UPDATE 1-China's securities regulator probes Sealand Sec amid bond scandal

* Sealand Sec defaults on bond deal with bank - local media

* Brokerage says company seal forged by 2 former employees

* Scandal has exposed counterparty risk in debt market (Adds quotes, more details)

SHANGHAI, Dec 20 (Reuters) - China’s securities regulator is investigating the bond-related business of Sealand Securities , the brokerage at the heart of a scandal that has hurt sentiment in the country’s wobbly debt market and threatens to trigger further volatility.

Sealand Securities defaulted on a bond transaction with Bank of Langfang, in China’s northern Hebei province, following the recent tumble in bond prices, local media reported last Wednesday.

Sealand Securities denied it the following day, saying it had no agreement with the bank and its company seal had been forged by two former employees. Bank of Langfang, in a statement on its website, also dismissed the media reports as rumour.

In an exchange filing on Tuesday, Sealand said that the Guangxi branch of the China Securities Regulatory Commission (CSRC) sent out a special team to start on-site inspection on Dec. 15. The brokerage said it would fully cooperate with the inspection.

The scandal has exposed the counterparty risk in the debt market, which has seen bond prices tumbling and yields spiking since late October, as Beijing steps up efforts to reduce leverage in the banking system to prevent asset price bubbles.

The Sealand scandal could “trigger panic, and cause a breakdown of trust” between lenders and non-bank financial institutions, because the brokerage’s response is seen as a refusal to bear the losses, said Zhou Li, president at bond-focused asset manager Rationalstone Investment.

If the incident is not settled properly it could result in more selling, Zhou said. “I’m worried that the bond market has witnessed just the first wave of sell-offs.”

The scandal has thrown into the spotlight a loosely-regulated type of bond agreement, a financing tool similar to a repurchase agreement. Such deals are typically backed by verbal promises rather than a formal agreement.

In a low-yield environment - China’s 10-year government bond yield fell from 3.5 percent in mid-2015 to a low of 2.6 percent in August and October this year - entrusted agreements were widely used by securities firms to obtain leverage for bond transactions in order to meet guaranteed returns to investors.

But as Beijing started to tighten liquidity after China’s economy showed signs of stability during the third quarter, bond prices began to collapse, finally exposing the counterparty risks illustrated in the Sealand case, according to OCBC.

“This incident has clearly dampened market sentiment and broke the trust between banks and smaller non-bank financial institutions. It may take some time to repair the trust. Therefore, we should still expect volatility ahead,” OCBC economist Tommy Xie wrote in a note late on Monday.

But the crisis may not worsen further as Chinese authorities have enough ammunition to maintain relatively stable liquidity, Xie said. (Reporting by Samuel Shen and John Ruwitch; Editing by Jacqueline Wong)