Acceptance of Chinese government bonds as collateral will hinge upon rule changes around defaults. Lynn Strongin Dodds reports.
The use of Chinese government bonds as collateral was put forward in a recent white paper from the International Swaps and Derivatives Association (ISDA) in conjunction with China Central Depository & Clearing (CCDC). It puts forward arguments for their use, but also challenges.
One of the key drivers behind the current push is phases five and six of the uncleared margin regulation (UMR) for non-cleared derivatives which brings many Asia Pacific institutions into scope, according to Darren Crowther, general manager at Broadridge Securities Finance and Collateral Management. These come into force in September 2021 and September 2022.
“We are definitely getting more questions from our clients about booking Chinese bonds as collateral,” he says. “Asian domiciled institutions are quicker to ask questions because of UMR but I think over time we will see US and European banks with Asian operations also interested. I think it will be a ripple effect.”
As the paper ‘Use of RMB-denominated Chinese Government Bonds as Margin for Derivatives Transactions’ points out, the rapid increase in the size of the China bond market coupled with the gradual opening to overseas investors has put the securities firmly on the collateral map. However, it warns users to carefully understand any regulatory or legal impediments that may affect their collateral options.
“Chinese authorities have made a huge effort to open up the financial markets and the bond market is one of their big areas of focus. In turn, foreign investors have increased their participation in this market,” says Jing Gu, head of legal, Asia Pacific at ISDA in Hong Kong. “Naturally, there is also growing interest from investors in using Chinese government bonds as collateral – for example, in derivatives transactions – rather than just holding the bonds to maturity.”
Hurdles in the way
However, Gu says the paper highlights a number of challenges that need to be overcome to fully align the Chinese bond market with its international counterparts. This includes the need to improve policies for the outbound transfer of funds upon enforcement of the collateral in cross-border transactions, as well as cross-border infrastructure connectivity.
As the paper notes the “goal is to establish a market system that offers product diversity, operational functions with clear rules and regulations to align with international standards.” The government aims to facilitate market access for foreign investors, optimise post-entry services and accelerate the development of China’s bond market infrastructure by establishing a multi-tiered market and introducing more trading methods to improve liquidity.
Gu also notes the paper points to the enforceability of an initial margin arrangement during the bankruptcy proceedings of a Chinese entity as another major issue. This would enable its counterparty to enforce the collateral without undue delay following a bankruptcy event or default.
“Accepting Chinese bonds is not an issue and will happen over time, but the real problem is close out netting is not recognised under Chinese law,” says Iris Pang, ING’s chief economist for Greater China. “The problem is if there is a default, foreign investors are at risk because the process of getting money back will take time. I think it will be resolved but it could take one to two years.”
There were glimmers of light at the end of April. The Standing Committee of the National People’s Congress of China published a draft Futures Law for public consultation. Among its provisions was the recognition of netting enforceability. It expressly stated that close-out netting cannot be invalidated or revoked because a party has entered bankruptcy proceedings.
A tri-party solution
In the meantime, BNY Mellon is offering a solution that allows investors to pledge Chinese debt purchased through Hong Kong’s Bond Connect as collateral for so-called tri-party repurchase agreements, a nearly $4 trillion corner of the global short-term financing market.
In a traditional repo agreement, one borrows funds by selling securities to lenders with an agreement to repurchase them back in the future. These securities, usually high-quality assets such as US Treasuries, essentially act as collateral that lenders can seize upon when borrowers default. In a tri-party transaction, a third entity acts as an intermediary between the borrower and lender to facilitate services like collateral selection, payment and settlement.
BNY Mellon’s move follows a similar programme launched in 2018, when the bank allowed clients to pledge Chinese stocks purchased via Hong Kong’s Stock Connect as collateral.
Brian Ruane, CEO of BNY Mellon Government Securities Services, Clearance & Collateral Management and Credit Services, notes that the solution conforms to both mainland Chinese regulations as well as to Hong Kong rules for Bond Connect which bring several points of differentiation to other triparty markets.
“The key one for clients is that the allocation of Bond Connect assets can only be managed on a non-title transfer pledge basis,” he says. “The use of pledge has grown significantly over the last few years, therefore many investors are now comfortable with this.”
He adds, “The Chinese bond market is now the second largest in the world, with overseas investors balances of Chinese assets ever growing. Providing a solution supporting assets to be used as collateral within the secondary market is critical in enabling liquidity, enhancing financial stability and reducing funding risk.”
Market participants also expect Chinese government bonds to play an important role in meeting global demand for safe assets due to the current low interest rate environment. Although there have been a few hiccups this year, they have defied inflation concerns and higher US yields. The spread may have narrowed at 3.1%, but China’s 10-year yield is still almost double that of US Treasuries.
Many analysts and fund managers were encouraged by the stronger than expected rebound in the Chinese economy. Growth is projected at 8.1% this year, powered by strong exports and a gradual recovery in household consumption, despite uncertainties over the coronavirus pandemic, according to a report from the Asian Development Bank.
“I think that the Chinese macro backdrop is pretty solid which is good for the bond market,” says Edmund Harriss, director and CIO at Guinness Asset Management. “The growth is quite buoyant in trade and manufacturing, although the consumer side has lagged and still needs a bit of a catch up. There was a slight drop in foreign buying but that was only temporary and demand for Chinese bonds and RMB denominated assets in general has and will continue to increase because there is a good supply of reasonable quality.”
Foreign investors briefly withdrew in March – the first time in two years – but they returned in April in force in April adding 52 billion yuan ($8.1 billion) to their holdings, bringing the total to a record 2.1 trillion yuan, according to data compiled by ChinaBond.
Nick Tolchard, head of EMEA, Invesco Fixed Income, says, “The Chinese economy is seen as more stable than other emerging markets and the bond markets look for a degree of stability. I also believe that the inclusion of Chinese bonds in the indexes has made a big difference to liquidity. For example, the current Chinese component of the BBG Barclays Global Aggregate Index is 7.455%, which is equal to $5.02bn.
FTSE Russell is set to be next and add Chinese government debt to its key indexes in October, a move that analysts expect could attract more than $100bn of foreign capital. The index provider said it has been encouraged by the Chinese government’s efforts to improve secondary market bond liquidity, enhance the foreign exchange market structure and develop global settlement and custody processes.
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