After Swap Connect, industry eyes onshore China repo market

With China’s Swap Connect now live, market participants are pushing for regulators to take the next step and extend similar infrastructure and close-out netting to onshore repurchase agreements, giving foreign investors a way to finance their renminbi bond holdings.

Philippe Dirckx, head of fixed income at the Asia Securities Industry and Financial Markets Association, said the group is in discussions with China’s financial regulators to develop legislation akin to the recent Futures and Derivatives Law (FDL) to cover close-out netting for repo, with the aim of making it more attractive for foreign investors to tap the onshore market.

“In the conversations we had with both the regulators here in Hong Kong and on the other side of the border, repo has now come to the forefront of those conversations – it is clearly something they are open to discuss, which is, I think, reassuring,” said Dirckx, speaking on a panel at Asifma’s China Capital Markets conference in Hong Kong earlier today (June 27).

International investors have increased their exposures to Chinese bonds in recent years through schemes such as Bond Connect and the CIBM Direct scheme, which allows foreign institutions to trade onshore through banks holding a bond settlement licence in China.

Since May 15, foreign investors can tap the onshore renminbi (CNY) interest rate swap market via Swap Connect, as a way of hedging risk on their CNY bond holdings. They can also get close-out netting thanks to the FDL, which came into effect in August last year.

In the conversations we had with both the regulators here in Hong Kong and on the other side of the border, repo has now come to the forefront

Philippe Dirckx, Asifma

International investors are now increasingly demanding the ability to mobilise these burgeoning bond holdings for funding, but there are a number of hurdles to doing so – first and foremost being the lack of close-out netting for the instrument.

Despite efforts by industry groups, close-out netting, which allows banks to collapse multiple exposures to a defaulting counterparty into a single net payment, was not extended to onshore repos in the FDL. Netting allows banks to measure their credit risk exposures on a net basis instead of gross, allowing them to potentially free up substantial amounts of regulatory capital that is normally required for such transactions.

International repo markets with close-out netting operate on a title-transfer basis, where the collateral is legally owned by the recipient in the trade and can be rehypothecated for other purposes. They are governed by the International Capital Market Association’s global master repurchase agreement (GMRA), which includes netting provisions.

Foreign investors can already access the onshore Chinese repo market via CIBM Direct. But absent close-out netting protections, most of the market operates on a pledge system in which the collateral is not legally owned by the recipient, making it very difficult to rehypothecate the bonds. Onshore trades also need to use the bond repurchase master agreement produced by the National Association of Financial Market Institutional Investors, which do not include netting provisions.

Asifma believes that if netting is extended to onshore repos and the GMRA is recognised for onshore trades, the market could shift to a title-transfer approach that foreign investors are more familiar with and boost local liquidity.

“What we are advocating now is for the global master repurchase agreement and repos to be covered by a set of regulations that are similar to the ones that are covered by the Futures and Derivatives Law,” Dirckx added.

Dealers say there is definitely growing demand from clients to trade onshore repos.

“In our conversations with clients, we hear that a lot of them would like to have repo [for China bonds],” said John Luk, head of emerging markets and Greater China at Crédit Agricole, speaking on the same panel.

“Because a lot of international bond markets, like the US Treasury market, European and Japanese government bonds, all of them have a very deep, liquid bond repo market clients can use to fund their bond portfolio. This is something that’s on everybody’s wish list.”

Also speaking on the panel, Robert Yu, managing director and deputy head of fixed income at the China International Capital Corporation – a Chinese investment bank – said further infrastructure innovation akin to Swap Connect might be needed to allow foreign firms to tap the onshore repo market.

Swap Connect introduced a novel interoperability arrangement between the Hong Kong Exchange’s OTC Clear and the Shanghai Clearing House that connects offshore investors with onshore market-makers, with neither offshore or onshore counterparty having to change their trading or settlement practices. Yu believes the Swap Connect infrastructure could be adapted to allow a similar structure for repo.

“They came up with this innovative arrangement where you have two clearing houses and set up this intra-clearing-house margin so that they can connect different pockets of investors who have different trading or settlement practices without changing much of their habits,” he said.

“I think that it could equally be applied to your tri-party solutions, maybe with some little tweaks.”