香港製造 (Made in Hong Kong) 2: Renminbi Credit Default Swaps

CreditLime Special Report
May 20, 2010

香港製造(Made in Hong Kong) 2: Renminbi Credit Default Swaps

The sequel to the award-winning 1997 movie, Made in Hong Kong (perhaps called 北京製造), could be out later this year. Rumours have it that Autumn Moon returns (played by Yin Long, Deputy Director of the Business Innovation and Supervisory Cooperation Department for Banking Innovation at the China Banking Regulatory Commission or CBRC), this time having risen up the ranks from a violent teenage debt collector in the original movie to his new role as a volatile young professional credit default swaps trader. Time will tell whether film critics empathize with the alienation and commercial bank gang (also referred to as associations, forums and committees) issues that CDS traders are facing in the sequel in the same way they did with teenage alienation and youth gang issues when awarding the Best Picture Award back in 1997.

Yin Long was recently speaking at an FX Week conference in Beijing where he spoke to attendees in a way that alluded to the CBRC’s intention to introduce regulations to allow the trading of so-called onshore credit default swaps.

Onshore Credit Default Swaps

Onshore refers to derivatives under Chinese jurisdiction that would adhere to China’s own banking laws – as opposed to foreign investors or banks trading derivatives in foreign countries under foreign banking laws (on the same underlying Chinese companies).

This could also lead to the growth of renminbi currency-denominated corporate CDS. Currently investors don’t have an easy way to purchase or sell protection on Chinese entities in its own currency and have to resort to Hong Kong dollar-denominated or other currency swaps (i.e. like Yen-denominated or US dollar-denominated CDS). This can lead to important foreign exchange and basis risk management issues for investors that try to hedge renminbi-denominated corporate debt with CDS in other currencies and the CBRC appears to believe that providing an onshore (and renminbi-denominated) CDS solution could give a boost to China’s efforts to develop its own yuan corporate bond market.

Mr. Long was quoted saying “many people are still seeing CDS as [an instrument] invented by a group of elite on Wall Street that used to intoxicate people in a similar way to narcotics……I can tell you, this is wrong. CDS is definitely a good thing – it is a risk management tool for credit risk……Today, when one judges a bank’s operational performance one can no longer look merely at its cash or credit businesses, you need to look at a bank’s risk management.”

China CDS is clearly a focus

Mr. Long’s comments, on behalf of the CBRC, echo a trend shown by other Chinese authorities that reinforces the country’s overall focus on the issue of developing its own CDS markets. Yi Gang, a deputy governor of the People’s Bank of China (PBoC), was quoted saying “In order to hedge risk we need to have instruments to do that. We need to have swaps.” DerivativesWeek recently reported that PBoC could give the green light to its banks for a test trial of renminbi-denominated CDS as early as the end of this month. This follows reports that the National Association of Financial Market Institutional Investors (NAFMII) setup by PBoC had asked, the western-bank influenced and led, International Swaps and Derivatives Association (ISDA) for help in crafting its own derivatives documentation that one would assume all future onshore China or yuan CDS would have to adhere to.

ISDA and NAFMII have already collaborated together in the past. For example, the China Inter-bank Market Financial Derivatives Transactions Master Agreement (NAFMII Agreement) 2007 and 2009 editions, which covers financial derivatives transactions, is the work of NAFMII in consultation with ISDA on a variety of issues including close-out netting.

Close-out netting is simply a method believed to reduce credit risk and systemic risk (although there is a debate surrounding those claims), by combining all claims and  liabilities between bilateral counter-parties into a single payment in bankruptcy as opposed to the possibility of significantly increasing credit and systemic risk exposures for all affected counter-parties by becoming a general creditor in line with everyone else for each derivative contract separately (and a chance of getting less or even nothing).

DerivativesWeek reported that China Everbright Bank was given the lead role in the test trial of China CDS trading. They also report that China may not actually use the term credit default swap or CDS because of the negative connotations that the term has generated over the last couple years and are instead calling them credit risk management tools for now with the possibility of developing a new name for their product by the time of introduction.

A long time in the pipeline

While industry insiders are hopeful that China could launch onshore CDS later this year, Risk.net points out that China has a track record of lengthy delays when introducing new financial products or reform. Political and administrative issues can also sometime get in the way. For example, China’s first financial index future which started trading in April took over 5 years to launch. And interest-rate swaps in the country only began trading in 2006 – but since their release have seen torrid growth from 35.57 million renminbi in 2006 to 461.64 billion renminbi in 2009. ISDA reported that China was nowhere in 2006 structured debt issuance with only about $100 million issued yet, by some accounts, became one of the top 5 retail structured products markets in Asia by issuance in 2007.

With regards to CDS, Risk.net quotes Mr. Long saying he had been thinking about the introduction since 2001 although such discussions have  become more serious only recently. In fact, Eric Slighton, an MD in Asia Pacific credit derivatives in Hong Kong, at Barclays Capital had reportedly completed the first onshore Chinese credit default swap trade back in 2008 with a large Chinese bank. That achievement led to a nomination at the Institutional Investor’s 2008 Derivatives Awards for Structured Credit House of the Year – although the award was ultimately won by Deutsche Bank. The trade reportedly used a customized version of the standard ISDA template at the time to adhere to the local financial laws and referenced a US dollar-denominated bank loan to a domestic Chinese company.

Using a US dollar-denominated loan helped avoid some of the more stringent currency controls that China had in place at the time. One would think that these kinds of currency controls are also the subject of separate but related reforms if China is to re-introduce and expand onshore CDS in the future.

In the meantime, 甄子丹, 谢霆锋, 梁家辉, 黎明, 王学圻, 任达华. 胡军, 曾志伟, 范冰冰, 李宇春, 张学友, 李嘉欣, 孟克·巴特尔 from 十月围城 (Border in October/Bodyguard and Assassins) which won this year’s Hong Kong best film award, will be enjoying their time in the spotlight for as long as it lasts until Autumn Moon returns to do what he does best – this time with financial weapons of mass destruction.

CreditLime Financial News Bureau