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REGULATION

Bond Market Next in Line for Regulatory Overhaul

By Zhang Yuzhe and Han Wei

(Beijing) — China’s financial regulators are turning their attention to the country’s 63 trillion yuan ($9.1 trillion) bond market in their latest efforts to clean up shady practices that could threaten the stability of the financial system.

Spurred by the ballooning leverage of financial institutions and a scandal that sent the bond market into a panic in December, the central bank, along with the three commissions overseeing banking, securities and insurance, are working together on the rules that will be issued soon, sources close to the watchdogs told Caixin.

With the government opening the doors wider to foreign institutional investors, it has also recognized the need to streamline one of the most fragmented areas of China’s capital markets. Bond issuance and bond trading are currently overseen by five state agencies, including the central bank.

This is only the second time that regulators have sought to unify supervision of the financial markets, which are becoming increasingly integrated and difficult to oversee effectively as companies overseen by one watchdog moved into the territory of the others. Last month, the central bank and the three commissions made their first concerted effort to transcend their jurisdictions by proposing one overarching regulatory framework to bring the burgeoning asset management industry under control.

The detailed draft of the regulations has not been finalized, but sources with knowledge of the matter have told Caixin that a key section will cover the use of bond repurchase agreements and, in particular, a variety of this instrument known as entrusted bond holdings. These have been widely used by many banks, securities companies and other financial institutions to skirt regulations, increase their leverage and channel money raised through wealth management products into the bond market.

Bond repurchase agreements had largely fallen through the cracks of regulatory oversight, but the potential dangers of these instruments were exposed in December when Sealand Securities, a midsize brokerage firm, became embroiled in a dispute over 16.5 billion yuan of such agreements signed with more than 30 financial institutions.

In a scandal that became known as “the Radish Stamp Incident,” a nod to the ancient practice of using radishes to make seals because they were cheap and easy to engrave, Sealand threatened to renege on the agreements, claiming they were unauthorized and made by former employees using a fake company seal.

When the news leaked into the market, it triggered a massive selloff as investors lost confidence and liquidated billions of yuan of their holdings out of fear that more such problems would emerge. It took a major intervention of the China Securities Regulatory Commission (CSRC) to defuse the crisis and restore calm.

Skirting Regulations

A bond repurchase agreement allows the holder of a bond to pledge or temporarily transfer ownership to another financial institution for cash, and promise to buy it back at a later date. It is a common tool used by bond traders to make more efficient use of their own funds.

Securities companies have driven the boom in bond repurchase agreements in spite of government-mandated limits on the use of such instruments to raise money to invest in the bond market. In an effort to skirt these rules and avoid limits on using borrowed money to invest in bonds, institutions made increasing use of what’s known as an entrusted bond holding, which allowed them to keep the agreements off their books. Agreements were often informal contracts or even just verbal agreements to keep them out of sight of regulators.

The practice allowed brokerages and funds to borrow more money, increase their leverage and buy more bonds.

Banks were happy to stand on the other side of the agreements as it allowed them to earn income by charging fees to the seller and channel funds they raised from selling wealth management products into the increasingly profitable bond market.

The outstanding value of bond repurchase agreements rose to 4.2 trillion yuan in December 2016 from 1.7 trillion yuan in January 2014, a jump of 150% in two years, according to Wang Tao, chief China economist at UBS AG in Hong Kong. The growth highlights the tidal wave of money that poured into the bond market and the risks to market stability posed by incidents like the Sealand Securities scandal.

Entrusted bond holdings worked well when bond prices were rising, but when they started to fall, things went terribly wrong, as the Sealand Securities incident demonstrated. The scandal also destroyed the vital ingredient of trust between institutions.

“Trading on verbal confirmation became an industry norm because it was efficient, and it worked fine when people trusted each other,” according to a bond trader at Shenwan Hongyuan Securities.

The draft regulations are set to put these shady practices under proper oversight. They will require entrusted bond holding arrangements to be signed as formal repurchase contracts and listed on financial institutions’ balance sheets. They will also be used in calculations of an institution’s capital adequacy, leverage ratio and other risk-control measurements, regulatory sources said.

The CSRC is also formulating a separate directive under the new regulatory framework to govern securities firms’ investments in bonds. The directive will set strict requirements on the use of seals in repurchase agreements and the ways the documents are archived in order to avoid forgery and to better trace transactions, a source close to the commission said.

Leverage Caps

In addition to enhancing supervision of repurchase agreements, the new regulations will set maximum leverage ratios for different types of institutions, consolidating and expanding on existing rules imposed by individual watchdogs, sources with knowledge of the draft regulations told Caixin.

Banks and other depository institutions will be allowed to hold bond repurchase agreements with a total value of only up to 8% of their outstanding deposits. Other financial institutions including trust, securities, futures, insurance and financial services firms will be allowed to make repurchase agreements equivalent to as much as 80% of their net assets. The cap for investment funds such as bank wealth management products is 40% of net assets and for private funds the limit will be 100%, according to a draft seen by Caixin.

The regulations, once they are put into effect, will allow for a one-year transition period for institutions to adjust their bond trading activities, and those who fail to meet the new requirements will not be allowed to make new bond investments. The rules will be phased in gradually and will apply only to new products and agreements, according to the draft.

“The most significant aspect of these new regulations is that they provide unified rules and standards,” an official at the central bank said. “If they are strictly implemented, they will bring great challenges to the industry and many institutions will suffer” as they are forced to deleverage, he said.

Contact reporter Han Wei (weihan@caixin.com)

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