China’s financial regulators have introduced new rules that seek to contain leveraged and under-the-table bond trading.
The new regulations jointly issued by the People’s Bank of China in conjunction with the bank, insurance and securities agencies specifically target “dai chi” (代持) or pledged financing, as well as repo and reverse repo agreements.
According to Shanghai Securities News, “dai chi” or “proxy holding” refers to an informal form of pledged financing or outright repo, in which people use their personal contacts to arrange for financial institutions to hold bonds on their behalf.
The cost of proxy holding is usually lower than the par value of the bond, enabling investors to profit from both the spread between the proxy holding cost and the par value, as well as capital gains should market rates decline.
Dai chi are considered to occupy a “grey area” in the Chinese financial sector, given that many are established via informal verbal or under-the-table agreements.
Regulators are concerned that dai chi could emerge as prime sources of risk given that they fly under the radar of official scrutiny yet can greatly magnify the real leverage levels of financial institutions.
According to the new regulations bond market participants must “abide by the principle that substance is more important than form,” by executing transaction contracts and related agreements in accordance with regulatory requirements.
The regulations also prohibit the use of any form of under-the-table agreement, or covert or combinations transactions, to side-step internal controls and regulatory requirements.
Market observers say the new regulations come as a severe blow for informal pledged financing of bond transactions, with some even claiming that they could stamp out the practice completely.
The new regulations also seek to control leverage in relation to repo and reverse repo transactions, requiring that market participants “abide by liquidity, leverage ratio and other risk indices,” and maintain “reasonable” control of bond transaction leverage levels.
Regulators have set leverage thresholds at which market participants are required to promptly report on their bond transactions.
For example deposit-taking financial institutions are required to submit reports to regulators once their own bond repo or reverse repo balances exceed 80% of net assets for the preceding quarter.
Industry observers point out that regulations mark the first time that Beijing has sought to standardise bond transactions, and indicates that the leading financial authorities are increasing their level co-ordination following the establishment of the Financial Stability and Development Commission by China’s State Council last year.
Li Yuehua (李跃华), head of Fullgoal Fund’s fixed income account, said to Shanghai Securities News that despite the potential impact of the new regulations, the curbs do not come as a huge surprise for the Chinese bond market.
Li does point out that curbs on leverage ratios could have a greater impact on small-scale banks and brokerages that engage in bond trading on their own account, with some institutions potentially coming under pressure to sell off their debt holdings.