Monday, November 30, 2009

China Creates Derivatives Clearinghouse

Posted in the Wall Street Journal by Denis McMahon:

China launched a new body to centralize settlement and clearing of financial products traded among the country's banks, in a move that could bolster confidence in China's derivatives markets and open the way for the regulators to approve new products.

The move, announced by the central bank over the weekend, comes as the U.S. and the European Union have also been trying to centralize trading of some derivatives in their markets, to prevent markets seizing up if a key player defaults as they did when Lehman Brothers filed for bankruptcy last year. A central clearing body removes some of the risk that counterparties won't deliver and makes the overall market situation more transparent to regulators.

China's strict capital controls meant its markets weren't directly affected by last year's financial turmoil. But the financial crisis greatly shook the trust that Chinese banks had in their foreign counterparts, and China's largest lenders even now decline to trade key products with the local units of most foreign banks.

That has increased the expense and reduced the liquidity in China's interest-rate and foreign-exchange swaps markets. Those are the country's two main financial derivative products and key tools for companies trying to manage their foreign-exchange and credit risks.

By inserting itself between counterparties trading those products, a central clearinghouse would assume the risk that either party might default, and take insurance against that happening by collecting collateral from each party.

There are few details as to how the new clearinghouse will actually work. In a statement posted on its Web site Saturday, the People's Bank of China said the Shanghai-based clearinghouse will clear local- and foreign-currency financial markets, but didn't specify which markets it will start with or when.

The clearinghouse will "raise the transparency of the interbank market...better guard against systemic risk, and maintain the stability of the financial system," People's Bank of China Governor Zhou Xiaochuan said in a separate statement. Mr. Zhou said it also will reduce settlement costs and "provide the necessary technical support for financial products innovation."

That may signal that regulators feel the new clearinghouse will give them better ability to handle more volatile and heavily traded markets. So far China has been slow to introduce new financial products, with their reservations about derivatives reinforced by the financial crisis.

One possible concern is the lack of experience any Chinese government institution has in calculating risk and assessing appropriate levels of collateral to collect, given the huge amount of risk clearing centralizes in one organization.

The PBOC statement said the clearinghouse has signed a cooperation agreement with Deutsche Börse, which owns the Eurex derivatives trading platform and operates clearinghouses for exchange and over-the-counter products..

In June, China's foreign-exchange trading platform, the China Foreign Exchange Trade System & National Interbank Funding Center, launched central counterparty clearing for the foreign-exchange spot market. The move was somewhat unusual by global standards, because the two-day settlement period for foreign-exchange deals in China diminishes the risk of default. Market watchers said the move was likely to build experience to help guard against default in markets with longer maturities.

The foreign-exchange trading center is one of the six government agencies, also including the central bank and the Ministry of Finance, backing the new clearinghouse. It will have 300 million yuan ($43.9 million) of registered capital, the central bank said.

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