financial market.However,due to the high leverage and low liquidity nature of OTC derivatives,inevitably it carries high level of risk.The financial crisis in 2008 had made governments and market institutions become aware of the various deficiencies in the financial market,especially regarding the transparency and default management in the OTC derivatives market.In light of London Clearing House's successful handling of Lehman Brother's default,the advantages of Central Counterparty(CCP)Clearing for OTC derivatives have been widely recognized.Governments have now started supporting the previously market-spontaneity-only promotion of CCP Clearing.The corresponding supporting and regulatory measures are also gradually put in place.However,both practical and theoretical research from either finance or law field on CCP clearing is still at the exploratory and trial stage in China.Existing laws are inadequate for safeguarding the development of CCP clearing.This is disadvantageous to the long-term development of China's financial markets,especially OTC derivatives.This paper uses the default management mechanism of CCP clearing for OTC derivatives as an entry point.This chapter first clarifies the concept of clearing in different markets and defines CCP clearing with reference to expressions in authority normative documents.Through analyzing the characteristics of OTC derivatives and comparing the purpose of exchange and OTC CCP clearing,we elucidate the characteristics of OTC derivatives CCP clearing.This paper then explains the three basic processes in CCP clearing of OTC derivatives,namely clearing obligation performance,default management and risk sharing.Finally,by analyzing the linkage mechanism among internal processes of CCP clearing,and functions of defaultmanagement in cutting off risk transmission,preventing systematic risk and handling default,the paper presents default management as the core of CCP clearing.The research of default judgment mechanism,begins with analyzing the "future" feature of financial derivatives contracts,then introduces the economic theory of "incomplete contract theory".This theory states that due to the existence of foreseeable costs,contractual costs and confirmed costs,any contract for future agreement will inevitably leave room for negotiation,thus reducing social effectiveness.The dominance over renegotiation is called "residual control",and this right should be explicitly given to the more important party in the market to improve social efficiency.Then,from the perspective of "incomplete contract theory",taking KIKO contract dispute in Korea as an example,this paper demonstrates the problem of “holdup problem” caused by "residual control" in derivatives,hence deduct the rationale of the CCP possessing "residual control" of the clearing contract.And only with "residual control" could the CCP introduce flawed asset clause and cross-default clause into the default judgement.This section then proceeds to explain that as anticipatory breach of contract clause offers protection of benefits and improve trust and financial security,it is required in the default judgment process.However,being hindered by restriction on provision of anticipatory breach of contract clause under current law in China,the flawed asset clause is introduced,which is to identify participants' default based on their violation of commitment on their own assets.An analysis of the application of flawed asset clause is also provided.Finally,this section introduces the cross-default clause,which is default determined by the participant's breach of contract in other financial transactions or clearing process,as well as the function and application of the cross-default clause.The study on close-out netting mechanism,first introduces the advantages of netting in capital flow management and default management,and then offers an in-depth introduction to the process of close-out netting and its functions in increasing liquidity and reducing risk exposure.Secondly,clarifies the concept of early termination from the legal point of view,analyze the conflict between netting settlement,close-out netting with the picking performance and the bankruptcy offset system in the context of offset theory.Next the paper examines the how different jurisdictions legislate protection towards close-out netting: United States amended the bankruptcy law,EU formed a separate legislation,while Britain amended the bankruptcy law according to the EU instruction.Finally,the paper analyzes the legaldifferences in China's close-out netting between exchange and OTC markets.And commented that while close-out netting of CCP clearing was protected by specific laws in the exchange market,the OTC market CCP clearing is still affected by the picking performance and the bankruptcy offset due to lack of legal protection.The latest judicial interpretation of the bankruptcy law has played a positive role in easing the conflict.The study on collateral mechanism,first introduces the variable margin,initial margin,the default fund,and types of risks covered by the three collaterals as well as their order of use in default management.Then the paper proceeds to analyzes the legal independence of collateral,uncertainty of the guarantee elements and collectivity characteristics of collateral from the legal perspective,followed by using the Man Financial case to show the importance of collateral segregation and its legal requirements,as well as the need to process collateral promptly due to the existence of asset impairment risk and liquidity risk.United States protects the convenience of the establishment and processing of collateral by modifying the Code of Commerce;while the EU introduced collateral directive to legally guarantee the safety of derivative transactions.Finally,the paper analyzes the legal differences in collateral mechanism in China between the exchange and OTC market,and comments on while the existing securities and futures laws offers protection to the exchange market collateral mechanism,the absence of such legal protection in the OTC market has resulted in OTC CCP clearing collateral mechanism being constructed in accordance with the provisions of ordinary civil law,resulting in the lack of proper legal protection in setting monetary pledge,handling collateral,etc.,but the latest judicial guidance case made a favorable decision towards the pledge of money.Discussing legal protection of default management,first introduces the default management of Lehman Brothers processed by London Clearing House,and the three challenges LCH faced: default judgement by flawed asset clause;successful close-out netting settlement;obstruction from bankruptcy administrator during collateral disposal.Learing from the success and experience of London Clearing House and other CCPs,worldwide national regulators has reached a consensus on recognizing the core legal issues during CCP clearing default management,which urges international regulatory authorities to put forward corresponding legislative requirements on OTC derivative default management.The paper then deducts that legislation on default management of CCP clearing in China is necessary based on theinternationalization of financial legislation,equivalence in legal enforcement of cross-border regulations and the need to ensure the effectiveness of default management.Finally,the paper analyzes three legislative paths to protect default management of CCP clearing: formulating special judicial interpretation,revising relevant laws,and finally,legislating special laws.The topic of this article is selected based on author's legal practice experience in CCP clearing over the last five years.At present,there has been no comprehensive study on relevant applicable laws on specific mechanisms of CCP clearing,which makes this article innovative and groundbreaking.At the same time,given the increasingly important role of CCP clearing in Chinese financial market and the core position of default management in CCP clearing,it is of great practical significance to carry out this research. |
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