Will Bond Market Tidying Trigger Clean Sweep?

China’s financial regulators are rewriting rules for the interbank bond market after criminal investigations early this year led to the arrests of several well-known bond traders and exposed serious flaws in the market’s supervision system.

The changes affect several agencies and more than a dozen market areas, from the trader account application process to bond issues and settlements. Rules governing bond trader and supervisor qualifications are also being tightened.

Regulators sharpened their pencils in April after bond supervisors at the central bank and other agencies froze applications for the Class C trading accounts at the heart of the criminal investigations. They also barred trading between accounts held by the same institution, and took steps to close loopholes that have been exploited by rogue traders.

Regulators ultimately expect the adjustments to push banks and other financial institutions to upgrade internal controls at a faster rate, a source close to the central bank said.

Meanwhile, the police are continuing their financial crime investigation in cooperation with the regulators.

Among those most recently detained by police was Wu Hongjian, the director of cash management at Harvest Fund, a foreign-invested securities investment fund that had more than 287 billion yuan of assets under management by the end of last year. He was taken in for questioning May 30.

Other executives rounded up in the probe worked for CITIC Securities, Wanjia Asset Management, Sealand Securities, Bank of Beijing, China Merchants Fund and E Fund Management.

“Everyone is nervous,” said an analyst familiar with the investigation. “No one knows how far this will go.”

Other analysts have indicated their nervousness with critical comments about the regulatory system and the latest adjustments. Some in the industry think the new rules may negatively affect the entire 2.7 trillion yuan bond market.

“The new rules are so intense and harsh that they might affect the market’s efficiency, as well as financial institution participation and their initiatives,” the analyst warned.

A First Capital Securities analyst said the new rules could make bond-writing failures more common. Another analyst took aim at new account application procedures imposed by the China Government Securities Depository Trust & Clearing Co. Ltd. (CGSDTC), which handles all transaction-related depositories, settlements and clearing on the interbank market.

Through a rule that says a bond issuer’s new account can’t open until after an issuance has been completed, he said, the agency has been leaving doors open to unnecessary arbitrage.

CGSDTC’s system frees the agency from having to manage empty accounts before a bond issuance. But up to a week may pass between an issuance and an account approval, the analyst said, which leaves time for a flurry of arbitrage deals, where people with good connections with the bond underwriters make money from helping secondary market buyers access the bonds.

“Many institutions in the bond market are state-owned, monopolistic businesses,” the analyst said. “CGSDTC, for example, is not a private enterprise, so it does not have such a strong sense of service as a registration and depository institution.

“Regulations are not customer-oriented or based on market demand. They instead are oriented toward facilitating self-management.”

Account to Account

Regulators and securities analysts have clashed over the recent decision to ban bond trading between accounts held by the same institution. Until now it’s been common, for example, for banks to swap bonds internally between their proprietary investment accounts and customer-driven wealth management accounts.

Some banks have arranged for bond-swapping between two, separate wealth management accounts as portfolios change. And when investors in a maturing wealth management product are paid off with money raised through a newly sold wealth management product, the latter buys bonds from the former.

Bond trading is a simple and sound way to bridge the time gap between wealth products, which generally mature in less than a year, and investments with longer payoff periods, said an analyst. For that reason, he said, the regulatory decision to halt all internal trades could lead to liquidity trouble. Any bank that’s suddenly not allowed to arrange trading between wealth product accounts could suffer.

A bond trader at one bank lamented that the ban prevents innocuous, goodwill trading that’s arranged solely to avert risk, not to inflate a bank’s bottom line. He said he’s often sold bonds without realizing until later that the buyer’s trader is a fellow bank employee working for a separate department—and he sees nothing wrong with that.

“As long as it [a bond trade] follows the principles of fair exchange, why must we sell to outsiders?” he asked.

On a separate note, critics of CGSDTC’s system say the agency is managed in a fragmented way that contributes to inefficiencies in the bond market. At least three central government agencies oversee the agency: CGSDTC’s start-up funds partly came from the Ministry of Finance in 1997; the central bank is responsible for guiding agency operations; and all authority for executive appointments is in the hands of the China Banking Regulatory Commission.

Another analyst wagged a finger at the agents handling bond settlements, accusing them of dodgy accounting practices. He said up to 70 percent of the nation’s nearly 50 settlement agents lack proper internal financial controls.

“Have the regulators evaluated their [the agents] performance and risk control abilities, to see whether they have the qualifications to operate as settlement agents?” he asked rhetorically.

Many bond traders particularly oppose the decision to eliminate Class C bond trading accounts altogether. One said these accounts have a key advantage: They are flexible, and this flexibility has significantly helped invigorate the bond market.

“Some people have taken advantage of institutional loopholes,” the trader said. “But the problem is with the agent settlement system rather than Class C accounts themselves.”

Some analysts said any regulatory effort to clean up the market should focus on improving internal controls at bond trading agencies. Some suggest creating a restraint mechanism that rewards good behavior and punishes bad behavior, said an analyst at Hongyuan Securities.

Fresh Settlements

The system currently relies on three alternatives for settlements. One delays payments for bonds, while another delays their delivery. This creates a time gap that critics say has been advantageous for rogue traders.

The most notable case of a rogue trader in China in recent years involved a bank worker named Li Kun, who in 2010 was working as managing director of the financial markets department at Yunnan Province’s Fudian Bank. Officials say he illegally made personal, short-term trades with the bank’s money, which he was allowed to control for a few hours between a bond account payment and an actual bonds delivery.

Now, the settlement system is changing. The central bank, for example, plans to unify bond transaction settlement methods under a third settlement method called a Delivery Versus Payment (DVP) system that will see sellers and buyers will receive bonds at the same time.

Under a new central bank rule, all transactions on the interbank market must be settled using the DVP method starting in October, several sources at banks and securities firms said.

“In the future, there will be no loopholes, no way for someone to take advantage of the settlement mechanism,” said a banker at Everbright Bank.

The National Association of Financial Market Institutional Investors (NAFMII), which helps regulate the interbank market, has responded to the government’s initiative by strengthening the information disclosure requirements for bond issues.

In May, it ordered bond underwriters to start setting prices at levels about even with secondary market expectations for bond prices, on the grounds that narrowing what has been a gap between these two prices was expected to force underwriters to improve bond pricing capabilities.

NAFMII is also mulling over plans to form a mechanism for evaluating bond pricing. An agency source said existing Class C accounts were being closely examined to help regulators decide what to do next.

Possible next steps being considered included upgrading qualified Class C accounts to Class B accounts, while shutting down the rest.

Closing Class C accounts is not expected to impact the market’s liquidity market, said a source from the NAFMII. “They were not playing much of a role” in the market, he said.

Indeed, regulator data shows more than 6,000 of the existing 7,500 Class C accounts have not had trading for a long time. And the remaining 1,500 active Class C accounts handle bonds worth only about 90 billion yuan combined—a tiny fraction of the bond market.

Upgrading a Class C account to Class B is possible, but the minimum capital requirements—at least several billion yuan, according to the NAFMII source—are significantly higher, and account qualifications are much stricter. The rules allow independent operations for Class B accounts, but transactions for Class C accounts must be settled through Class A accounts which are held by banks.

NAFMII also said that it will start training and testing bond traders, each of whom will have to pass exams and earn a certificate before being allowed to trade. Regulators also plan to start a certification system for bond trading supervisors.