* Executives from CITIC, two other firms arrested
* Alleged profit skimming via complex trading practices
* Investigation could involve other institutions
* Regulation lags bond market's explosive growth
By Gabriel Wildau
SHANGHAI, April 18 Three Chinese financial industry executives have been arrested for allegedly using complex bond trading practices to skim client profits for personal gain, state media reported this week.
Executives from state-owned CITIC Securities , China's largest brokerage by assets, unlisted fund management company Wanjia Asset Management and Qilu Bank, a small lender 20 percent owned by Commonwealth Bank of Australia , are under investigation by the Shanghai Public Security Bureau, the official Securities Times reported on Wednesday.
On Thursday, the official Shanghai Securities News reported that "related departments" had sent investigators to multiple brokerages in Beijing, Shanghai, Jiangsu province and other locations.
State media said the alleged skimming centred on a complex technique known as "substitute holding", in which a fund manager temporarily transfers a portion of his bond portfolio to a counterparty's account.
Market participants say the practice can be used to disguise profits or losses, increase leverage, or skirt limits on the types of instruments a fund is allowed to hold.
The executives allegedly used substitute holding - which is not in itself illegal - to divert to themselves profits that should have accrued to clients, according to state media.
A Shanghai-based bond fund manager who asked for anonymity told Reuters that the strong performance of bond markets in recent months, combined with inadequate regulation, makes it possible for fund managers to use this practice to enrich themselves.
"The market has been pretty good this year, and yields have mostly been falling. At times like this, you find a third party for substitute holding and add some leverage - the risk is pretty small. It's not like when the market is weak and you could take huge losses," the fund manager said.
FORMAL AND INFORMAL AGREEMENTS
A Beijing-based bond trader said that while large banks typically formalise substitute holding arrangements with repurchase agreements or similar contracts, smaller institutions often use informal agreements with trusted counterparties. That creates leeway for self-dealing, he said.
A CITIC Securities spokesman confirmed to Reuters that an employee was under investigation but said that it was for "personal reasons not involving the company." Media reports said the person arrested was a senior manager in the company's fixed-income division.
China Business News, which broke news of the investigation on Monday, reported that the arrest occurred more than a month ago.
In a statement, Wanjia Asset Management confirmed that one of its employees, who media reports described as a high-profile director and fund manager, was under investigation. Wanjia said the probe is "unrelated" to the company and that the arrested person no longer works there.
Qilu Bank did not respond to requests for comment. CBN reported that an executive in the bank's finance department was arrested.
The media relations department of the Shanghai Public Security Bureau did not answer calls seeking comment.
China's interbank bond market has exploded in recent years, with outstanding interbank bonds totalling 24.4 trillion yuan ($3.95 trillion) at the end of March, up from 17.7 trillion yuan at end-2009 and 7.3 trillion yuan at end-2005.
Market participants say regulation has failed to keep pace with the growing size and complexity of the industry.
China's securities regulator has moved aggressively to combat insider trading and other corrupt practices in China's stock market over the past year, but the bond market has received less scrutiny.
Regulators have encouraged the growth of the bond market as a means to diversify China's financial system away from reliance on bank lending.
Corporate bond issuance accounted for 14.4 percent of China's total social financing in 2012, up from 10.6 percent in 2011 and only 3.8 percent in 2007. ($1 = 6.1723 Chinese yuan) (Additional reporting by Yong Xu and Samuel Shen; Editing by Richard Borsuk)