Last week's yuan liquidity crunch has shone light on the cracks in the Hong Kong Monetary Authority's mechanism for maintaining yuan liquidity. The city's quasi central bank and industry players tasked with safeguarding liquidity in the system botched up when interbank liquidity seized up to a level when the seven-day offshore yuan Hong Kong interbank offered rate shot up to 10.95 per cent. After a week of drama, the rate has since returned to 3.93 per cent as of Friday. The onshore-offshore markets are still two markets with completely different dynamics It was 10 months ago, the HKMA appointed seven banks as primary liquidity providers (PLPs) for the yuan with great fanfare. The idea was to ensure a deep pool of liquidity along with a protection mechanism to help Hong Kong market itself as the yuan hub of choice against the likes of Singapore, London and Taipei, before others with yuan ambitions, from Johannesburg to Zurich, move in. "The launch of the PLP initiative was an important step for enhancing the infrastructure for the offshore [yuan] market in Hong Kong," HKMA chief executive Norman Chan Tak-lam said at the time. "The PLPs will help make the [yuan] products in Hong Kong more liquid and make more use of Hong Kong to support their [yuan] business worldwide. "This will reinforce the status of Hong Kong as the global hub for offshore [yuan] business." The latest crisis has made it clear the primary liquidity providers mechanism has failed. It has shown they are not obliged to serve the way they were thought to. Even if they do, the HKMA's provision for yuan liquidity - either through its open market facility or the providers - at 24 billion yuan (HK$29 billion) is obviously inadequate for a city that sees one trillion yuan of settlement on an average day. Sure enough, the provision failed when crunch time came last week. The HKMA had to ring up banks to inject 40 billion yuan. Spokesmen for the seven banks - HSBC, Standard Chartered, Citi, BNP Paribas, Bank of China, China Construction Bank and ICBC - refused to comment. "We all have asked the HKMA to provide for more PLP facility [exceeding two billion yuan]," said one senior banker in charge of PLP implementation at one of the seven lenders. "In the end, the PLP arrangement is really too small and expensive to make any meaningful impact." In reality, PLP banks have nowhere to source yuan other than those received as payments and the two billion yuan facility given to each by the HKMA. None of the banks are allowed an overdraft facility with Bank of China, the mandated clearing bank for the city that has a direct link with the People's Bank of China's discount window. In the next available window, the HKMA provides a small 10 billion yuan open-ended facility. "The authority charges banks Hibor plus 50 basis points for borrowing," said Frances Cheung, the head of rates strategy for Asia, excluding Japan, at Societe Generale. Since the changes to the yuan's fixing this month, volatility in liquidity and swings in Hibor had risen, with rates for less than seven days being the most under pressure, Cheung said. Bankers say the HKMA's habit of being tardy in confirming trades and in providing timestamps blurs banks' borrowing costs - seen as a huge source of risk as Hibor swings all day. All of these mean few banks ever take overnight positions or engage in intraday borrowing, limiting the available pool of yuan to what banks physically have. It has been a clumsy design, turning into a scenario where "no bank can have yuan before receiving yuan", as an insider put it, which in turn is subject to the whims of the currency market and corporate treasurers' cross-border payments - as the market saw last week. He also said most banks with PLP facilities took it as a licence to get cheap yuan and lend it to the less fortunate banks for a profit. "We are not obliged to serve, we just risk losing the status," he said. All of which open the door for a scenario such as last week's and raise questions about the efficacy of the PLP mechanism. "Everyone's problem with [the yuan] is that it cannot be addressed properly," said one banker. "The onshore-offshore markets are still two markets with completely different dynamics. "Onshore liquidity is exclusively driven by the PBOC. The offshore yuan is still a currency without a central bank, despite the HKMA."