The rise of corporate bond defaults and corporate downgrades has renewed calls for the establishment of a credit default swap (CDS) market in China. The People’s Bank of China appears poised to give the hedging scheme the go-ahead in the near future.
History of CDS
The CDS is an insurance type financial swap contract with a particular bond (or any securitized loan portfolio) as the underlying instrument. The buyer of a CDS makes payments to the seller in the life of the swap contract, and in the case of an underlying bond default (technically known as a credit event), the seller will pay the buyer of the CDS the insured swap amount and take over the bond ownership. In theory, the CDS is a type of credit risk transfer mechanism that passes the risk of the bond from the bond holder to the seller of the CDS. The CDS was introduced in the 1990s by J.P. Morgan. As The J.P. Morgan Guide to Credit Derivatives puts it:
“Consider a corporate bond, which represents a bundle of risks, including perhaps duration, convexity, callability, and credit risk. If the only way to adjust credit risk is to buy and sell that bond … there is a clear inefficiency. Fixed income derivatives introduced the ability to manage duration, convexity, and callability independently of bond position; credit derivatives (CDS) complete the process by allowing the independent management of default or credit spread risk.”
The CDS proved wildly popular, and on hindsight, perhaps too popular. The original intention of the CDS as a credit risk mitigation hedge mechanism had been subverted, and by the mid-2000s, banks and traders were using the CDS to bet on the future performance of various financial instruments, particularly mortgage securities. When the housing bubble burst and the value of mortgage securities began to drop, investors who had sold CDS protection on mortgage related securities suddenly found themselves on the hook for the immediate settlement of hundreds of billions of dollars to CDS buyers. The most prominent casualty of the CDS collapse was the mega-insurer, AIG. The company was eventually bailed out by the US government and the reputation of the CDS as a “financial weapon of mass destruction” was a buzzword at that time. The collapse of AIG and its subsequent rescue has been studied extensively and the Basel rules formulated subsequently have discouraged the use of the CDS by banks.
It is poignant to note that AIG was one of the most sophisticated and established insurers at the time of its collapse and its inability to prevent risk implosions from its CDS portfolio is a clear reminder of the potential destructive power and the unpredictability of meltdowns of new financial instruments. After 2008, new regulations effectively reduced the ability of big banks to deal in such products. In late 2008 the US government imposed a mandatory CDS position reporting requirement and central clearing at the Depository Trust and Clearing Corporation (DTCC). The market in single-named swap CDS not tied to indexes dropped to USD 686 billion in 2014 from more than USD 1.58 trillion in late 2008.
CDS in China
China has twice attempted to establish the CDS market. In 2010, the state-controlled and little-known National Association of Financial Market Institutional Investors (NAFMII) attempted to introduce the CDS in the credit risk mitigation (CRM) market, but it never took off. At the time, there were almost no bond defaults. Most borrowers and issuers in the capital market were state-owned enterprises (SOEs), and they enjoyed implicit government backing and generous support from the state-centric banking system under a benign macro-environment. There were no bond defaults and the market participants all viewed the CDS market as an easy and riskless way to collect premium income by selling such insurance. The market participants were limited to the banks and the one-sided trade simply floundered.
Now the situation is different. More private companies are issuing bonds, and in 2014 the government started allowing bond defaults. The number of defaults is rising. Even if most of the defaults by SOEs subsequently worked out, the bond market still remains jittery. As of mid-August 2016, 41 companies have defaulted on RMB 25.4 billion worth of bonds in 2016 and more than 1,000 ratings downgrades have happened in the past two months alone. The increasingly adverse credit events in the RMB 50 trillion (USD 7.5 trillion) bond market have increased calls for some kind of credit insurance scheme and CDS market has been favored by some financial market participants as the tool for the day.
Prospects for the CDS Market in China
If the contemplated new Chinese CDS market incorporates all the new safeguard measures introduced overseas after 2008, can it perform its designated role as a credit insurance instrument, as its proponents claim? Or will it metamorphose into another financial weapon of mass destruction under the perverse profit incentives available in the market? The answer depends on how the new CDS market will be set up and operated. However, current financial market conditions in China seem to argue against an optimistic prognosis.
First, the history of 2008 shows that it was not the credit quality of the underlying assets that ultimately killed AIG. Rather, it was the freezing of the financial markets in which the unprecedented bid-ask spreads of 10-20 percent in most bonds that caused the collapse of CDS market. It is a well-known fact that the collapse of AIG was not due to the credit quality of the underlying mortgages of its CDS holdings, but was instead due to its inability after credit froze to meet the margin calls on the huge CDS that it had underwritten. In fact, the US government was able to make money in its rescue of AIG after taking over the swapped assets underlying those CDS. The Chinese secondary bond market is still very inactive today in relation to its bond market size and is prone to market manipulation. The absence of an efficient secondary market and the propensity for margin call manipulation virtually makes the CDS market a potential “financial weapon of mass destruction” if it is introduced to the Chinese financial market.
Market participants should focus more on checking the credit fundamentals of bonds and eliminate quality issues, and these will be more effective than turning to CDS.
Second, the ability to issue CDS depends on the credit standing of the issuing financial institutions. It is a market reality in China today that most financial institutions with sufficient credit standing to issue CDS are state-owned financial institutions. If the CDS are designed to alleviate the bond holding risk of the state-owned banks, and the issuers of CDS are likely to be state-owned insurance companies, then the risk transfer is from one state-owned sector to another. The government must step in to rescue the CDS issuing state-owned insurance companies in case of large scale credit market volatility. There is hence no risk transfer as the state is both the seller and buyer of the CDS. There is evidence that credit quality often suffers when risk can be transferred away from the buyer of the bond to the seller of the CDS. The bond buyers will simply lower their guard against the credit quality of the bonds.
Third, credit information is one of the most asymmetric information in any market economy. The smooth operation of such a highly skewed market requires an enlightened supervisory agency, and the presence of an efficient credit information system is a precondition. At the moment, Chinese credit rating agencies are still far from providing the necessary credit information that a sophisticated document-based derivative market needs. Bond underwriting financial institutions are still the credit gate-keepers in China today, and the absence of a reliable third-party credit information provider just makes adverse selection in the CDS market a highly probable event.
Fourth, many recent events have shown the propensity for regulatory arbitrage among Chinese financial institutions and the increasing clamour for a single supervisory agency simply reflects such a reality in the market. While central clearing of CDS contracts and the amended Basel rules introduced overseas have controlled the risk appetites of banks and other financial institutions, the same will probably not hold true in China. The takeover battle of Vanke by the Baoneng Group and the recent imposition of limits on universal life selling by insurance companies highlight two serious regulatory issues facing the financial sector in China: the issue of financial sector regulatory arbitrage and incredible risk appetite of selected financial institutions.
Fifth, the existing market structure of the Chinese bond market sans derivatives like the CDS is working in some form to control bond credit risk. At the moment, the Chinese bond market is a short- and medium-term market, and very few issues run for more than 5 years. Duration control has effectively helped in limiting the credit risk of bonds. Bond-sponsoring banks are often also holding these bonds in their clients’ wealth management account. The current practice of the banks subscribing to bonds and acting as credit gatekeepers for these same bonds looks arcane but is effective in keeping credit standards. An available risk mitigating instrument like CDS might tempt banks to hand over their duty as credit gatekeepers and increase the overall risk of the system. The market participants should focus more on checking the inherent credit fundamentals of bonds and eliminate quality issues associated with these bonds, and these will be more effective in building a sound bond market than turning to credit enhancement measures like CDS.
Keys to Financial Derivative Market Development
In the financial sector, not all innovations work and the traditional way of evaluating credit by the four Cs (character, capital, capacity and conditions) remains important for the long-term soundness of credit. In fact, financial history is littered with many unsuccessful rather than successful products.
The smooth functioning of a credit derivative market relies on two key pillars: first is an efficient market structure that minimizes information asymmetry among participants, and the second is an alert regulator that can come out with timely rules to stop market participants from exploiting market loopholes for their personal gain and inadvertently push the financial market to the dangerous edge. A reform of credit information bureaus and the establishment of an efficient and uniform regulatory framework are probably the two most urgent tasks in the case of China if it wants to develop an efficient credit derivative market.
The issue of market manipulation and corruption is still very much on people’s minds when one discusses the issue of financial sector reform in China. Unless these concerns can be meaningfully addressed, the introduction of new financial instruments to the Chinese market could easily degenerate into an introduction of a “financial weapon of mass destruction.”