Monday, November 23, 2009

Chinese regulators clamp down on derivatives

Posted in the Financial Times by Robert Cookson, Patti Waldmeir and Jamil Anderlini

When, at the beginning of 2008, Antoine Castel took control of the fixed-income unit in Beijing of Calyon, the investment banking arm of Crédit Agricole, the world’s biggest banks were making fat profits in China’s nascent derivatives markets.

But just weeks into his new job at the French bank, Mr Castel watched in horror as Chinese companies began to lose billions of dollars on the bespoke trades they had struck with western dealers. It was the start of a chain reaction that this summer unleashed a fierce backlash from regulators and local banks.

In stark contrast to the slow pace of reform in derivatives markets in the US and Europe, China’s regulators have in recent months shut down the main route by which foreign banks sold derivatives from offshore operations and have banished speculative deals – moves that have important implications not only for Chinese companies and foreign banks, but also for the evolution of China’s capital markets and the internationalisation of the renminbi.

As a result of the sweeping regulatory overhaul, trading volumes have plunged and foreign banks are scrambling to adapt to doing business in the new environment. “If you compare the business we are doing today with the business we were doing two years ago, it’s completely different,” says Mr Castel. “You have to forget about [the old] market. It’s gone.”

Previously, dozens of western banks such as Goldman Sachs and Morgan Stanley were striking huge deals with mainland companies that wanted to manage their exposure to swings in commodity prices, interest rates and currencies.

In two cases where trades went spectacularly wrong, Citic Pacific, the Hong Kong-listed arm of China’s largest investment conglomerate, lost $1.9bn last year on bets against the Australian dollar, while Air China, the country’s flag carrier, lost $1.1bn on oil derivatives.

They were just two of hundreds of companies that entered trades that were wildly mismatched with their hedging requirements, market participants say.

Chinese regulators suspect that in some instances companies used derivatives as a way to speculate, rather than hedge, while banks frequently sold overly complex products – the most profitable – without fully explaining the potential downside.

Products with names such as “snowballs” and “snowblades” proliferated, many with so-called “zero cost” structures that failed to live up to their name. Dealers say billions of dollars of trades are being renegotiated in private, some under pressure from Sasac, the shareholder and regulator of hundreds of state companies.

Total trade volumes have more than halved since a year ago, say market participants. Complex trades have vanished from the market.

“We are selling plain vanilla business in China, that is it,” says Mr Castel.

Deals that banks were once able to complete in five minutes over the phone now take an hour as the risks are explained in detail, says Mark Wightman of Super Derivatives, a data provider. The biggest shock to the established order came this summer when the China Banking Regulatory Commission banned most of the trades that can be originated offshore.

Until recently, almost all derivatives deals between foreign banks and China’s industrial and commercial companies were struck overseas, typically in Hong Kong. To surmount obstacles including foreign exchange controls that made it difficult to trade with Chinese companies directly, overseas groups would typically get mainland banks to stand in the middle of each deal for a fee. These “intermediary trades” also allowed those overseas groups to minimise their credit risks by dealing with a small number of big banks rather than dozens of more risky companies.

For the Chinese banks, however, acting as middlemen proved less advantageous. When the crisis struck in 2008, they were forced to provide their foreign trading partners with vast amounts of collateral, but were unable to recover nearly as much money from the local companies on the other side of each trade.

Regulators are said to be furious that local banks got into such a vulnerable position and enabled offshore groups to use “suitcase salesmen” to do business on mainland soil.

As well as banning the practice of intermediary trades, the CBRC now requires that banks ensure clients only buy derivatives that are appropriate for their hedging needs. The rules make it “virtually impossible to do some of the hairier trades and will really chill the market for anything but vanilla trades in future”, says Fred Chang, an industry veteran who now works for the law firm Lovells in Beijing.

In spite of grumbling among some bankers, most market participants believe that the regulations, while a stumbling block for the time being, are necessary foundations for the growth of a market that traders expect to be enormous within a decade.

David Liao, head of global markets at HSBC China, says the rules would be “a short-term sting in terms of revenue” but would be helpful over the longer term.

But regulation is only the start of the problems for many western groups. The Chinese banks that dominate onshore trading have grown more assertive and are demanding that foreign banks play by their rules.

The big four state-owned commercial banks are refusing to deal with the local operations of foreign banks unless they provide contractual guarantees on the trades from their global headquarters.

Foreign banks are reluctant to provide these guarantees or other concessions being demanded because it would lead to higher capital charges, and they fear it would trigger a cascade of similar demands from banks across the world.

As a result of the stalemate, a two-tier system has emerged, with foreign banks trading almost exclusively among themselves, while local banks do the same. Most market participants expect a solution to the deadlock to emerge in time, most likely with foreign banks backing down on their positions. More­over, at some point the trading books of the Chinese banks will reach bursting point and they will need to offload their risks to their western peers.

What is clear is that foreign banks, while bruised, are unwilling to let either regulatory clampdown or local competition drive them out of the market. As one western banker in China says: “You have to be in this market. You can’t afford to stay out of it.”

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