DisConnect: no deluge of demand for onshore CNY swaps – yet

The torrent of overseas demand expected to flood onshore renminbi swaps on the May 15 launch of China’s Swap Connect is so far merely a modest stream, say dealers. But, given that the move opens China’s $3 trillion onshore renminbi (CNY) swap market to foreign investors, they believe it is only a matter of time before the scheme reshapes the renminbi swaps trading landscape.

The platform launched to a somewhat subdued start, in contrast to the hubbub that preceded it. When Swap Connect was announced in 2022, it generated quite the buzz among foreign firms that invest in China’s bond market, says George Sun, head of global markets for greater China at BNP Paribas.

Much of the interest is from non-Chinese clients that invest in China’s bond market, says Sun: “It’s mostly the big real money managers, pension funds and insurance companies.” That observation is echoed by other dealers in the region.

What’s more, dealers believe Swap Connect could erode the market for offshore renminbi non-deliverable interest rate swaps (NDIRSs) – CNY swaps settled in US dollars – billions of dollars of which sit in derivatives clearing houses.

And a shift in liquidity to onshore CNY swaps would buoy OTC Clear, the Hong Kong Exchange clearing house which faces offshore clients that trade onshore CNY swaps on Swap Connect. OTCC provides clearing for CNY non-deliverable swaps, but its volumes in the product are dwarfed by those of rival LCH. By settling these swaps in onshore CNY, it offers investors a hedge that is cheaper, less volatile, and more closely correlated with the Chinese government bond (CGB) yields that CNY swaps typically hedge.

“The niche for HKEX is onshore-offshore connectivity,” says a regulatory affairs head at an investment bank in Hong Kong. “So now, they can offer both offshore and onshore derivatives, and offer offshore investors better liquidity and better pricing that you get onshore. I think we could see some liquidity moving [from NDIRSs] to Swap Connect.”

When [Swap Connect] actually started [last] month, the impact on the basis was probably already priced in

Charles Feng, Standard Chartered

Indeed, such an impact was hotly anticipated. When it was announced in Q4 2022 that the platform would launch this year, the spread between non-deliverable swaps and CNY swaps narrowed by 78.4%, from 19.7 basis points, where it began 2022, to 4.2bp at the launch, as pricing adjusted to reflect the prospect of a much wider user base.

Charles Feng, head of macro trading for greater China at Standard Chartered in Hong Kong, says some banks positioned for the move, factoring in that Swap Connect, by giving offshore investors access to both onshore IRSs and offshore NDIRSs, will allow investors to put on trades in opposite directions to lock in the spread for almost no market risk if there is a significant spread between the two, he says.

“We think some market participants, including local dealers that have access to both the onshore and offshore IRS and NDIRS markets, have been putting on the basis-narrowing trades with the expectation of Swap Connect,” says Feng. “So, when [it] actually started [last] month, the impact on the basis was probably already priced in.”

Similarly, bid/offer spreads on non-deliverable swaps have come in significantly since Swap Connect was mooted. In June last year, the spread was around 100bp on a new non-deliverable swap, according to Bloomberg data, compared to 0.6bp for a CNY swap.

But since the end of February, bid/offer spreads on non-deliverable swaps have tightened dramatically to match the new rival product, and were sitting at 1.9bp as of June 6.

Onshore thing

Offshore investors can access China’s bond market through Bond Connect, the mutual market access scheme between Mainland China and Hong Kong. They can also use the China Interbank Bond Market (CIBM Direct) scheme, which allows foreign institutions to trade through banks holding a bond settlement licence in China.

“We cover well over two hundred overseas clients who buy bonds onshore through Bond Connect or direct CIBM and many of them are interested in Swap Connect. They would like to use it,” says BNP Paribas’s Sun.

But the big question is whether this apparent investor interest translates into large trading volumes in Swap Connect, and how this in turn impacts the offshore swap market.

Foreign investment in China’s bond market has risen steadily since the launch of Bond Connect in 2017. And as those flows have increased, so have investors’ needs for tools to hedge CNY interest rate risk.

The northbound leg of the scheme – trading that comes from offshore to onshore China – was launched through a joint venture company formed by China Foreign Exchange Trade System (Cfets) and HKEX. It allows investors to access China’s massive interbank bond market by way of its offshore infrastructure.

It is enormously popular. In March, the total monthly northbound trading volume hit a new high of 956.2 billion yuan ($134 billion). As of April 2023, total foreign holdings of CNY bonds – not limited to Bond Connect – stood at 3.1 trillion yuan.

International investors typically hedge with CNY non-deliverable interest rate swaps, which are clearable at both LCH and HKEX and do not require any filings or registration with Chinese regulators. But dealers say the absence of a route to hedge the interest rate risk of their bond investments in the onshore market has always been perceived by clients as Bond Connect’s big shortcoming.

“The two biggest complaints we would hear from Bond Connect investors were that they couldn't use CGB futures, and they effectively couldn’t hedge on the onshore interest rate curves,” says Sun.

The China Securities Regulatory Commission said last year that it intends to allow trading of futures on Chinese government bonds to be launched at HKEX soon. And in the meantime, northbound Swap Connect is addressing Bond Connect investors’ second big complaint.

Unlike CGB futures, onshore swaps are not directly linked to the hedged asset but have floating rate legs that are tied to benchmarks like the seven-day repo rate and the Shanghai interbank offered rate. This means swap movements can sometimes differ from the performance of the underlying bond because the rates reflect banks’ short-term secured and unsecured funding costs.

But swaps in the onshore market tend to be more closely correlated than offshore NDIRSs are to CGBs, represented by benchmarks such as the Bloomberg Five-Year China Government Bond index (see chart). Between July 6, 2022, and May 23, 2023, the average correlation of onshore CNY interest rate swaps against the Bloomberg Five-Year China Government Bond index was 0.854 compared to 0.824 for CNY NDIRSs against the same index.

Unlike NDIRSs, which are settled in US dollars, onshore swaps are settled in CNY like the bonds they are hedging, thereby eliminating foreign exchange risk for the investors. The FX risk can be significant, given the gyrations seen in the USD/CNY market in the past year. Between June 6, 2022, and June 6, 2023, the renminbi saw a high of 6.6539 against the US dollar and a low of 7.305.

Furthermore, despite the recent narrowing in the difference between onshore and offshore swap bid/offer spreads, onshore spreads remain 1bp or 2bp tighter than those for CNY NDIRSs. This is attributed to the onshore market being considerably bigger than the CNY NDIRS market, with a greater diversity of market participants.

Hedging in the onshore market, then, comes with both risk management and potential pricing benefits for investment companies that can access it.

“Using onshore swaps as a direct hedge is probably more relevant than using NDIRSs, which sometimes has basis [risk],” says Lillian Tao, head of macro and GEM sales for China at Deutsche Bank in Hong Kong. “Clients were asking us questions about having access to this market and we were curious about this, asking them why they want it when the NDIRS market is there already,” she adds. “However, we are seeing strong client demand for CNY settlements and onshore instruments.”

This therefore begs the question: why have foreign investors, until now, preferred to hedge their interest rate risks in offshore NDIRSs?

After all, they already had other access channels to the onshore market before Swap Connect. International investors could trade swaps onshore if they were direct participants in CIBM Direct, or had successfully filed as a qualified foreign institutional investor (QFI) with the People’s Bank of China to trade in CIBM.

But the application process for CIBM Direct is long, complex and cumbersome. Brokerage agreements need to be signed and accounts set up with local custodians subject to Chinese domestic laws – and an eligibility assessment undertaken by the PBoC. The process for getting set up can take many months.

Furthermore, interest rate swaps cannot be traded through the Bond Connect scheme, meaning that Bond Connect users would have to open separate accounts with CIBM Direct in order to access the interest rate swap market – an operationally cumbersome undertaking.

“So, coupled with the fact that there are NDIRS products in the offshore market, we didn't see much demand from investors back then,” says a chief operating officer at a European bank in Hong Kong.

“There were only a few institutions that are willing to come onshore and trade swaps, and there is not much volume.”

Only Connect?

Market participants expect that the combination of Swap Connect’s relative convenience and the onshore market’s better liquidity, pricing and CNY bond correlations will establish the scheme as a strong alternative to the NDIRS market. But it appears that it will be a gradual shift.

The first day of trading on Swap Connect saw a notional value of 8.3 billion yuan in swaps traded by 27 institutions, including both offshore banks and asset managers, according to figures published by Cfets. In subsequent weeks, Cfets has not published trading volumes on Swap Connect, but banks say they have seen a marked decline in trading activity in this time.

Feedback from those that traded on the first day suggests more firms will eventually participate, however. One of the asset managers trading on day one was Eastfort Asset Management, a Hong Kong-based firm that provides a suite of investment portfolios with a focus on the China bond market. The firm traded a total of three one-year interest rate swaps linked to the seven-day repo rate.

“There were many firms that couldn’t make it on time for this round,” says Harvey Lim, a portfolio manager at Eastfort Asset Management. “But I think gradually there will be more investors. So far, from the list I see, it’s buy-side clients and mostly banks. But actually, I think lifers [insurers], if they invest in onshore bonds, it also makes sense for them to get on Swap Connect as well.”

Lim adds that Eastfort Asset Management has not put on any further trades since the first day. Before it trades again, he would like to conduct a review of those initial trades, paying particular attention to the overall cost of trading through the new clearing structure.

“We really want to go through the whole cycle before doing more,” says Lim. “We need to check the actual fees; the PM margin; and also the interest that’s actually charged on gross margins. And on the clearing part, we have to monitor how it works.”

A business director at a European bank’s greater China markets unit says other firms that traded on Swap Connect on that first day could well be taking the same wait-and-see approach.

“It’s not really a surprise that we didn’t see huge trading activities after day one,” says the business director.

An emerging market trading head at another European bank agrees that trading volumes on Swap Connect have been relatively modest so far. After day one, the daily trading volume has amounted to roughly 20–30% of the 20 billion yuan daily trading cap, he says.

But a recent increase in demand for client clearing services seen at OTCC as the scheme’s go-live date neared indicates that trading in Swap Connect should gradually begin to pick up.

“With Swap Connect, definitely, we also see an increasing demand on the OTC client clearing services,” says Jacky Mak, head of fixed income and currency product development at HKEX. “We see some non-bank financial institutions as well as some of the banks – the smaller ones – that might not pursue becoming a direct clearing member of OTCC, are asking for client clearing services from any existing clearing member.”

If the momentum behind Swap Connect does ultimately begin to build as expected, this will likely impact offshore CNY non-deliverable swaps trading in several significant ways, dealers say.

They think the scheme could kick off a gradual – but permanent – shift in trading liquidity away from the offshore CNY NDIRS market towards the already much larger onshore CNY swap market.

“Right now, there’s very little foreign investor base in onshore interest rate swaps, so that’s going to increase for sure,” says BNP Paribas’s Sun. “The NDIRS may come down as more investors move onshore.”

Nobody expects to see the CNY non-deliverable swaps market vanish completely, however, even in the long term. First, any influx of new client clearing business to OTCC will be tempered by the fact that the CCP is a so-called exempt derivatives clearing organisation under US rules, which means US buy-side users will need to sign up as direct clearing members in order to access the scheme.

There may also be foreign investors that simply prefer to continue trading NDIRSs and clearing at LCH under that CCP’s cleared derivatives execution agreement (CDEA).

To paint a picture of how the future of offshore CNY swap trading might look, Eastfort Investments’ Lim harks back to the launch of the Bond Connect scheme. The ability to access CNY bonds onshore did not kill off issuance and investment in offshore renminbi (CNH) bonds, as some predicted it might when Bond Connect was launched back in 2017.

“You still have some types of investors who are hesitant to go into onshore in the CIMB, so they prefer CNH on bonds,” says Lim. “I think maybe it will be similar with Swap Connect and LCH.

“Maybe some investors will still prefer to sign a CDEA only with LCH [and not with] Swap Connect. I think in the short term, both should co-exist.”