Exclusive: China quietly tightening grip on offshore yuan market
HONG KONG/SINGAPORE (Reuters) - China is working quietly behind the scenes to tighten its control of the rapidly growing offshore yuan market, and risks turning off some investors from participating in the market and slowing use of the renminbi in global trade.
Chinese regulators are making bankers uneasy by systematically shaping the structure of the so-called CNH market through derivatives regulation and financial bureaucracy, banking and regulatory sources said.
China's offshore yuan market, originally meant to be an experiment to help internationalize the yuan, has grown at a dizzying pace, with investors hungry for exposure to the strengthening but still non-convertible currency.
Beijing, which has made currency reforms in fits and starts, has been trying to ensure a CNH derivatives market follows the mainland market's rules, not international standards.
Bankers and investors, meanwhile, have been trying to push it in a more sophisticated direction by kick starting an offshore yuan derivatives market to hedge the interest rate risk on their bonds.
On May 17, the head of China's National Association of Financial Market Institutional Investors (NAFMII), the country's interbank association, visited several banks in Hong Kong, trying to persuade them to use mainland China's legal documentation for their trades in CNH-denominated derivatives.
Bankers in the NAFMII meetings were reluctant to agree to the rules because it could make derivatives trading more expensive and legally cumbersome, but also fear rejecting them may hurt their chances of expanding their businesses on the mainland, sources familiar with the discussions said.
"Chinese regulators tend to hold out carrots for people who toe the line. All the banks like to think they have special relationships with the Chinese regulator, when at the end of the day it is a divide and conquer strategy by the regulator to fragment the industry," said a Hong Kong derivatives market banker with knowledge of the discussions.
Yuan deposits in Hong Kong as of April climbed six-fold to 511 billion yuan ($79 billion) from a year ago, and outstanding renminbi-denominated assets, mostly bonds, have expanded to around 130 billion yuan.
NAFMII has various regulatory functions bestowed on it by the People's Bank of China, the country's central bank, and can grant foreign banks key licenses for some mainland activities including underwriting corporate debt.
NAFMII's secretary general Shi Wenchao visited several banks in the city and held discussions with front and back office staff, including some at Bank of China (Hong Kong), HSBC and Standard Chartered, according to two sources at one of banks involved who declined to be named because negotiations were still under way.
While the meetings were friendly, NAFMII were persistent with their suggestions. NAFMII's proposal would mean banks trading over-the-counter derivatives denominated in CNH would have to use NAFMII's legal documentation to bind that trade rather than the International Swaps and Derivatives Association (ISDA)'s Master Agreement, which is used for the vast majority of derivatives traded in global markets.
NAFMII told people at the meeting they had even been hoping to call a press conference that day to announce Hong Kong banks were amenable to using their legal documentation.
NAFMII did not respond to questions from Reuters about the issue.
Bankers said its proposal was unsuitable for the CNH market because it is not set up to handle cross-border transactions and currently requires disputes over issues such as changes to margin requirements be settled in a mainland arbitration tribunal or court.
"We would take a very negative view on this, we use NAFMII's agreement in China because we have to, but no one is interested in using it where we don't have to," said a senior lawyer at a bank active in the CNH market.
A key benefit for banks in having a one-size fits all document, such as ISDA's Master Agreement, is that it is easier for banks to arrange how to offset exposures to various trades because they are all bound by the same rules.
"There could be difficulties with netting arrangements in terms of how to bridge the two documents so that banks can get the full netting benefits of different trades," said Chin Chong Liew, a partner at law firm Linklaters in Hong Kong who specializes in handling derivatives law.
HSBC and Deutsche Bank traded the first CNH interest rate swap in October 2010, but the swap market has failed to take off, forcing banks to resort to other creative methods to hedge their risks.
"Currently, it is not a deal breaker as people are using the cross-currency swap market to hedge their risk exposure but we do need a more stronger form of risk management for this market to take off," Linan Liu, a strategist at Deutsche Bank in Hong Kong, said.
"I hope that something is done about this quickly to let the IRS market grow."
WAITING FOR THE PBOC
In addition to rules surrounding CNH derivatives, banks in Hong Kong are also concerned about the slowgoing, murky process to set up fiduciary accounts with the PBOC.
Authorities in China and Hong Kong allowed banks to set up special accounts with the PBOC in April, in response to concerns of Hong Kong-based banks that placing more of their yuan deposits with the Bank of China Hong Kong -- which remains the sole clearer for the CNH market -- raised counterparty credit risks.
Banks participating in the CNH market are required to invest a quarter of their yuan deposits with the Bank of China Hong Kong (BOCHK), but the proportion has been usually larger because of the lack of yuan investment avenues in the territory.
In addition, BOCHK itself said that acting as a yuan depository was eating into its margins.
In response, the Hong Kong Monetary Authority (HKMA), the territory's de-facto central bank, and the PBOC launched a scheme whereby banks could instead place the yuan funds in fiduciary accounts at the PBOC with BOCHK acting as the custodian in the middle.
The fiduciary accounts structure immediately ran into controversy, and only a handful of banks out of the 121 involved in offshore yuan trading have secured approval for these accounts.
The biggest concern is that the PBOC is placing all yuan deposits from foreign banks into one large pool of liquidity, rather than keeping each bank's deposits separately.
This has fueled fears that in the event of a liquidity crunch, banks would find it difficult to withdraw their yuan deposits all at once, said the head of capital markets at a foreign bank who was not authorized to speak to media.
Lack of clarity about the fiduciary accounts has been a factor weighing on interbank deposit rates in recent weeks. Banks sitting on excess deposits have been forced to scour the money market to invest the funds, pushing down deposit rates to as low as 20 to 30 basis points from around 60 basis points, which is what China offers to Hong Kong banks for their yuan deposits.
By comparison, the mainland's one-year onshore deposit rate is 3.25 percent.
The HKMA dismisses criticisms that the fiduciary arrangement is not functioning properly.
"The arrangement was launched in March 2011 and is now fully operational. Banks requiring such services have already opened a fiduciary account with the Bank of China (Hong Kong), the Clearing Bank for RMB business in Hong Kong," they said in an emailed statement.
"This was unlike what we had seen in clearing and settlement agreements before," said the capital markets banker.
($1 = 6.471 Chinese Renminbi)
(Editing by Kevin Plumberg)
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