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7 Things to Know about China’s Bond Rout

By Wang Yuqian

China’s bond market, which boomed for three years, seemed to have hit a tipping point in December, with many traders saying it was “the darkest time ever.” One obvious cause was the U.S. Fed predicting more-than-expected rate hikes next year, which would lead to more capital flows out of China. But a few domestic factors paved the way for the big rout that shocked the market.

What may have triggered the rout?

It all started with a rumor that proved true. A midsize brokerage firm, Sealand Securities, was said to be reneging on a deal involving bonds worth originally 10 billion yuan ($1.44 billion) on Dec. 14. It soon turned out that it had made similar under-the-table repurchase agreements with more than 20 financial institutions to buy back bonds worth more than 20 billion yuan. Because those bonds were now trading at a loss, Sealand did not want to complete the agreements and buy them back. And what made it think it could do that? Because it said the seal used for all the repurchase agreements was forged. This had a far-reaching impact on the bond market, regardless whether a firm was directly involved in the troubled agreements or not. Sealand later said it had solved the disputes with the financial institutions after the direct intervention of high-level securities regulatory officials.

What’s a repurchase agreement, and why would securities firm hide them?

A repurchase agreement allows the holder of a bond to pledge or temporarily transfer the ownership of the bond to another financial institution for cash, while making a promise to buy it back. It is a common tool used by bond traders to make more efficient use of their own funds. Some repurchase agreements are monitored by financial regulators, others are not.

The latter usually appear as two unrelated transactions. The obligation for the bond seller to buy the securities back often comes in the form of a footnote, a separate contract, or — as is often the case according to many bond traders — a verbal commitment made by individual traders. When bond prices rise, no one would have a problem fulfilling the repurchase agreement. When the prices fall, as they did recently, the selling party stands to lose by purchasing the bonds back.

Securities firms face strict ceilings on government-monitored repurchase agreements, so they turn to under-the-table deals. No one knows how big the shadowy market is because it’s hard to gather data on the deals. China Central Depository & Clearing Co., the provider of settlement services for the interbank market, estimates that roughly 15% of bond transactions this year with a combined value of 12 trillion yuan were repurchase agreements not officially registered as such.

Why would anyone not directly involved in the fraudulent deals worry?

The Sealand episode was deeply unsettling for many bond traders because it shook the very foundation of similar repurchase agreements that have been prevalent in the market.

“Trading on verbal confirmation has become an industry norm because it’s efficient, and it worked fine when people trusted each other,” a bond trader from Shenwan Hongyuan Securities said. The Sealand fraud and its aftermath indicated that this trust may have been abused. Many bond traders scurried to examine their repurchase agreements, holding off transactions and exacerbating a liquidity crunch in the market.

What role did the banks play in the bond market crisis?

If you live in China and you buy wealth management products from banks, chances are that some of your money went to the bond market. Banks outsourcing the management of funds — including their own capital and those from wealth management clients — provided the ammunition bond traders needed to take on more debt and increase the return on their own capital. This was mainly carried out through the use of repurchase agreements. By selling a bond to another company, a securities firm gets cash and uses it to buy more bonds.

What happened when the government intervened to control risk?

To prevent systemic risk, China’s central bank, starting in October, intervened to root out speculation in the bond market by tightening the supply of short-term, cheap funds. This made it more costly for traders to borrow, and the hope was that this tightening would force traders to gradually deleverage.

This process unfolded perhaps more violently than some analysts had predicted. Why? One explanation, put forward by Gao Shanwen, chief economist of Essence Securities, is that the change in the liquidity environment triggered a run by banks on non-bank financial institutions, such as a securities firms.

A run on non-bank financial institutions? How so?

To understand what this means, let’s first take a look at how funds flowed from banks to non-bank financial institutions and the bond market.

Typically, the process would start with a big bank purchasing the wealth management products offered by a smaller bank. The small bank then outsources the investment of the fund it received to a non-financial institution, such as a securities firm. The securities firm invests the money into bonds. But when bond prices kept falling, combined with the pressure of tightened liquidity that banks now need to grapple with, the flow of funds went into reverse as banks wanted cash.

This set in motion events that reinforced one another and increased the bond market volatility. As the securities firm sells off bonds to pay back the small bank, which itself may be facing increased pressure of retuning funds to the large bank, bond prices fall further and more banks want their money back.

What does this say about China’s financial markets and their regulations?

The Sealand case underscored the weak implementation of proper rules at financial institutions and the inability of financial regulators to monitor and control risk across different sectors of the market. The China Securities Regulatory Commission (CSRC), for example, does not know how many under-the-table repurchase agreements securities firms have made in the interbank market. The National Association of Financial Institutional Investors, which oversees the interbank market, thinks it is the CSRC’s job to make securities firms abide by the rules.

Contact reporter Wang Yuqian (yuqianwang@caixin.com)

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