China bans OTC derivative lending for stock trades

Brokerages told to stop offering the products to investors for stock trading, the latest move to wind down leveraged financing in the country’s stock markets.

China’s securities regulator has ordered brokerages to stop offering financing to investors through total return swaps and other over-the-counter derivatives, the latest move to wind down margin financing in the country’s stock markets.

Total return swaps are a previously little-regulated business at Chinese brokerages, which easily enable investors to obtain margin financing to invest in listed and over-the-counter stocks.

Margin financing was a major factor in the year-long stock market rally that turned to a rout over the summer, wiping trillions of dollars of the year’s gains. The Shanghai Composite Index is now up more than 20% from its August lows.

“Some brokerages have been using the total return swaps to provide margin financing to clients for their stock trading. This deviates from their role as a risk management tool,” Zhang Xiaojun, a spokesman at the China Securities Regulatory Commission, said at a briefing on Friday.

He added that, for the sake of the market risk control, securities houses were no longer allowed to provide funding to their clients using OTC derivatives.

Meanwhile, the Securities Association of China, a self-regulatory organisation for China’s securities industry, on Sunday also ordered brokers not to issue new total return swaps or extend such business beyond existing arrangements. If clients are looking for margin lending, brokers can carry it out through the official channels of margin trading within the exchanges, it added.

According to a report by Caixin magazine, total return swaps can offer up to five-times leverage to investors as long as they pay a deposit to the broker and then a fixed interest rate on the expiration of the contract, to receive the full return from their stock trades.

Such business however set a high threshold for clients, requiring them to have net assets of at least Rmb20 million and financial assets of at least Rmb10 million. They also need to have at least two-year experience in securities investment, Caixin reported.

“If clients have abundant financial resources, they would prefer the total return swaps to borrow margin capital as they can invest in more equities. The stock pool is much bigger for them,” one Beijing-based fund manager at Citic Securities told FinanceAsia. The broker is so far the biggest player in the country’s swaps business.

“And brokers prefer this type of business too as it gives them more flexibility and freedom because the agreement is signed off-the-market,” the fund manager added.

Total return swaps were used during the stock market boom earlier this year. In the wake of the summer’s market rout, such business has been developing rapidly as Beijing moved to crack down on other main grey markets in margin finance.

As of the end of October, the OTC derivatives businesses of 39 domestic brokerages stood at Rmb279 billion ($44 billion), according to data from the Securities Association of China. Of that, return swaps accounted for 44%, while options contracts accounted for the remaining 56%.

By comparison, the amount of margin finance recorded by the association reached about Rmb1 trillion.

“Compared with margin finance, the scope of return-swap business isn’t massive. But Beijing couldn’t keep it under control if it’s off-the-market business,” said the fund manager at Citic Securities.

On Wednesday, the brokerage said it had overstated its OTC derivatives transactions by Rmb1.06 trillion ($166 billion) between April and September during the height of the stock market volatility, 26 times higher than the actual figure of about Rmb40 billion. It corrected the figure later and blamed a computer system upgrade for inaccurate reporting.

Meanwhile, Citic Securities, along with another two of the country’s largest brokerages by assets, Haitong Securities and Guosen Securities, announced this week they had been formally investigated by the CSRC for suspected violations of securities rules, according to filings with the mainland’s and Hong Kong’s bourses.

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