China cracks down on under-the-table bond deals in latest attempt to reduce risk in markets
Regulators order institutions to sign written contracts in bid to stop practice of sale and repurchase agreements agreed informally and verbally
China has ordered financial institutions to sign written contracts for bond repurchases or forward transactions as it looks to crack down on the practice of entrusted bond holdings, which has been blamed for a US$2.4 billion bond scandal in 2016.
In a document issued by the central bank and the banking, securities and insurance regulators on December 29 and seen by the South China Morning Post, institutions were also ordered to report to regulators if their outstanding repurchase and reverse repurchase volumes exceeded certain limits.
The order is the latest coordinated effort among regulators to reduce leverage and risks in the financial markets, which China’s president, Xi Jinping, has identified as one of the biggest potential threats to the economy in 2018.
The entrusted bond structure allows brokers and funds to skirt existing limits on using borrowed money to invest in bonds.
By getting a third party to buy bonds with a promise they will be bought back, brokers and funds are effectively getting loans which boost their leverage and give them the capital to buy even more bonds.
Such deals are usually arranged informally and verbally, and the structure worked well with low interest rates, ample liquidity and plenty of trust among financial institutions. However when such conditions evaporate, the risk of the deals unravelling increases.
The entrusted bond structure came under the spotlight in the 2016 scandal, when broker Sealand Securities caused panic in the bond market by declining to repurchase bonds it had sold. Sealand blamed a rogue employee for forging documents over the deal, but analysts pointed to the structure as the root cause.
China’s US$11.3 trillion bond market has seen a tough year in 2017 as a raft of financial tightening has sent prices tumbling. Benchmark 10-year treasury yields climbed 87 basis points in 2017, the most since 2013. But industry insiders said the latest rules were within expectations.
“The number of under-the-table deals has actually fallen considerably since the 2016 scandal, and leverage levels have fallen a lot after intensive regulations in the past year, so the new rule is more like a confirmation and formalisation of the regulatory stance,” said Ming Ming, chief fixed-income analyst with Citic Securities.
Under the new rules, financial institutions need to report their financial data to regulators if their outstanding volume of repurchase, reverse trading and deposit-taking transactions exceeds 80 per cent of their net assets. The cap for insurers is 20 per cent, and 120 per cent for securities firms, funds and futures brokerages.
“The regulation will have a greater impact on small banks, securities firms and private funds, which carry higher leverage, while big institutions’ current holdings have not breached the limit,” Pengyang AMC, a bond-focused mutual fund, said in a research note.
“Banks with assets below 50 billion yuan (US$7.7 billion) may have to cut their bond positions,” it said.
The document said the rules will apply immediately, but the regulators have offered a grace period of one year, after which failure to comply will result in offending institutions being banned from conducting new trading.