High costs limiting CNY corporate swaps market

Isda AGM: Demand growing but high capital costs burdening banks

William Shek
William Shek, HSBC: Onshore swaps hampered by collateral and netting concerns

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The trading of interest rate swaps between banks in China’s onshore market has grown, but the dealer-to-client market on the mainland still faces cost hurdles, according to William Shek, head of credit and rates for Asia-Pacific at HSBC.

Chinese companies are increasingly using interest rate swaps to hedge Shibor-linked loans. The interdealer market to manage these risks is thriving as clearing of swaps is common and the trades are regularly compressed to reduce capital costs. However the dealer-to-client market is not as efficient or as developed as in the offshore hub of Hong Kong, Shek said at a panel discussion during the annual general meeting of the International Swaps and Derivatives Association in Hong Kong today (April 10).

Dealers face a higher counterparty risk capital burden when trading with corporates as they do not post collateral. The continuing legal uncertainty surrounding the use of close-out netting in China also exacerbates the problem.

“The dealer-to-dealer platform is quite well developed, but the client-to-dealer platform has room to improve,” said Shek.

In China, a lack of specific netting laws has made it difficult for lawyers to give an opinion that the technique will work upon default. Legal certainty on close-out netting in China would allow dealers to collapse offsetting dealer-to-client trades into a single net payment if a counterparty defaults. That way dealers would only need to hold capital against their net exposure with Chinese counterparties, rather than gross.

While some law firms have released conditional legal opinions on netting in China with Isda master agreements, onshore banks tend to use swap agreements developed by China’s National Association of Financial Market Institutional Investors, which currently doesn’t allow for netting. Combined, these create serious impediments for dealers’ ability to facilitate the growing demand for swaps from corporates in China.

“When you deal with a NAFMII counterparty obviously there is no netting in place, and banks don’t like to do an unsecured swap where there is no credit support annex,” Shek said. “In that bilateral framework the capital charges are a little high.”

The challenges in China’s onshore market stands in stark contrast to the more internationalised offshore renminbi market in Hong Kong, he pointed out.

Chinese corporates tapping the offshore market for US dollars through subsidiaries and using cross-currency swaps to hedge the proceeds back to onshore renminbi has been a growing trend over recent years. Offshore use of the Hong Kong Exchange’s clearing service for cross-currency swaps, and the ability to face a counterparty using Isda documentation – allowing close-out netting to be enforced – means the cost of hedging is much lower than in the onshore market.

“Capital charges are very low, and so the cost of hedging is pretty efficient,” he said. “In terms of legal basis risk there is none, because when the Chinese counterparty wants to raise money they will do it through their offshore sub, which is Isda based.”

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