China Rejects ‘Naked Swimming’ With Default Swaps: China Credit

China Rejects ‘Naked Swimming’ With Default Swaps: China Credit

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By Bloomberg News

Nov. 5 (Bloomberg) -- China plans to start trading in yuan- denominated credit-default swaps today as the government experiments with derivatives blamed by some European and U.S. officials for inflaming the global financial crisis.

China Everbright Bank Co. and China Development Bank Corp. started offering indicative prices for the contracts, to be known as “credit risk mitigation” tools, according to data compiled by Bloomberg. China Bond Insurance Co. will write the first swaps, according to three people with direct knowledge of the matter. The securities will be controlled by regulators to limit leverage and speculation, the people said.

“European and American markets show the main problem is blind innovation and lack of regulation,” Shi Wenchao, secretary-general of China’s National Association of Financial Market Institutional Investors, or NAFMII, said in comments posted on the association’s website this week. “Market participants have been swimming naked in a huge bond market and we can imagine their desire for a well-fitting life jacket.”

China’s central bank will regulate the swaps, which insure buyers against defaults by borrowers, as part of a plan to help manage risk in the nation’s 3.3 trillion yuan ($495 billion) interbank bond market, NAFMII said last month. The announcement came after European and U.S. officials met this week to discuss limits on the $615 trillion over-the-counter swaps market, which they say worsened the financial crisis because traders and regulators couldn’t easily determine banks’ positions.

Leverage Cap

Yuan swaps will be traded through the Shanghai interbank clearing system, may only be sold to investors holding the underlying assets and can’t be used to insure high-risk securities, according to NAFMII, which published guidelines on Oct. 29. The value of the swaps cannot exceed five times that of the underlying debt, the guidelines show.

China Everbright indicated it will sell contracts protecting AAA rated bonds and loans from default for five years for 86 basis points, while China Development Bank Corp. may offer similar contracts for 90 basis points, according to Bloomberg data.

Units of the U.K.’s Barclays Plc, France’s BNP Paribas SA and the U.S.’s Citigroup Inc. are among 17 banks that will be allowed to trade the swaps, NAFMII said in a statement posted on its website yesterday. China Development Bank, Industrial & Commercial Bank of China, HSBC Holdings Plc, Deutsche Bank AG and 10 other banks are authorized to write the contracts, the statement shows.

Liang Shidong, China Bond Insurance’s chief risk officer, declined to comment on the start of trading when called by Bloomberg News yesterday. The People’s Bank of China formed NAFMII in 2007 to help develop the country’s over-the-counter financial markets, which span bonds, loans, foreign exchange, commercial paper and gold.

Central Clearing


China’s rules may accomplish what regulators in the U.S. and Europe are trying to achieve. The biggest overhaul of Wall Street rules since the Great Depression enshrined in the Dodd- Frank reform act will make it mandatory for most investors to settle derivatives trading through clearinghouses by next year. In Europe the deadline is 2012.

“Even though central clearing has been a major priority of the likes of the Bank for International Settlements and the Federal Reserve, there’s not been much progress in the last two years,” said Jeremy Amias, co-founder of fixed-income brokerage and advisory firm Amias Berman & Co. in Hong Kong. “China has the luxury, to some extent, of being able to organize and control the process as it is a purely domestic instrument.”

Dealers cleared $13.4 trillion of contracts in North America and Europe via Intercontinental Exchange Inc. clearinghouses through Oct. 29, according to the company’s website. About $27.3 trillion in contracts are outstanding globally, according to the Depository Trust & Clearing Corp., which runs a central registry for the market.

U.S. Legislation

The U.S. legislation, named after Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, and House Financial Services Chairman Barney Frank, a Massachusetts Democrat, became law in July. Congress took aim at the financial services industry after soured trades on mortgage securities and derivatives tied to the debt tipped the U.S. economy into the deepest recession since the 1930s.

India also plans to trade credit-default swaps on local- currency bonds, with the first contracts slated for the first week of 2011, Shyamala Gopinath, deputy governor of the Reserve Bank of India, said on Oct. 14.

The International Swaps and Derivatives Association, an industry trade group known as ISDA, said in a draft report to the Reserve Bank of India on Oct. 4 that there should be no restrictions on the swaps because “speculators are necessary for markets to be more liquid, efficient and complete.”

No China Defaults

“We have added some improvements compared to international products,” China Bond Insurance’s Liang said, in a telephone interview from Beijing. “The CDS have to be reported to the regulators so the whole market can easily know about it. If you control leverage then you can control bubbles in the market, which is better for overall development.”

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

About 29 U.S. companies and five European firms failed to meet their debt obligations this year out of a global total of 40, according to Moody’s September Default Report. No company has defaulted on publicly traded debt in China since the PBOC started regulating the market in 1997, according to Ivan Chung, a senior analyst at Moody’s Investors Service in Hong Kong.

‘More Appetite’

China’s economy, which grew at a 9.6 percent rate in the third quarter, will probably expand 10.5 percent this year and India’s gross domestic product will rise 9.7 percent in 2010, the International Monetary Fund said on Oct. 6. The U.S. economy will grow 2.7 percent this year, down from a 3.4 percent estimate four months ago, the Washington-based fund said.

China’s bond market is headed for its busiest year since Bloomberg began tracking the data in 1999. Companies have issued a record 771 new notes totaling 1.6 trillion yuan.

Credit-default swaps may eventually “create more appetite for issuance from lower-rated companies as investors will have tools to hedge the risk,” Manoj Kulkarni, head of credit research at brokerage SJS Markets Ltd. in Hong Kong, said in a telephone interview.

Five-year swaps on China’s dollar bonds fell six basis points to 54 basis points this week after dropping seven basis points in October and 19 in September, according to data compiled by CMA in New York. Prices typically decline as investor perceptions of creditworthiness improve. A basis point, 0.01 percentage point, equals $1,000 annually on a contract protecting $10 million of debt.

Rate Swaps

Elsewhere in credit markets, the yield on the 3.28 percent government bond due August 2020 rose one basis point today to 3.88 percent, the highest for a benchmark 10-year note since September 2008, according to data from the National Interbank Funding Center.

China’s debt has returned 8.5 percent this year, compared with 16 percent in Brazil and 12 percent in Russia, JPMorgan Chase & Co. indexes show.

One-year interest-rate swaps, or the fixed cost needed to receive the floating seven-day repurchase rate, climbed two basis points as of 10:05 a.m. in Shanghai to a two-year high of 2.53 percent. Five-year swaps also gained, rising two basis points to 3.80 percent, the highest level since March. That’s up from this year’s low of 2.69 percent on Aug. 12, according to data compiled by Bloomberg.

The yuan gained 0.1 percent to 6.6595 per dollar, according to the China Foreign Exchange Trade System. It has appreciated 2.5 percent versus the dollar since a two-year peg was relaxed in June, and non-deliverable forwards show traders are betting on a 3.7 percent increase in the coming 12 months.

The extra yield investors demand to hold Chinese corporate bonds rather than government debt shrank to the lowest level since October 2008, according to Bank of America Merrill Lynch’s China Corporate Index. Spreads narrowed to a low of 1.21 percentage points yesterday, the index shows.

--Henry Sanderson, Shelley Smith. With assistance by Shannon Harrington in New York. Editors: Will McSheehy, Hugh Chow

To contact the reporters on this story: Henry Sanderson in Beijing at hsanderson@bloomberg.netShelley Smith in Hong Kong at ssmith118@bloomberg.net

To contact the editor responsible for this story: Will McSheehy at wmcsheehy@bloomberg.net