As China suffers a rise in company defaults and an increase in corporate downgrades, the need for a credit default swap market in the country has become more pressing. And now it looks likely the People’s Bank of China will give the hedging scheme the go-ahead in coming months.
This is the second time interested parties have tried to establish the market, which would allow participants to buy and sell credit insurance that pays out if a Chinese company fails to make payments on its debts. The fact that it is now likely to succeed is a sign of how much has changed in China.
In 2010, the little known National Association of Financial Market Institutional Investors first attempted to introduce the product, which allows banks and other investors to hedge the risk of default. But the market never took off for a variety of reasons.
For one thing, in 2010 there were almost no defaults. Most borrowers and issuers in the capital market were state-owned, and had government backing. Meanwhile, almost all potential participants saw the market in the same light — as an easy and riskless way to collect premium income by selling such insurance. “At the time, everyone wanted to sell,” says the head of markets in China for one large international bank. “It would have been very one-sided.”
Today, by contrast, the number of defaults is rising. Being state-owned no longer means that the government stands behind every borrower. As of mid-August, 41 companies defaulted on Rmb25.4bn worth of bonds since the beginning of the year. In addition, many more companies are being downgraded. Indeed, there were more than 1,000 ratings downgrades in the past two months alone, according to a report from Credit Suisse, citing Wind Information. That makes the need for the market more obvious and suggests it will not be as one-sided as in the past.
Also at that time, credit rating was in its infancy and there was little trading in the secondary market. Even in the US, there is concern with the accuracy of pricing of many names in the corporate debt market. In China, it was almost impossible to price or mark to market a security or a loan with any accuracy back then.
Moreover, six years ago, regulators wished to limit participation in the market to banks. “But the whole point was for banks to eliminate the risk of their exposure, not to pass it around among themselves, so that stance made no sense,” says the executive in charge of risk management at a Shanghai-based fintech company, who was a participant in those early discussions.
However, not all the details have been hammered out and issues remain.
In the US, for example, there has always been a debate about the problem of perverse incentives, when buyers of protection can make money from the demise of a company. Hedge funds and even banks have been suspected of having small and transparent long exposures to a given credit but massive short exposures by quietly purchasing credit insurance. As the cost of insurance increases, it then causes both the price of the debt and the stock to go down, triggering a death spiral.
Trading will take place in Shanghai and likely involve the Shanghai clearing house. But it also is not yet clear whether it will serve as a central clearing house that will stand in-between both sides, and be the counterparty of each, given the fact that the big state-owned banks, who are likely to be big players, have higher credit ratings.
The coal-dependent province of Shanxi is one example of those keen to benefit from a CDS scheme. Shanxi’s provincial government said earlier this month it was looking into CDSs as a way of helping its troubled coal companies. The provincial government is proposing setting up a financial services company (based on the model of China Bond Insurance Company) aimed at improving the financing of Shanxi’s companies — mainly through CDS trading.
Shanxi is going through a crisis of bad debt, with a state-owned enterprise defaulting on a bond in April.
Additional reporting by Yuan Yang
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