Swap Connect growth hampered by unwinding issues

While China’s Swap Connect structure was unveiled with great fanfare in May, one significant flaw is keeping many foreign investors from using it: they can’t unwind their positions.

Launched on May 15, Swap Connect gives foreign investors access to China’s onshore interest rate swap market, which allows them to hedge their onshore China bond exposures.

Under the scheme, foreign investors face the Hong Kong Exchange’s (HKEX) central counterparty – OTC Clear – while their onshore counterparties face the Shanghai Clearing House (SCH). However, Swap Connect doesn’t allow users to enter bespoke maturity trades that would perfectly close out a position, meaning they would be left managing cashflows from not-quite-offsetting positions until maturity.

The real-money accounts want the freedom to get in and out of the trades whenever they want, because they need to take advantage of that flexibility

Industry source with knowledge of Swap Connect.

This is a real turn-off for foreign asset managers that are used to being able to easily close out cleared positions at other CCPs, and is said to be the reason why a number are holding back from participating for now.

“The real-money accounts want the freedom to get in and out of the trades whenever they want, because they need to take advantage of that flexibility,” says one industry source with knowledge of Swap Connect.

At a regular CCP, a fund might have traded a 10-year interest rate swap with a fixed leg of say 5%. If it wanted to unwind that position in six months, it would trade a bespoke nine-year and six-month swap in the opposite direction at the same fixed rate, which might now be off-market. Once that trade is completed, the two swaps perfectly offset, all cashflows are netted out by the CCP, profit and loss amounts can be realised and the position is considered unwound.

But Swap Connect does not allow for so-called broken-dated swaps, and all trades must be done at yearly intervals. So in the same example, the fund would have to trade a nine or 10-year interest rate swap against that nine-year and six-months position if it wanted to offset the risk. But as the two positions don’t perfectly match, the position would remain open in the CCP, which creates a problem due to a quirk in how SCH deals with the coupon payments.

Interest rate swap CCPs usually include the fixed-versus-floating cashflows incrementally as part of the daily variation margin payments, but SCH typically transfers these payments on a quarterly basis. This means foreign investors would have to process these coupon payments manually every quarter for this open position until maturity, creating operational headaches.

"You still have cashflow being generated when the trades are having quarterly fixings, and we have to manage those cashflows,” says the head of fixed income for Asia at one European dealer.

It is technically possible to trade broken-dated swaps in the onshore market via voice, but the maturities are restricted to the quarterly coupon dates. And in any case, it lies outside of Swap Connect and so is unavailable to foreign investors.

The industry source with knowledge of Swap Connect says this is just the way the onshore market practice works, as they are not used to closing out positions quickly as is done in other markets. “Investors based onshore have never been using anything like this,” he says.

An HKEX spokesperson says they are always looking at ways to improve the scheme: “Following the successful launch of Swap Connect, our latest innovation in mutual market connectivity with mainland China, we continue to explore with our partners possible enhancements to the programme. We will provide updates as required.”

SCH declined to comment.

As of June 30, 129 billion yuan ($18 billion) notional of interest rate swaps were traded under the scheme from 540 trades, according to the latest available data from the People’s Bank of China, with 162 trades totalling 8.3 billion yuan traded on the May 15 launch day. The daily trading cap is set at 20 billion yuan after netting.

So far though, a measure of foreign interest in Swap Connect – the basis between non-deliverable CNY interest rate swaps that are typically used by foreign investors, and CNY onshore interest rate swaps – has stayed steady.

This basis fell dramatically from 19.7 basis points at the start of 2022 to 4.2bp after Swap Connect was announced at the end of last year, as market expectations shifted to assume foreign firms would ditch the non-deliverable swaps and flock to the cheaper onshore versions. The basis though has remained stable since launch and sat at around 4.7bp as of July 26, according to Bloomberg data.