Chinese capital markets mature
As Chinese capital markets continue to expand, a recent Calypso/Asia Risk survey indicates Chinese securities firms need improved derivatives risk management
Although the explosive growth in the Chinese economy started slowing in mid-2015, the Chinese capital markets have continued to expand. The biggest change is the proliferation of new derivatives brokerage firms – there are now about 20 different publicly traded Chinese securities houses in both Shanghai and Shenzhen.
These firms have attracted the attention of big global exchanges, as the prospect of greater connectivity focuses the minds of such players seeking to capitalize on the eventual opening of China’s capital account – an event that is expected to unleash a flood of outbound investor funds. Local governments are even getting in on the action, throwing up “hedge fund towns” similar to those in Greenwich, Connecticut.
The rapid liberalization of derivatives in China has spurred the development of an ecosystem of more aggressive traders that are willing to take greater risks to boost profits in a low interest rate and withered equity market environment. The result has been exponential growth in the use of derivatives for proprietary trading. In a recent Calypso survey of Chinese securities firms conducted with Asia Risk, 67% of respondents said they used derivatives for proprietary trading.
In addition, a substantial and growing portion of investment income for these firms is derived from proprietary trading. It accounted for 37% of total income in the first half of 2015, almost level with the 38% derived from brokerage. As recently as 2011, those proportions were 14% and 53% respectively, according to FT Confidential Research.
Lack of Integrated Risk Systems
The expansion of derivatives trading activity has certainly helped Chinese securities firms increase their revenues, but their risk management practices have not quite kept pace. In fact, according to the Asia Risk survey, only 18% of Chinese institutions reported taking an integrated approach to risk management, with just under 50% still heavily reliant on manual processing.
The widespread lack of front-to-back systems likely explains why the greatest concerns expressed in the survey are in the more complex area of OTC derivatives, where seven times as many respondents cited that asset class as an operational concern compared to those who saw no reason for concern.
OTC derivatives are also the area where the greatest risk management fears are voiced in China, with 89% of respondents indicating at least modest concern, and five times as many respondents expressing significant concern versus no concern.
The risk management fears are especially noteworthy given that in the next 12 months respondents predicted a fivefold increase in their interest rates derivatives trading activity and a sevenfold increase for FX derivatives.
The increased systemic risk from the current derivatives boom has not been lost on Chinese regulators. In November, the Securities Association of China announced it would ban brokerage firms from financing equity trading using derivatives, according to Bloomberg.1 Swaps offered by some brokerages have deviated from their role as a risk management tool, instead becoming a way to offer unofficial margin loans for investors, according to a government spokesperson.
“In the next 12 months respondents predicted a fivefold increase in their interest rate derivatives trading activity and a sevenfold increase for FX derivatives”
Increased Demand for Real-Time Risk Measurement
The next big structural change for Chinese brokerage firms is the requirement for mandatory central clearing. A joint consultation from the Hong Kong Monetary Authority and Securities and Futures Commission has led the way to a September 1, 2016 implementation date for Phase 1, which will focus on certain standardized IRS transactions between major dealers.2 Phase 2 is expected to come into play a year later, expanding to cover all OTC derivatives and widening the information needed. The result of this move is an increased need to manage collateral more efficiently – ideally in a real-time environment.
In addition to mandatory clearing, several other structural changes are in progress. ETF trading is now permissible in Hong Kong, though regulators have placed restrictions on participants to ensure market integrity is maintained. In mainland China, less stringent regulations give IPO candidates and their underwriters a bigger role in the process.
The overall picture is clear: an unsettled economic future, the emergence of new and more aggressive strategies, and a wave of pending regulation. While true cross-asset, real-time risk management is still a little way off, financial participants in China now realize that they must take action today, or face the consequences of driving while impaired on a dangerously fast and treacherous trading highway.
“Only 18% of Chinese institutions reported taking an integrated approach to risk management, with just under 50% still heavily reliant on manual processing”