Chinas derivatives revolution
China’s onshore OTC renminbi interest rate derivatives market only got the go-ahead from the People’s Bank of China in 2005. Since then, the pace of deregulation has matched the growth in volumes traded. Renminbi derivatives are close to becoming the biggest derivatives market in Asia, writes Nick Herbert.
The headline rate of growth in turnover of renminbi-denominated interest rate swap volumes has been steady since the People’s Bank of China first allowed interest rate swap transactions in February 2006.
From the date of the first swap up until December 2006, Rmb35bn (US$4.67bn) of interest rate swap transactions were concluded in the onshore market, according to China Forex Trading Centre. That figure was beaten in just the first quarter of 2007 (which registered Rmb39bn in turnover), and totally eclipsed in the second quarter of 2007 when almost Rmb64bn of swaps went through.
Compared with the US$1trn of volume outstanding in the offshore market, this looks meagre, but for a market starting from scratch, the numbers are significant.
The growth of the market marches hand in hand with each successive round of deregulation and product innovation. The past couple of years have seen the introduction of various new products and a decent flow of groundbreaking deals that have set a benchmark and a reference point for transactions.
Derivatives are not new to China, at least non-renminbi denominated ones. Structured notes referenced to foreign currency derivatives have been around in China for many years, with demand for non-renminbi derivative products growing rapidly from the early 1990s when China began to play a bigger role in the global economy.
At that time, there were only a few mainly state-run buyers, but since then it has increasingly been the cash-rich commercial banks and corporates that have needed to put their excess liquidity to work – a fact highlighted by the Bank of China’s admission in August of exposure to almost US$10bn of sub-prime related structured products.
The development of a local currency market for managing assets and liabilities has been a more recent phenomenon, one that was hampered by a rigid regulatory environment, a lack of legal clarity, and the absence of market-driven and freely determined interest rates for different credits.
The development of renminbi-based derivative products was bound to take place, given the increasing demand from banks, corporates and investors to manage interest rate risk. Local banks sit on huge exposure at a time when the central bank is putting up interest rates to temper the economy.
Another motivating factor was the requirement for China to open its banking market to foreign competition as part of the country’s accession to the World Trade Organisation.
By making an early move to liberalise the derivatives sector, the central bank has given local institutions time to gain experience, beef up their risk management systems, and address any issues in documentation and settlement before the arrival of full-scale international competition.
The first foreign currency swaps were allowed in August 2005 and, in a clear example of its step-by-step approach to liberalisation, the central bank has moved to expand products at least every six months since then.
Onshore OTC interest rate derivatives were also sanctioned in the form of renminbi-bond forwards in June 2005, but their inception was marked by illiquidity, although the instrument registered turnover comparable to that of swaps in Q2 2007.
The next significant leap forward for interest rate derivatives came about in February 2006 when the central bank approved the trading of interest rate swaps. It came about at the same time as deregulation in the banking sector allowed the likes of China Everbright Bank (CEB) to start extending long-term fixed-rate loans. Hedging of this fixed-rate exposure was the motivation behind the first onshore interest rate swap.
It was a profitable exercise for both sides on the transaction: CEB and China Development Bank (CDB). As well as hedging its 10-year fixed-rate exposure, it locked in the equivalent of US$200m over the lifetime of the swap, while CDB achieved a 10bp saving on cost of its floating rate funds.
Profits per trade have undoubtedly been whittled down since then with the introduction of more competition and more players. At the end of December 2006, there were 47 licensed interest rate swap financial institutional counterparties, including 13 state banks and commercial banks, 31 foreign banks and three insurance companies.
It is, however, the participation of the local counterparties that determines the success or failure of any domestic financial market. In China, as in many nascent markets, the major international banks tend to start the process, but there is only so much volume they can sustain without a real outlet for their trades. The tipping point arrives when local banks and corporates begin to actively manage their interest rate exposure.
That need to manage interest rates is only an issue when there is interest rate risk that needs hedging and that only applies in a system where interest rates are not centrally managed, as has been the case in China until fairly recently.
Irrespective of the central bank’s deregulation programme, the lack of a proper market-set interest rate benchmark has been and would remain the main hindrance to the development of a derivatives market. That matter was addressed in 2007 with the introduction of the Shanghai interbank offered rate (Shibor).
Shibor’s appearance was significant as it represented a shift to market-determined interest rates away from centrally administered lending rates. Also significant is the promotion of Shibor by the People’s Bank of China (PBOC) as the preferred benchmark reference interest rate.
Its introduction, however, brings with it a steep learning curve for the local banks. Domestic banks are more familiar with trading interest in collateralised form, via the repo market, whereas Shibor has no collateral component and requires the risk management discipline associated with credit risk, something that many banks in China lack as there is no real local credit market.
That is slowly changing as the central bank encourages the development of a domestic corporate bond and CP market, with borrowing costs determined by investors employing credit discipline. Likewise, issuers are increasingly using Shibor as the reference rate for floating-rate note deals.
It is not only credit issues that have to be overcome for Shibor to gain wholesale acceptance. The size of the respective interest rate markets also illustrates that Shibor has its work cut out to overtake repos as the preferred method of short-dated lending. Roughly Rmb150bn trades per day in the repo market, according to estimates, while Shibor trades account for around Rmb15bn per day.
A limitation on the dealing size in the Shibor market for non-PRC incorporated foreign banks (1.5-times operating capital) is also holding back the development of a market-determined benchmark. That cap on its use will change, however, as more international banks make the next step to full incorporation in China.
At present, interest rate swaps are most commonly referenced to the seven-day repo, the one-year PBOC deposit rate and Shibor, but mainly the seven-day repo.
As well as the increasing acceptance of Shibor, there have been other developments in the interest rate derivatives sphere over the past 12 months.
In December 2006, the first non-deliverable swaption straddle was conducted between HSBC and Standard Chartered, while in September of 2007, Barclays Capital and Deutsche Bank transacted the first cap/floor straddle in the offshore market. Onshore options are not yet sanctioned by the regulator.
There was also talk of the first range accrual structure being bought by an end- client.
The most recent development in China’s quest for the full suite of interest rate derivatives products was the introduction on November 1 of forward rate agreements (FRAs) in the onshore market. Use of FRAs will significantly impact firms’ ability to hedge interest rate exposure, as up until November hedging could only be completed with swaps out of the spot market.
The introduction of FRAs was a dramatic move. By using forward rates rather than the spot, firms can better manage interest rate risk.
Demand was swift for the new instrument, with deals struck on the first day of trading: HSBC, Citic Bank and JPMorgan traded the first-ever batch of onshore renminbi FRAs using the Shibor as a reference rate.
Perhaps just as significantly, the FRAs became the first derivative trades to use the new Master Agreement for financial derivatives – a Chinese version of the International Swaps and Derivatives Association introduced by the National Association of Financial Market Institutional Investors on October 12. It has proved the workability and the flexibility of the new Master Agreement, sets a solid base for the commoditisation of derivate deals, and enhances the liquidity of the entire market.