The Chinese car industry was built on a simple principle: observe what works overseas, then copy it. The same applies to the domestic credit industry. Take credit default swaps, a peculiarly Chinese version of which began trading among qualifying institutions for the first time on Friday.
A glance at the introductory rubric from the National Association of Financial Market Institutional Investors (NAFMII), the bond-market regulator, confirms that this will be no free-for-all. Participants will be limited to buying and selling protection on plain old corporate bonds and loans. Trades will be disclosed to a central database, and – in time – cleared through the Shanghai interbank clearing system, to help with netting and reducing counterparty risk. Each financial institution can sell gross contracts worth no more than five times registered capital. And perhaps most importantly, there’ll be no skinny-dipping in this new pool of liquidity: contracts may be sold only to investors holding the underlying assets. Hence the name: “credit risk mitigation” contracts. That is more subtle than the exchange of exposures implied in “credit default swap.”
The constraints are tight enough to keep trading minimal. Banks will likely buy protection through CRMs discreetly, perhaps after a big loan to a corporate client, to lay off some of their risk. The ability to take a positive view on a particular bond by selling protection, meanwhile, should increase the appeal of corporate bond issuance in a local-currency bond market which remains dominated by the government.
The NAFMII will have observed how the CDS market ran amok in the US and elsewhere after 1999, when standardised documentation dramatically cut the time it took to put two parties together. The Chinese authority wants something different, an orderly market based on risk transfer between a select band of consenting adults. There’s no harm, for the time being at least, in thinking small.
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