China revives default hedging tool to mitigate national risk

As China continues to make noises about the imminent launch of a credit default swap market to help harness nationwide company defaults and increased corporate downgrades, brokerage firms operating in the country are looking for ways to help mitigate the economic risk of the previously untapped market. While defaults in the country were rare prior to 2010 – due in part to state-sponsored enterprises being the norm – the growing economic unsteadiness has led to the perceived need for a default market. 

A rising default risk
According to the Financial Times, as of August 2016, 41 companies have defaulted on a total of Rmb25.4bn worth of bonds since the start of the year. The past two months have seen over 1,000 companies with ratings downgrades, leading the previously hesitant regulators to tentatively push for the secondary market. Yet even these initial steps in previous years were limited in scope: Regulators conceived of participation being restricted to banks, rather than commercial interests or consumers. 

"Over 1,000 Chinese companies have gotten ratings downgrades."

"But the whole point was for banks to eliminate the risk of their exposure, not to pass it around among themselves, so that stance made no sense," an anonymous executive in charge of risk management at a Shanghai-based fintech company who was a participant in those early discussions told the Financial Times. Still, with a limited history related to possibly perverse incentives, regulators have yet to announce the structure of this market and what government participation in it will look like.

Revival of old tools in anticipation of a new market
Simultaneously, brokerage firms operating in China have been pushing to allow for default hedging tools as an interim response to increased risk. On August 17, one such allowance was granted to China Securities Co. to sell credit-risk mitigation warrants, a Chinese version of credit-default swaps. The National Association of Financial Market Institutional Investors reported the approval, saying the underlying assets will be the senior tranche of Agricultural Bank of China Ltd.'s non-performing-loan-backed securities

"Credit risks are much higher than before," Chen Kang, a bond analyst at SWS Research Co. in Shanghai, told Bloomberg. "Both regulators and market participants are actively pushing for the new CDS to be launched."

These products, called Credit Risk Mitigation Warrants (CRMWs), debuted in the country in 2010, but largely went untapped – 2010 reportedly saw no defaults in the country, leading to not a single credit-default swap product being sold after 2011. China Securities said it would issue CRMWs with initial notional values of 800 million yuan ($120.03 million), according to Reuters.

Will these CDS products be able to stem the tide of growing risk uncertainty? It is difficult to say, made more so by the actions of regulators to restrict index futures trading following last summer's market crash. However, this is a fascinating evolution and shows signs that China's markets may more closely resemble western markets in years to come.

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