Caixin
Dec 28, 2016 05:47 PM
FINANCE

Bond Woes in China Raise Concerns of Financial Meltdown

(Beijing) — Heightened volatility in China’s bond market — in part fueled by a recent bond default that roiled the market — is fueling concern about whether another financial meltdown is brewing similar to last year’s stock market rout.

Shenzhen-listed Sealand Securities sparked the turmoil last week after the emergence of online rumors— later proved true — that the midsize brokerage had refused to honor a bond transaction purportedly worth 10 billion yuan ($1.44 billion) with Lang Fang Bank.

Sealand balked on the grounds that the contract was made by two rogue employees who used a fake company seal to initiate the transaction. This left the bank temporarily holding the bonds for Sealand with a huge paper loss as bond prices dropped.

The episode soon sent shock waves through the already volatile bond market. When Sealand confirmed an investigation by the securities regulator on Dec. 15, China’s government bond futures plunged, with the 10-year bond futures crashing by 2%, the biggest daily drop in history.

To be sure, China's bond market was already under severe pressure as regulators tightened rules over “shadow banking” activities, a major source of borrowed funding for the bond market. Then, too, there was a U.S. Fed rate increase and subsequent hawkish comments, raising yields and lowering bond prices. Plus, all this came just as banks were becoming extra cautious. They need to make sure their capital reserves are adequate on the 15th of each month, so they were in no mood to hold bonds when they needed the funds and prices were declining.

Gray area

But the Sealand incident caused a crisis of trust in the interbank market. And it turned a spotlight on the risks of a loosely regulated gray area in China’s bond market, called “proxy holding arrangements,” or entrusted bond holdings. The widely used practice involves an agreement, usually made between banks and other financial entities, in which a brokerage or bank buys another institution’s bond and temporarily holds it for a certain period in return for a fee.

The arrangement allows the seller to pledge or temporarily transfer the ownership of bonds for cash and use it to buy more securities. For the buyer, it’s a chance to profit from a boom in the bond market. Years of a booming bond market and low interest rates have made such deals lucrative and prevalent in the industry.

Financial institutions have increasingly turned to proxy holding arrangements as it effectively gives the institutions access to loans and allows them to circumvent leverage restrictions. Some institutions also use the method to make its financial conditions look better on paper by getting money-losing assets temporarily off their balance sheets.

Many bond-market experts interviewed by Caixin said the proxy holding business has grown rapidly since 2013 as more banks have entrusted investment firms to invest their wealth management funds into the bond market.

Data from the China Government Securities Depository Trust & Clearing Co. (CDC) showed that interbank financial management, mainly entrusted investments, has increased from 3.57% of wealth management funds held by Chinese banks in 2013 to 15% in 2016. During the period, the value of wealth management funds has surged from 10 trillion yuan to 25 trillion yuan.

But China’s bond market started a correction in October after a three-year bull market as Beijing stepped up efforts to cut excessive leverage in the financial market with measures that included pushing up money market rates and tightening rules on wealth-management products. Between Oct. 24 and Dec. 20, yield of 10-year government bond climbed from 2.64% to 3.37%.

As the central bank tightened liquidity, lenders started to ask for their money back, adding pressure on brokers and sparking a chain reaction in the bond market, said analysts and bond traders.

The bond market volatility in mid-December is essentially a large-scale bank run on non-bank financial institutions, which triggered a liquidity crisis, said Gao Shanwen, Essence Securities' chief economist.

The Sealand crisis

In stepped Sealand. It was caught in the spotlight on Dec. 14 after rumors surfaced that it was disavowing the ownership of 10 billion yuan worth of bonds held by Lang Fang Bank on its behalf.

The brokerage said in a Dec. 15 filing to the Shenzhen Stock Exchange that the bond transaction agreement was unauthorized and was made by a former bond division executive, Zhang Yang, and a former employee named Guo Liang with a fake company seal. Zhang had left the company in August and could not be reached, while Guo had turned himself in to police, the firm said. Sealand confirmed an investigation by the securities regulator.

It’s unclear who issued the bonds or held them at the time the two rogue Sealand employees entered into the entrusted bond holding deal — or where the funds from that transaction went. Also unclear is whether Zhang and Guo were Sealand employees at the time they allegedly used the phony seal.

A Dec. 15 negotiation between Sealand and some of its counterparties on possible losses failed to result in an agreement. Sealand argued that it shouldn’t bear any responsibility and counterparties should have verified the seal on the contracts, according to the meeting minutes.

The incident rocked the market. Many blamed Sealand for undermining investor confidence and exacerbating market woes, which have seen bond prices tumbling and yields spiking in recent months.

The market outcry triggered the China Securities Regulatory Commission (CSRC) branch in Guangxi province, where Sealand is based, to conduct an investigation into the brokerage. The central bank also ordered its local offices to inspect proxy bond holding deals, sources close to the regulators told Caixin.

Regulators stepped in late on Dec. 20 with a five-hour meeting in downtown Beijing chaired by Li Chao, vice chairman of the CSRC. Executives from Sealand and 22 banks and brokerages attended the meeting. They were told by the regulator that the meeting “will not end without a resolution.”

At issue was whether Sealand would be responsible for covering any losses incurred from the questionable bond transactions facilitated by two employees using a forged company seal.

Sealand said after the meeting that fake seals were suspected of having been used in bond holding agreements involving 16.5 billion yuan. The broker said it would take responsibility for the bogus deals to ease the worries of its counterparties.

Sealand agreed to “jointly take responsibility with counterparties” in order to “maintain stability in the bond market” in a statement issued after the Dec. 20 meeting without elaborating how the arrangement was made. Sources close to the matter said banks and securities firms will continue holding Sealand’s bonds and wait for the market to recover.

Several sources close to Sealand and its counterparties said the alleged fake agreements have caused about 800 million yuan paper losses for the companies as bond prices fell. Sealand reported net profit of 1.8 billion yuan in 2015, company financial report showed.

Sealand’s announcement appeared to help calm the market as major government bond futures started to rebound. But the entrusted bond holding agreements of Sealand represent only “a drop in the ocean” of the whole industry, said a bond industry expert who asked not to be named. The expert said a credit risk still hangs over the market as liquidity drains away.

Under CSRC mediation, Sealand said on Monday that it had reached agreements with seven securities firms that have similar disputed bond deals with Sealand to extend their transaction contract and jointly bear possible losses, easing the tension for the possible default of a total of 5.9 billion yuan bond that the institutions allegedly held on behalf of Sealand.

Based on data from the CDC, market analysts estimated that the total value of bonds used for entrusted holding in the interbank market, by the most conservative estimate, has reached 200 billion yuan. If exchange-traded bonds are included, the overall value probably has exceeded 500 billion yuan.

“But since such deals largely remain off the balance sheet, no body knows the exact size,” said one analyst.

The Sealand case “exposes the risks of (financial institutions’) off-balance sheet businesses, which are mainly linked to banks,” said the bond industry expert.

Chain reaction

Although the disputes over Sealand’s bond deal have simmered down, the bond market is still facing risks from the proxy holding arrangement, and other cases may escalate into a crisis whenever the market become volatile, said Xu Hanfei, chief bond analyst at Guotai Junan Securities.

A trader from a large brokerage told Caixin that after the Sealand incident, financial institutions have started internal inspections of their proxy bond holding deals.

“Some have suspended the business while conducting verification on seals provided by counterparties,” the trader said.

The trouble is, unlike the Sealand transaction, many of the deals are made by verbal agreement and stay outside regulatory oversight, according to a person from Shenwan Hongyuan Securities.

“Trading on verbal confirmation has become an industry norm because it’s efficient, and it worked fine when people trusted each other,” the source said.

A central bank official said that “the Sealand incident illustrated the counterparty risk that has long been overlooked by financial institutions. It also exposed flaws of the segmented financial market and the need of more unified supervision.”

Many analysts interviewed by Caixin saw the Sealand incident a trigger of a round of deeper correction. Deng Haiqing, chief economist of JZ Securities, said regulators’ deleveraging efforts and tougher supervision will continue in the bond market next year. The bull market has ended, he said.

Contact reporter Han Wei (weihan@caixin.com)

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