China is mulling whether to allow credit default swaps trading

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Amidst a wave of defaults and mounting concerns over the creditworthiness of many corporate entities, China is considering whether or not to permit credit default swaps (CDS) trading.

According to a report from Bloomberg, citing persons familiar with discussions, China’s National Association of Financial Market Institutional Investors, a subsidiary of the People’s Bank of China which oversees interbank market bonds, sought opinions on CDS and credit-linked notes from market participants, including banks and brokerages, in March.

They added that the China Foreign Exchange Trade System, or CFETS, another wing of the central bank which oversees interbank bond trading in the nation, met with financial institutions last week in Shanghai to discuss the possible introduction of the product.

No other details of the discussions were provided, including whether the product would be open to foreign investors.

A CDS is a contract that transfers the credit risk of a fixed income product from one counterparty to another. The buyer pays the seller up until the contract expires. In return, the seller agrees to pay the buyer the maturing face value of the investment, as well all interest payments, in the event of the issuer of the underlying security defaulting on its obligations.

In essence, those who buy a CDS are taking out insurance on a fixed income product.

According to analysis from the National Australia Bank, at least seven Chinese firms have missed local bond payments this year. As a result, they note tighter liquidity conditions have seen the 7-day repo rate rise to 2.436% — a two month high — despite net liquidity injections by the central bank.

At present China uses bond default hedging instruments known as “credit risk mitigation tools”, products which are linked to single bonds of an issuer, distinguishing them from credit default swaps that are linked to all borrowings of a debtor.

As many China-watchers are already all too aware of, introducing new financial products in China is often fraught with danger, something Zhao Hengyi, a the deputy director of the bond fund department at HFT Investment Management in Shanghai, pints out.

“There has always been demand for CDS, but there are many concrete problems to solve,” he told Bloomberg. “For example, investors would have small demand for issuers with low credit risks and big demand for issuers with high credit risks, which will lead to structural imbalance.”

Not only that, as has been seen in stocks, property and more recently, commodity futures, it doesn’t take much to ignite speculative forces in Chinese financial markets, often leading to boom-bust cycles that are devoid of fundamentals.

One can only imagine what the price action in these instruments would look like if they ever got off the ground, particularly should non-sophisticated investors get involved.

Another concern would be the opaque nature of government involvement in Chinese credit markets, something that would also need to be addressed given countless interventions in the past to prevent some entities from defaulting on their debts.

You can read more from Bloomberg here.