China mulls bond repos to replace under-the-table guarantees
A practice called “entrusted bond holdings” has contributed to a rout in the world’s third-largest debt market as interest rates rise, liquidity dries up and trust breaks down, traders say
China should establish standard bond repurchase contracts to replace a current practice of so-called “entrusted bond holdings,” which contributed to the worst sell-off in the world’s third-largest bond market, said the head of the country’s securities depository agency.
“We should improve rules on outright repos, allowing the repo period to be open and flexible instead of fixed, to replace the entrusted bond holdings practice, which is problematic,” said Shui Ruqing, president of China Central Depository & Clearing Co. (CCDC), during the China Bond Market Forum over the weekend. “We should apply a more mature collateral management system, monitor the market on a daily basis and handle technical defaults quickly.”
China’s practice of “entrusted bond holdings” (代持), estimated at 1.728 trillion yuan, or 3 per cent of the country’s 57.6 trillion yuan interbank bond market, is under investigation by regulators and the central bank, after a broker refused to honour its buyback contract with several counterparties.
Entrusted bond holdings is a practice among Chinese brokers and funds that allow them to skirt existing limits on using borrowed money to invest in bonds.
By getting a third party to buy the bonds with a buyback addendum, these brokers and funds are effectively getting loans, which boost their leverage and give them the capital to buy even more bonds.
That worked well with low interest rates, ample liquidity and plenty of trust among financial institutions, said the Bank of Tokyo-Mitubishi UFJ’s analyst Li Liuyang.
When “all three conditions evaporate,” it’s every investor for himself, and the risk of them reneging on their under-the-table agreements emerge, Li said.
Sealand Securities Co., a broker based in Guangxi province, two weeks ago refused to buy back 16.5 billion yuan of notes held by counterparties, saying that the contracts were stamped with a forged seal.
Coming on the heels of a US Federal Reserve rate increase that ended the era of cheap financing, Sealand’s move spooked a jittery bond market, suggesting the breakdown of trust among China’s financial institutions.
That triggered a sell off in China’s bond market, prompting as many as 20 Chinese borrowers to cancel a combined 18 billion yuan of bond issuance in the three days from December 14 to 16. according to the CCDC’s data.
In a separate case, a Guangdong-based telecommunications company Cosun Group last week defaulted on US$45 million of private bonds guaranteed by China Guangfa Bank Co.
Cosun sold the bonds two years earlier to retail investors via the Zhao Cai Bao platform of Ant Financial Services Group, an affiliate of Alibaba Group Holdings, owner of the South China Morning Post.
Guangfa said the documents and seals for the letter claiming to guarantee the bonds were forged.
Following Cosun’s default, Ant will press various parties to repay investors, and has vowed to cover the legal bills for investors who decide to sue, but Ant doesn’t consider itself responsible for repayment since the products were developed by third parties, the Asian Wall Street Journal reported last week, citing Ant’s spokeswoman Miranda Shek.
To regulate the market and protect investors, the CCDC’s Shui has proposed ways to take everything above board with “outright repos” that prevent sellers from reneging their contracts.
It differs from a more pervasive trading pattern in China: pledge-style repos, in that the latter doesn’t allow buyers to “own” the notes, thus can’t use them for more trading. The outright repos increase the liquidity of the bonds and enhance their attractiveness.
An alternative could simply be to allow non-bank financial institutions such as brokers and funds to have access to capital, so that they wouldn’t need to engage in under-the-table tactics to bolster liquidity, said Shenwan Hongyuan Securities’ chief bond analyst Fan Wei.
Entrusted bond holdings could be standardised, instead of banned outright, Fan said.
China’s Securities Regulatory Commission is investigating the scope of the practice, and will issue clear rules after its probes.
The Shanghai Stock Exchange is also drafting rules to require brokers to be responsible not only for the sale of the bonds, but also to be charged with the default risks once the bonds are listed for trading on the bourse, said Hu Anjin, deputy head of the bond department.