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Christine Chan

Lack of authorised hedging tools leaves mainland banks vulnerable to rate shocks

New rules allowing domestic and foreign banks to trade a broad range of derivatives in China should allow investors more tools to manage risk stemming from huge government bond holdings.

The move will also potentially prepare the way for a liberalisation of the  closed capital account.

The resumption of authorised derivatives trading - largely halted after a bond trading scandal in 1995 - was unveiled by the China Banking Regulatory Commission (CBRC) on Sunday with new rules which allow qualifying foreign banks to participate.

Banks' need to better manage financial risk stems in large part from a maturity mismatch between short-dated bank deposits and longer dated government bonds which represent about 15 per cent of bank assets.

China Merchants Bank bond trader Yin Jinhua said: 'The need for hedging products is crucial because bond holders need to buy options to hedge against a potential rise in interest rates.'

The typical maturity of government-issued bonds is seven years while average bank deposits have a five-year term, giving rise to a financial risk that banks have laid off in the unregulated over-the-counter derivatives market.

A money market trader with a major foreign bank in Shanghai said the new rules legalised a trade led by the big state banks as the central government experimented with state firms laying off risk. 'There are no rules allowing derivatives trading ...  there are no rules banning them,' he said.

The lack of authorised hedging tools leaves mainland banks vulnerable to interest-rate shocks. Each 10-basis-point change in the base interest rate is reckoned to translate into a 0.6 percentage point move in bond prices.

'That sensitivity is important for mainland banks because they hold a large chunk of the outstanding government bonds worth more than two trillion yuan,' the trader said.

The foreign currency trader said mainland banks' and firms' long-term funding needs could be better managed through the use of interest-rate and foreign currency swaps.

China needs to increase the rate of return on its savings, and structured deposits linked to foreign currency or interest rate benchmarks should assist capital preservation.

In the early 1990s foreign banks aggressively sold high return structured notes to mainland companies, but a number of high-profile losses coincided with a worldwide aversion to aggressive sales tactics and poor disclosure of risks.

Foreign banks were already offering mainland clients offshore hedging services, one trader said.

Michael Preiss, chief investment strategist of  CFC Securities, said: 'What China really needs is a credit and risk culture. A lot of the decisions were made by politics, but now basically the financial system does the job, and this is where derivatives come in by allowing risk to be traded between parties.'

Derivative Rule Book

Derivatives defined as forward contracts, futures, swaps and options transactions

Permitted market participants include policy banks, commercial banks, trust and investment companies, finance companies of state-owned enterprises, financial leasing companies and other non-bank financial institutions

Foreign bank branches can apply for licence if their domestic regulator monitors derivatives trading

Applicants will be notified whether successful within 60 days of applying

At least five executives must have derivatives trading experience, woth the firm head having at least five years' experience

Criminal sanctions will apply to rule violators



New derivatives rules to lower risk