Non-deliverable CNY swaps defy doubters

As Swap Connect was preparing to launch in May last year, some dealers thought this new infrastructure that allows foreign firms to trade onshore renminbi (CNY) interest rate swaps would eventually erode the market for non-deliverable swaps, which until that point had been their go-to instrument.

But those fears were misplaced. A year later, CNY non-deliverable interest rate swaps (NDIRS) have boomed with foreign investors, as international dealers increasingly lean on Swap Connect for their interbank hedging.

“Since Swap Connect, interbank volumes and client activities from NDIRS have increased two to three times. Contrary to [it] vanishing, market participants are making better use of the market,” says Henry Hung, an executive director in the Greater China and North Asia macro trading team at Standard Chartered.

Swap Connect allows overseas investors to tap interbank CNY interest rate swaps to better manage their rate risks in a more liquid market.

Demand for Chinese interest rate swaps has surged recently due to renewed interest in the country’s fixed income markets, enhanced by favourable cross-currency swap levels.

Charles Feng, head of macro trading for Greater China and North Asia at Standard Chartered, says patchy liquidity meant bid/offer spreads in the NDIRS market were previously unstable, but the situation has improved considerably since dealers have been able to lean on Swap Connect for hedging the instruments.

“Compared to onshore interest rate swaps, offshore NDIRS have less liquidity. However, with Swap Connect linking these two, the offshore market has become very active,” says Feng.

Since Swap Connect, interbank volumes and client activities from NDIRS have increased two to three times

Henry Hung, Standard Chartered

“If clients trade a few times and the bid/offer spreads are unstable – sometimes good and sometimes bad – they may not continue to trade in this market. But now the spread is much more stable,” he adds.

As a result, Feng says one of the key requests the bank received from clients was to increase two-way liquidity and electronic trading of CNY NDIRS outside of Asia hours. The bank was recently the first to execute multiple NDIRS electronically on Tradeweb in New York hours.

Lilian Tao, head of China macro and global emerging markets sales at Deutsche Bank, agrees that dealers hedging NDIRS flows are making more use of Swap Connect, especially for trades with large sensitivity to a 1 basis point move in underlying rates, known as DV01.

“When big client flow or hedging needs arise, the onshore market is much deeper. The ability to absorb much bigger DV01 is very visible compared to NDIRS as NDIRS is more of a market designed to cater for offshore investors only – hence in comparison [it is] more niche and limited,” says Tao.

She also notes that some buy-side traders simply prefer remaining with the non-deliverable instruments they’re used to: “There are different rules and investors have been using NDIRS for a long time. So, there are certain levels of stickiness with NDIRS,” she adds.

Foreign investors considering Swap Connect face other hurdles. Users have to register with the Hong Kong Exchange, whose central counterparty clears the CNY swaps. And as HKEX is a so-called exempt derivatives clearing organisation under Commodity Futures Trading Commission rules, US buy-side firms are barred from utilising client clearing and must register directly as members if they want to participate, which is a major undertaking.

Upgrades and enhancements

Despite a slow start, Swap Connect has been gaining traction. According to the People’s Bank of China, the monthly average trading volume hit 12 billion yuan in April, compared with 3 billion yuan when it first launched. One dealer notes that the 20 billion yuan trading limit was reached a few times in April.

In May, the PBoC released improvements to the scheme, introducing swaps with international monetary market (IMM) dates and allowing backdated trades and compression, all of which had been requested by market participants since its launch.

As IMM contracts have standardised starting dates, this allows investors to manage their positions under Swap Connect more easily. Meanwhile, the ability to write backdated swaps and compress positions will allow investors to unwind their positions – something users had said was hampering Swap Connect’s development.

However, it is understood that unwinding is available only for single trades and with the original counterparty, as multilateral compression is not available yet.

“These are very important updates for international investors. I would say these are the main asks from [them] over the year since Swap Connect was launched,” says John Luk, head of emerging markets trading for Greater China at Crédit Agricole.

Charles Lam, head of Hong Kong markets at Citi, agrees the changes will help boost the use of the scheme.

“The Swap Connect enhancements will help further support the continued development of onshore financial markets.  As such, we would expect to see an increase in transactions and appetite from foreign investors via Swap Connect and a further deepening of liquidity,” says Lam.

Further improvements sought by market participants include the introduction of straight-through processing of trades to reduce manual inputs and operational risk.

Users also want to see the scope of eligible collateral expanded to include renminbi-denominated bonds, such as China government debt. While HKEX allows offshore-issued Chinese government bonds to be used, the limit is very small.

Taking a 50 million yuan margin call as an example, only 2–3 million yuan of Chinese government bonds may be used as collateral – the remainder must be cash.

Editing by Lukas Becker