Shanghai, the key hub for commodities trading in China, has long been a city keen to experiment with new ideas. Its latest initiative is the China (Shanghai) Pilot Free Trade Zone (the “Zone”). The Zone was launched on 29 September 2013 following the publication by the State Council, China’s cabinet, of the General Plan of China (Shanghai) Pilot Free Trade Zone (the “Plan”). (see note 1)
The Plan sets in motion wide-ranging reforms covering finance, commerce and regulation. By many measures, China is the most significant player in the commodities markets. The Plan addresses this critical role by introducing a raft of measures to attract participants in the commodities markets to the Zone. The Zone is being designed as a leading international commodities trading location: both a major global trading hub and, significantly, a conduit to the rest of Mainland China.
This is an opportune moment for management, and also in-house legal and other risk functions in commodity market participants to reconsider (and possibly re-calibrate) their views on the opportunities (and risks) of transacting in China. In this bulletin, we take a closer look at the key reforms and share our insights on some of the challenges that may lie ahead.
Key areas of commodities reforms
Through the creation of the Zone, China is in a most fortunate position as regards being able to introduce significant reforms (including a new legal and regulatory framework to support such reforms) in a controlled and systematic fashion, thus achieving at a stroke what many other countries have been struggling to achieve in a piecemeal fashion over decades.
The key areas of reforms to be introduced in the Zone that impact commodity traders include:
Foreign investments: a more liberal regime
- Relaxing foreign investment restrictions: certain foreign investment restrictions for 18 service industries spanning six service areas have been relaxed, such as eligibility requirements for foreign investors, foreign shareholding limits and business scope restrictions.
- Requiring post-filing rather than pre-approval: foreign-invested entities operating in industries that do not appear on the “Negative List” generally no longer need foreign investment approvals from the Ministry of Commerce (MOFCOM) and the National Development and Reform Commission (NDRC) for their establishment, being subject only to “post-filing” requirements. Note that included in the Negative List are securities market services, futures market services and other unlisted financial business; exploitation of raw energy resources; energy manufacturing; and warehousing of cotton and other agricultural products for national reserves or military purposes.
To this end, we are already seeing a number of commodity market participants taking advantage of the more liberal regime by establishing subsidiaries in the Zone as wholly foreign-owned enterprises (WFOEs).
Commodities futures
- Establishing a crude oil futures trading platform: the China Securities Regulatory Commission (CSRC) has already preliminarily approved the Shanghai Futures Exchange (SHFE) to set up an international resource-trading limited company to promote the establishment of a crude-oil futures platform and attract foreign investors to take part in domestic futures trading through this platform. According to Xinhuanet (see note 2), this company is being set up and it will be a new futures exchange which will share the same trading platform with SHFE.
- Gateway to domestic investments: CSRC plans to introduce measures to support financial institutions and other entities incorporated in the Zone to trade in the securities or futures exchanges in the other areas of Shanghai. These include the SHFE (which trades futures covering a wide range of underlyings such as copper, zinc, gold, silver, oil, platinum, steel, lead, fuel oil, bitumen, natural rubber), the Shanghai Metal Exchange, the China Financial Futures Exchange and the Shanghai Shipping Exchange. CSRC also plans to introduce measures to support qualified foreign individuals who are employed by an entity in the Zone to invest in the domestic securities and futures markets.
- Gateway to offshore investments: qualified (see note 3) financial institutions and other entities incorporated in the Zone, as well as qualified individuals who are employed by an entity in the Zone, are allowed to invest in the offshore securities and futures markets without going through the Qualified Domestic Institutional Investor (QDII) channel.
- Supporting the establishment of futures business: CSRC plans to introduce measures to support securities and futures companies to set up subsidiaries in the Zone to conduct futures business.
OTC derivative transactions with domestic investors
- Encouraging OTC derivatives transactions with domestic investors: the measures introduced by the CSRC include supporting securities and futures companies incorporated in the Zone to conduct OTC commodity and financial derivative transactions with Chinese domestic investors. However, before domestic OTC derivative transactions in China could take off, further legislative clarifications would be desirable in relation to enforceability of transactions, finality, netting, novation and collateral.
FX trades
- Establishing a foreign exchange administrative system: the Plan contemplates exploring the trial establishment of a foreign exchange administrative system in line with international practices to better facilitate trade and investment in the Zone.
Physical commodities
- Establishing a commodity trading and resource allocation platform: the Plan envisages that a feasibility study will be conducted into the establishment of commodity trading and resource allocation platforms for the international trade of energy products, bulk industrial raw materials and bulk farm produce.
Warehousing
Given that Shanghai is one of the busiest ports in the world, a critically important transport hub and a major break bulk cargo point, it is not surprising that the Plan explicitly addresses issues relating to warehouses.
- Expanding base metals bonded warehouse pilot project: SHFE began its pilot project for bonded delivery of copper and aluminium in December 2012 in Yangshan Deep Water Port, a constituent port within the Zone. The Plan endorses the expansion and improvement of this project in relation to base metals stored in bonded warehouses being delivered under domestic Chinese futures contracts.
- Developing warehouse receipts financing structures: the Plan states that the structures that are used for the financing of warehouse receipts, such as pledges, will be further developed.
>>>>> Warehouse financing – some hurdles
Typically, the owner of warehouse warrants uses them to raise money either by way of a loan secured by a pledge over those warehouse warrants or by entering into a commodity ownership structure where the owner sells the warrants to a financier and then repurchases the warrants at a higher price (a “repo” being the classic example). There are a number of issues which could helpfully be addressed by legislative changes to further facilitate warehouse financing:
- Management of warehouses: legislation could set up a regime for the licensing of warehouses and set out minimum licensing conditions on storage conditions, maintenance of records, capital adequacy, liquidity, managerial qualities, insurance and bonding cover (to protect against mismanagement and fraud).
- Warehouse warrants: in China, as in many other jurisdictions, there are many uncertainties and complexities associated with warehouse warrants.
Some of the questions that need to be considered include:
- are warehouse warrants documents of title (similar to bills of lading) or are they merely documents evidencing rights to possession?
- under Art. 387 of PRC Contract Law, a warrant needs to be signed or stamped by the issuing warehouse before it can be transferred. Warrants issued by international futures exchanges are typically freely transferable without registration, attornment or notice to the warehouse. Can Art. 387 be contracted out of?
- can acquisition of warrants from a non-owner pass legal title?
- will liens asserted by creditors of previous owners (or of the warehouse) and attachments (legal execution of judgments) obtained by creditors of previous owners (or of the warehouse) bind a bona fide purchaser of warrants without notice?
- is the warehouse obliged by law to recognise the warrant-holder’s claim?
- do transferees of warrants obtain the full range of rights against the warehouse as the depositor?
The benefits of statutory endorsement of an efficient and secure warehouse warrant system (possibly involving dematerialising or immobilising warrants) would be enormous. The European Bank for Reconstruction and Development’s (EBRD’s) Warehouse Financing Framework, and advanced warehouse legislation from jurisdictions such as Brazil, the Netherlands, and the United States could be considered.
>>>>> Foreign futures delivery warehouses – what if?
In the run-up to the publication of the Plan, there was media speculation as to whether foreign commodity exchanges would be permitted to designate warehouses in the Zone for physical delivery under commodity futures. Although the CSRC has recently re-stated its longstanding position, namely “to ensure economic stability and growth of the domestic futures exchanges, foreign bourses are still not allowed to designate warehouses on the mainland for the time being” (see note 4), the issue remains on the table. If at a later date the scope of the Plan was to widen to facilitate the establishment of foreign licensed commodity futures delivery warehouses that use a warrant system in line with international practices, then one would still need to contend with the challenges thrown up by the following legal issues:
- Fungibility of warrants: the role of warrants is to provide a simple, convenient and legally effective way of delivering vast quantities of metal. Each warrant is a bearer document of title evidencing the deposit of one lot of metal in the relevant futures-exchange licensed warehouse. It is, in effect, the currency of the futures exchange: each warrant is freely transferable and warrants relating to metal of the same specifications are fungible even though they may be issued by different licensed warehouses. As warrants issued by a licensed warehouse in the Zone would be governed by Chinese law, changes to Chinese law might be required to ensure that such warrants would have the same legal effect as those issued in other jurisdictions where other licensed warehouses are located.
- Liability of the exchange: in China, if a warrant issued by a delivery warehouse for a commodity future is not honoured, the futures exchange and the warehouse are jointly and severally liable. As a matter of international practice, however, a futures exchange typically has an arm’s-length relationship with its warehouses and does not assume liability for the performance of any of its warehouses.
It is hoped that foreign commodity exchanges will be able to eventually license warehouses in Mainland China itself. Such a step would assist consumers in China by cutting logistics costs. Further, it would follow the now established trend of collaboration between Chinese institutions and foreign commodity exchanges. (see note 5)
Shipping
- Developing shipping industry: the Plan calls for the active development of the shipping finance, international shipping, international ship management and international shipping brokerage industries.
- Increasing coordination among ports: there will be increased co-ordination between the customs supervised areas at Waigaoqiao Port, Yangshan Deep Water Port and Shanghai Pudong Airport.
- Increasing international transhipment cargo capacity: the Plan calls for Shanghai Pudong Airport to launch more flights for international transhipment cargo (including commodities).
- Developing freight derivatives: the development of freight derivatives will be accelerated.
Customs
- Streamlining customs supervision procedures: customs supervision will be adapted to promote free flow of commodities and other cargo within the Zone.
Taxes
- Introducing favourable tax policies: tax policies will be introduced to promote trade and investment.
Business establishment and integration; Mainland China
- Encouraging business establishment and integration: multinational companies will be encouraged to set up their Asia-Pacific regional headquarters in the Zone and to integrate their investment, management, trading, logistics and settlement functions.
- Supporting offshore businesses and their integration with domestic trading: enterprises in the Zone will receive support to develop their off-shore businesses and be encouraged to integrate the development of their domestic and foreign trading businesses.
- Gateway to other parts of China: in principle, enterprises within the Zone are not restricted to transacting with other entities within the Zone, and may make investments in or carry out business with counterparties outside the Zone. This is subject to the important caveat that all pre-existing laws are observed in relation to those counterparties.
Dispute resolution
- Bringing alternative dispute resolution in line with international practice: for a commercial dispute involving any enterprise in the Zone, the parties concerned may proceed in the People’s Court or, if they agree, file for arbitration or commercial mediation. The institutions in Shanghai that provide for arbitration and mediation will be encouraged to improve their arbitration regulations to meet international laws, regulations and practice. In choosing an international trading location, one of the factors which commodity companies consider is whether there are well developed judicial and arbitral systems with relevant commodity industry expertise for enforcing contracts.
Looking ahead
China’s pre-eminent role in the commodities markets means that the Plan for the Zone has considerable significance. The Plan is just the beginning but its importance cannot be overemphasized. The Plan envisages further organic growth: it expressly contemplates that both the geographical area of the Zone and its scope of activities will be expanded to further facilitate the establishment of Shanghai as a major hub for international trade and commerce.
It is probably too early to predict whether the Zone will be a dramatic turning point in China’s history of economic reform – a step-change to a more open and internationalised approach to investment and trade in commodities, goods and services. However, the initiative is driven by the central Chinese leadership (hence “Mr Li’s big idea”) (see note 6) and, if successful, will likely be replicated in the rest of China.
The Plan has already sparked considerable attention from the global business community. It is worth understanding the details in the Plan and keeping track of the practical implementing rules, many of which are still awaited.
For commodity market participants who currently do not have a presence in China, or who do not trade significantly with Chinese counterparties, the wide ranging reforms set in motion by the Plan may mean that now is the right moment to re-examine their appetite for exposure to China.
As mentioned earlier, a number of market participants are taking advantage of the relaxation in the regulatory frame work for foreign investments and setting up a local subsidiary.
It is still early days – but China is now one of the fastest moving markets on the planet, and we recommend that you stay tuned!
For further information contact:
Chin Chong Liew ([email protected])
Andrew Malcolm ([email protected])
Fang Jian ([email protected])
Richard Gu ([email protected])
Simon Zhang ([email protected])
Notes:
[1] Linklaters has published a bulletin which gives a general introduction to the Plan, covering issues such as the liberalisation of interest rates and RMB conversion for capital account items.
[2] Click here to access the Xinhuanet article (in Chinese).
[3] No official guidance has been given on what such qualifications are.
[4] http://www.csrc.gov.cn/pub/newsite/bgt/xwfbh/201310/t20131025_236961.htm (in Chinese)
[5] See, for the latest example: “Singapore Exchange to develop commodity futures with Shanghai Futures Exchange”. October 21st, 2013. (Reuters)
