Derivatives: Beijing grapples with an inverted world


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The blow-up of corporate trades in China might lead to regulatory restraints on transparent, run-of-the-mill derivatives use.

When Jean-Claude Trichet, president of the European Central Bank, made a market-moving speech on June 5, the fortunes of Chinese companies were perhaps not at the forefront of his mind. Yet in another blow to the increasingly discredited theory that Asia’s markets are immune to troubles elsewhere in the world, Trichet’s comments sparked events that led to widespread losses among Chinese corporates and could yet have further troubling consequences.

Details of these losses were recently brought to light on the blog of Michael Pettis, a professor at Peking University’s Guanghua School of Management, and have been confirmed by traders interviewed by Euromoney. They are worried: the losses – although not sufficiently substantial to threaten a serious outbreak of corporate failures across China – have been widespread and the foreign banks fear the end of their lucrative China-related derivatives business if the regulators clamp down on such activities.

The trade in question is complex and the details vary according to the client. However, a simplified example will suffice. A Chinese company borrows from a Chinese bank and agrees to pay 8% on the loan. It then enters into an agreement with the bank in which the bank pays back a few percentage points, so long as the euro yield curve does not invert. The actual rate involves a multiplier dependent on dividing the number of days in the quarter by the number of those days in which the curve does not invert, a figure that past evidence suggests would always be one, since the curve was not then known for such inversion. The Chinese bank would then strip the option and sell it on to a foreign bank, which in turn would not usually be aware of the identity of the ultimate corporate client. The corporate gets cheaper funding, the Chinese bank makes money on the option and the foreign bank has the necessary skills to do likewise.

The problems began when unexpected comments from Trichet (following on from his US counterpart’s similar remarks) caused the curve on euro paper between two and 10 years to invert almost immediately by 60 to 70 basis points. That meant the multiplier in the transaction grew, meaning that instead of receiving a few percentage points back from their banks the Chinese corporates were now paying out an increasing amount as the curve inversion became more pronounced. A trade designed to reduce funding costs had achieved quite the opposite result.

The Chinese currency might be affected, since many of these contracts were modelled on the behaviour of the euro curve but actually paid out in renminbi, so that as the curve inverted the corporate took on a risk position in renminbi.

The euro curve has returned to normality in recent weeks but too late for the Chinese companies that bought in to this trade and too late for the banks that are reportedly having trouble getting the contracts honoured. There might be consequences for the relationships between the three parties involved in these transactions – the corporates, the leading Chinese banks, and the foreign banks – but the industry as a whole might be affected.

Traders at foreign banks fear that any regulatory crackdown as a result of these events will lead to restrictions on the legitimate use of transparent derivatives for hedging, as well as the employment of complex and seemingly innocent options that backfire spectacularly when the market throws up another of those "one in a million" events that seem so common these days.